Characteristics of Bonds
Chapter 7 - Valuation and
Characteristics of Bonds
Bonds pay fixed coupon (interest)
payments at fixed intervals (usually
every six months) and pay the par
value at maturity.
2005, Pearson Prentice Hall
Example: AT&T 6 32
Characteristics of Bonds
Bonds pay fixed coupon (interest)
payments at fixed intervals (usually
every six months) and pay the par
value at maturity.
$I
$I
$I
$I
$I
$I+$M
...
Example: AT&T 6 32
or $65 per year ($32.50 every six months).
Maturity = 28 years (matures in 2032).
Issued by AT&T.
Types of Bonds
Par value = $1,000
Coupon = 6.5% or par value per year,
Debentures - unsecured bonds.
Subordinated debentures - unsecured
or $65 per year ($32.50 every six months).
Maturity = 28 years (matures in 2032).
Issued by AT&T.
Mortgage bonds - secured bonds.
Zeros - bonds that pay only par value at
$32.50
Par value = $1,000
Coupon = 6.5% or par value per year,
$32.50 $32.50 $32.50 $32.50 $32.50+$1000
28
junior debt.
maturity; no coupons.
Junk bonds - speculative or belowinvestment grade bonds; rated BB and
below. High-yield bonds.
Types of Bonds
Types of Bonds
Eurobonds - bonds denominated in
Eurobonds - bonds denominated in
one currency and sold in another
country. (Borrowing overseas.)
example - suppose Disney decides to sell
one currency and sold in another
country. (Borrowing overseas.)
example - suppose Disney decides to sell
$1,000 bonds in France. These are U.S.
denominated bonds trading in a foreign
country. Why do this?
$1,000 bonds in France. These are U.S.
denominated bonds trading in a foreign
country. Why do this?
If borrowing rates are lower in France.
Types of Bonds
Eurobonds - bonds denominated in
one currency and sold in another
country. (Borrowing overseas).
example - suppose Disney decides to sell
$1,000 bonds in France. These are U.S.
denominated bonds trading in a foreign
country. Why do this?
If borrowing rates are lower in France.
To avoid SEC regulations.
Value
Book value: value of an asset as shown on
a firms balance sheet; historical cost.
Liquidation value: amount that could be
received if an asset were sold individually.
Market value: observed value of an asset
in the marketplace; determined by supply
and demand.
Intrinsic value: economic or fair value of
an asset; the present value of the assets
expected future cash flows.
The Bond Indenture
The bond contract between the firm
and the trustee representing the
bondholders.
Lists all of the bonds features:
coupon, par value, maturity, etc.
Lists restrictive provisions which are
designed to protect bondholders.
Describes repayment provisions.
Security Valuation
In general, the intrinsic value of an
asset = the present value of the stream
of expected cash flows discounted at
an appropriate required rate of
return.
Can the intrinsic value of an asset
differ from its market value?
Valuation
n
V =
t=1
$Ct
(1 + k)t
Bond Valuation
Discount the bonds cash flows at
the investors required rate of
return.
Ct = cash flow to be received at time t.
k = the investors required rate of return.
V = the intrinsic value of the asset.
Bond Valuation
Discount the bonds cash flows at
Bond Valuation
Discount the bonds cash flows at
the investors required rate of
return.
the investors required rate of
return.
The coupon payment stream (an
annuity).
The coupon payment stream (an
annuity).
The par value payment (a single
sum).
Bond Valuation
n
Vb =
t=1
$It
$M
+
(1 + kb)n
(1 + kb)t
Vb = $It (PVIFA kb, n) + $M (PVIF kb, n)
Bond Example
Suppose our firm decides to issue 20-year
bonds with a par value of $1,000 and
annual coupon payments. The return on
other corporate bonds of similar risk is
currently 12%, so we decide to offer a 12%
coupon interest rate.
What would be a fair price for these
bonds?
120
120
120
...
1000
120
...
20
Bond Example
Mathematical Solution:
PV = PMT (PVIFA k, n ) + FV (PVIF k, n )
PV = 120 (PVIFA .12, 20 ) + 1000 (PVIF .12, 20 )
P/YR = 1
N = 20
I%YR = 12
FV = 1,000
PMT = 120
Solve PV = -$1,000
Note: If the coupon rate = discount
rate, the bond will sell for par value.
