VALUATION OF BONDS

Parties in the Issuance of Bonds

1. Bondholder (creditor/lender)
2. Issuer (debtor; government or corporation)

Characteristics of Bonds

A. Common Characteristics
Maturity Date – January 31, 2032
Face Value – 1000
Coupon Interest Rate – 6%
Coupon Payment – 60

Example: CBM Corporation issued a 20 year, ₱1000 bond with a stated rate of 6% on January 31, 2012

B. Other Characteristics
1. Issued with Call Provision (Callable Bond)
– gives rights or privilege to the issuer to redeem the bond at a certain call price prior to its maturity
– normally attached to a corporate bond but not to a treasury bond.

The issuer may exercise the right to call the bond:

A. starting from issue date, or
B. 5 years after issuance (call protection)

 When to exercise its rights to call?

 if already exercisable (call protection expires)
 decline in the market interest rate which causes the value of the bond to appreciate

Interest rates and bond prices have an inverse relationship

What if market interest rates go up?

Now let's suppose that later that year, interest rates in general go up. If new bonds that cost $1,000 are paying
an 8% coupon—or $80 a year in interest—buyers will be reluctant to pay the $1,000 face value for your 7%
ABC Company bond. In order to sell, you'd have to offer your bond at a lower price—a discount—that would
enable it to generate approximately 8% to the new owner. In this case, that would mean a price of about
$875.1
What if market interest rates fall?

Similarly, if rates dropped to below your original coupon rate of 7%, your bond would be worth more than
$1,000. It would be priced at a premium, since it would be carrying a higher interest rate than what was
currently available on the market.

So in the event that the market interest rate significantly declines, it is more advantageous or cost-wise for the
issuer (debtor) to call the old bonds and replace them by new bonds at a lower interest rate.

 Will investor demand higher interest rate?

 Since the issuer will call the bond any time prior to its maturity provided that the right is exercisable
and the market interest rates declines, it will be detrimental to the long term investors who will
reinvest in a lower interest rate bond after the call made by the issuer (debtor). Higher risk is to be
borne by the investor in a callable bond than in non-callable bond which makes them demand a higher
interest rate.

2. Issued with Put Provision (Putable Bond)

– gives rights or privilege to the bondholder (creditor) to “put back” or require the issuer to repurchase the
said bond at a certain “put price” prior to maturity

 When to exercise its rights to put back?

 if already exercisable
 rise in the market interest rate

3. Issued with Convertible features

– gives the bondholders the right or option to convert the bond into number of shares of common stocks at a
predetermined price
– The coupon payment offered to a convertible bond is practically lower than those offered to a non-
convertible bond with the same credit risk.

4. Issued with Warrants

– gives the bondholder the right or option not to convert the bond but an option to buy shares of common
stock from a company at a predetermined price
– the bondholders have to pay in cash in order to exercise their rights provided by warrant.

FOUR FACTORS AFFECTING THE VALUATION OF BONDS

1. Coupon Interest Rate (simply, interest rate; stated rate)

– used to compute the peso amount of interest payment to be made by the issuer throughout the life of the
bond
– constant until the bond matures

2. Discount Rate (effective interest rate; required rate of return which is the min. acceptable rate for an
investor)
– used to compute the present value factors

3. Years until maturity

4. Face Value of the bond

CLASSIFICATION OF BONDS
Nonzero Coupon Bond – offers a stream of coupon interest payments during the life of the bond
Zero Coupon Bond – does not pay any interest at all

FORMULAS

Nonzero Coupon Bond

BV = PV Coupon Payment + PV Face Value

Zero Coupon Bond

BV = PV Face Value

Present Value of 1 = (1 + 𝑖) −𝑛
1 − (1 + 𝑖) −𝑛
Present Value of an ordinary annuity of 1 =
i

Discount Rate or YTM

Interpolation Process Formula
R1 − R2 P1 − P2
=
R1 − R3 P1 − P3
CP + [(Face Value − Bond Value)/t]
YTM =
Bond Value (0.6) + Face Value (0.4)

Callable Bond
CP + [(Call Price − Bond Price)/t]
YTC =
Bond Price (0.6) + Call Price (0.4)

Expected Total Returns on Bonds

ETR = CY + CG/ (L) Y

CP BPn − BPo
ETR = +
BPo BPo

ILLUSTRATIVE PROBLEMS

Illustrative Problem 6-1 for Nonzero Coupon Bond

What is the value of a fifteen-year (15), ₱1000 corporate bond with a stated rate of 10% per annum?

Assume that:
A. The bond of similar quality yields 10% rate.
B. The bond of similar quality yields 8% rate.
C. The bond of similar quality yields 12% rate.

Illustrative Problem 6-2 for Zero Coupon Bond

BlueBlurry Corporation issued a zero coupon bond with 15 years until maturity and a ₱1000 face value.
Determine the value of the bond if the discount rates (required rate of return) are as follows:

A. 8%
B. 9%

Illustrative Problem 6-3 for Discount Rate or Yield to Maturity

A ₱1000 ABCD Corporate bond was issued on January 1, 2018 with annual coupon interest rate of 8%. The
current market value of the bond is ₱935.82 and it matures in 10 years. Determine the discount rate or the
yield to maturity.

Illustrative Problem for Callable Bond

Assume that a 10-year callable bond has 12% coupon interest rate upon issuance and assume that it was
issued at ₱1000 par value. This bond is with call protection period of 4 years from issuance, meaning, the
issuer cannot call the bond from the issue date (year 0) until the end of fourth year (year 4). In the beginning
of year 5, the market interest rate falls from 12% to 10%. The call premium is 5%.

Illustrative Problem 6-4 for Yield to Call

CBA Corporation has bonds outstanding with ₱1000 face value and 10 years left until maturity. They have 12
annual coupon payments, and the current market value is ₱1120. These bonds can be called starting 5 years at
105% of the face value.

1. Determine the Yield to Maturity assuming the Corporation did not exercise its right to call.
2. Determine the Yield to Call assuming the Corporation call.

Illustrative Problem 6-3 for Expected Total Returns on Bonds

AMV purchased on January 1, 2017 a ₱1000 face value bond issued by CBM Corporation with 9% annual
coupon interest and 10 years to maturity for ₱950. If AMV sold the bond on January 1, 2018 for ₱970 to Wash
Sy Gorres, what is the total rate of return earned by AMV on the investment?