Bond Example
Bond Example
Mathematical Solution:
Mathematical Solution:
PV = PMT (PVIFA k, n ) + FV (PVIF k, n )
PV = 120 (PVIFA .12, 20 ) + 1000 (PVIF .12, 20 )
PV = PMT (PVIFA k, n ) + FV (PVIF k, n )
PV = 120 (PVIFA .12, 20 ) + 1000 (PVIF .12, 20 )
PV = PMT
1
1 - (1 + i)n
i
+ FV / (1 +
i)n
PV = PMT
PV =
1
1 - (1 + i)n
i
120 1 -
+ FV / (1 + i)n
1
(1.12 )20 + 1000/ (1.12) 20 = $1000
.12
Suppose interest rates fall
immediately after we issue the
bonds. The required return on
bonds of similar risk drops to 10%.
What would happen to the bonds
intrinsic value?
P/YR = 1
Mode = end
N = 20
I%YR = 10
PMT = 120
FV = 1000
Solve PV = -$1,170.27
Bond Example
P/YR = 1
Mode = end
N = 20
I%YR = 10
PMT = 120
FV = 1000
Solve PV = -$1,170.27
Mathematical Solution:
PV = PMT (PVIFA k, n ) + FV (PVIF k, n )
PV = 120 (PVIFA .10, 20 ) + 1000 (PVIF .10, 20 )
Note: If the coupon rate > discount rate,
the bond will sell for a premium.
Bond Example
Bond Example
Mathematical Solution:
Mathematical Solution:
PV = PMT (PVIFA k, n ) + FV (PVIF k, n )
PV = 120 (PVIFA .10, 20 ) + 1000 (PVIF .10, 20 )
PV = PMT (PVIFA k, n ) + FV (PVIF k, n )
PV = 120 (PVIFA .10, 20 ) + 1000 (PVIF .10, 20 )
PV = PMT
1
1 - (1 + i)n
i
+ FV / (1 +
i)n
PV = PMT
PV =
1
1 - (1 + i)n
i
120 1 -
+ FV / (1 + i)n
1
(1.10 )20 + 1000/ (1.10) 20 = $1,170.27
.10
Suppose interest rates rise
immediately after we issue the
bonds. The required return on
bonds of similar risk rises to 14%.
What would happen to the bonds
intrinsic value?
P/YR = 1
Mode = end
N = 20
I%YR = 14
PMT = 120
FV = 1000
Solve PV = -$867.54
P/YR = 1
Mode = end
N = 20
I%YR = 14
PMT = 120
FV = 1000
Solve PV = -$867.54
Bond Example
Mathematical Solution:
PV = PMT (PVIFA k, n ) + FV (PVIF k, n )
PV = 120 (PVIFA .14, 20 ) + 1000 (PVIF .14, 20 )
Note: If the coupon rate < discount rate,
the bond will sell for a discount.
Bond Example
Bond Example
Mathematical Solution:
Mathematical Solution:
PV = PMT (PVIFA k, n ) + FV (PVIF k, n )
PV = 120 (PVIFA .14, 20 ) + 1000 (PVIF .14, 20 )
PV = PMT (PVIFA k, n ) + FV (PVIF k, n )
PV = 120 (PVIFA .14, 20 ) + 1000 (PVIF .14, 20 )
PV = PMT
1
1 - (1 + i)n + FV / (1 + i)n
i
PV = PMT
PV =
1
1 - (1 + i)n + FV / (1 + i)n
i
120 1 -
1
(1.14 )20 + 1000/ (1.14) 20 = $867.54
.14
Suppose coupons are semi-annual
Bond Example
Mathematical Solution:
P/YR = 2
Mode = end
N = 40
I%YR = 14
PMT = 60
FV = 1000
Solve PV = -$866.68
PV = PMT (PVIFA k, n ) + FV (PVIF k, n )
PV = 60 (PVIFA .14, 20 ) + 1000 (PVIF .14, 20 )
Bond Example
Bond Example
Mathematical Solution:
Mathematical Solution:
PV = PMT (PVIFA k, n ) + FV (PVIF k, n )
PV = 60 (PVIFA .14, 20 ) + 1000 (PVIF .14, 20 )
PV = PMT (PVIFA k, n ) + FV (PVIF k, n )
PV = 60 (PVIFA .14, 20 ) + 1000 (PVIF .14, 20 )
PV = PMT
1
1 - (1 + i)n + FV / (1 + i)n
i
PV = PMT
PV =
1
1 - (1 + i)n + FV / (1 + i)n
i
60 1 -
1
(1.07 )40 + 1000 / (1.07) 40 = $866.68
.07
Yield To Maturity
Yield To Maturity
The expected rate of return on a
The expected rate of return on a
bond.
The rate of return investors earn on
a bond if they hold it to maturity.
bond.
The rate of return investors earn on
a bond if they hold it to maturity.
n
P0 =
t=1
YTM Example
Suppose we paid $898.90 for a
$1,000 par 10% coupon bond
with 8 years to maturity and
semi-annual coupon payments.
What is our yield to maturity?
$It
(1 + kb)t
$M
(1 + kb)n
YTM Example
P/YR = 2
Mode = end
N = 16
PV = -898.90
PMT = 50
FV = 1000
Solve I%YR = 12%
Bond Example
Bond Example
Mathematical Solution:
Mathematical Solution:
PV = PMT (PVIFA k, n ) + FV (PVIF k, n )
898.90 = 50 (PVIFA k, 16 ) + 1000 (PVIF k, 16 )
PV = PMT (PVIFA k, n ) + FV (PVIF k, n )
898.90 = 50 (PVIFA k, 16 ) + 1000 (PVIF k, 16 )
PV = PMT
Bond Example
1
1 - (1 + i)n
i
+ FV / (1 + i)n
Bond Example
Mathematical Solution:
Mathematical Solution:
PV = PMT (PVIFA k, n ) + FV (PVIF k, n )
898.90 = 50 (PVIFA k, 16 ) + 1000 (PVIF k, 16 )
PV = PMT (PVIFA k, n ) + FV (PVIF k, n )
898.90 = 50 (PVIFA k, 16 ) + 1000 (PVIF k, 16 )
PV = PMT
1
1 - (1 + i)n
i
1
898.90 = 50 1 - (1 + i )16
+ FV / (1 +
i)n
+ 1000 / (1 + i) 16
Zero Coupon Bonds
No coupon interest payments.
The bond holders return is
determined entirely by the
price discount.
PV = PMT
1
1 - (1 + i)n
i
1
898.90 = 50 1 - (1 + i )16
i
+ FV / (1 + i)n
+ 1000 / (1 + i) 16
solve using trial and error
Zero Example
Suppose you pay $508 for a zero
coupon bond that has 10 years
left to maturity.
What is your yield to maturity?
Zero Example
Zero Example
Suppose you pay $508 for a zero
P/YR = 1
Mode = End
N = 10
PV = -508
FV = 1000
Solve: I%YR = 7%
coupon bond that has 10 years
left to maturity.
What is your yield to maturity?
-$508
$1000
PV = -508
0
10
Zero Example
FV = 1000
Mathematical Solution:
PV = FV (PVIF i, n )
508 = 1000 (PVIF i, 10 )
.508 = (PVIF i, 10 ) [use PVIF table]
The Financial Pages: Corporate Bonds
Polaroid 11 1/2 06
395 59 3/4
Net
Chg
...
Solve: I/YR = 26.48%
Cur
Yld
Vol
...
20
Close
51 1/2
Net
Chg
+1
What is the yield to maturity for this bond?
FV = 1000,
Solve: I/YR = 4.24%
19.3
Close
P/YR = 2, N = 10, FV = 1000,
PV = $-597.50,
PMT = 57.50
The Financial Pages: Treasury Bonds
The Financial Pages: Corporate Bonds
P/YR = 1, N = 16,
PV = $-515,
PMT = 0
Vol
What is the yield to maturity for this bond?
PV = FV /(1 + i) 10
508 = 1000 /(1 + i)10
1.9685 = (1 + i)10
i = 7%
HewlPkd zr 17
Cur
Yld
10
Rate
9
Maturity
Mo/Yr
Nov 18
Bid
139:14
Asked
139:20
Chg
-34
What is the yield to maturity for this
Treasury bond? (assume 35 half years)
P/YR = 2, N = 35, FV = 1000,
PMT = 45,
PV = - 1,396.25 (139.625% of par)
Solve: I/YR = 5.457%
Ask
Yld
5.46
