Bond Valuation

 1. Definition and Example of a Bond

2. How to Value Bonds
3. Bond Concepts

Asset or Security Valuation Principles
• General Principle:
– Value of any asset or financial securities = PV
of expected future cash flows discounted at
an appropriate risk adjusted rate of return.
• To value an asset we need to:
– Estimate future cash flows:
• Size (how much) and
• Timing (when)
– Appropriate discount rate- The rate should
be appropriate to the risk presented
by the security.
–
 Financial Asset Valuation

0 1 2 n
r
...

Value CF1 CF2 CFn

CF1 CF2 CFn

PV = + + . .. + .
(1+ r )1
(1 + r )2
(1+ r )n
 Bonds and Bond Valuation
• A bond is a legally binding agreement
between a borrower and a lender that
specifies the:
– Par (face) value
– Coupon rate
– Coupon payment
– Maturity Date
• The yield to maturity is the required
market interest rate on the bond.

 Bond Valuation

• Bond value is, therefore, determined by

the present value of the coupon
payments and par value.
• Interest rates are inversely related to
present (i.e., bond) values.
 How to Value Bonds
• Identify the size and timing of cash flows.
• Discount at the correct discount rate.
– If you know the price of a bond and the
size and timing of cash flows, the yield to
maturity is the discount rate.
 Pure Discount Bonds
Information needed for valuing pure discount


bonds:
– Time to maturity (T) = Maturity date
– Face value (F)
– Discount rate (r)

$0 $0 $0 $F

0 1 2 T −1 T
Present value of a pure discount bond at time 0:
F
PV =
(1 + r )T
Pure Discount Bonds: Example
Find the value of a 30-year zero-coupon


bond with a $1,000 par value and a

YTM of 6%.


$0 $0 $0 $1,000 0$ ,1$0

01 30229
0


0 1 2 29 30

F $1,000
PV = = = $174.11
(1 + r ) T
(1.06) 30
 Level-Coupon Bonds
Information needed to value level-coupon bonds:


– Coupon payment dates and time to maturity (T)

– Coupon payment (C) per period and Face
value (F)
– Discount rate
$C $C $C $C + $ F

0 1 2 T −1 T
Value of a Level-coupon bond= PV of coupon payment annuity + PV of face value

C 1  F
PV = 1 − T 
+
r  (1 + r )  (1 + r )T
 Example of a Bond Value
• Consider a U.S. government bond listed as
 6 3/8 of December 2001.
– The Par Value of the bond is $1,000.
– Coupon payments are made semi-annually (June 30 and
December 31 for this particular bond).
– Since the coupon rate is 6 3/8 the payment is $31.875.
– On January 1, 2002 the size and timing of cash flows are:

$31.875 $31.875 $31.875 $1,031.875


1 / 1 / 02 6 / 30 / 02 12 / 31 / 02 6 / 30 / 09 12 / 31 / 09
 Level-Coupon Bonds: Example
Find the present value (as of January 1, 2002), of a 6-3/8


coupon T-bond with semi-annual payments, and a maturity

date of December 2009 if the YTM is 5-percent.
– On January 1, 2002 the size and timing of cash flows
are:

$31.875 $31.875 $31.875 $1,031.875


1 / 1 / 02 6 / 30 / 02 12 / 31 / 02 6 / 30 / 09 12 / 31 / 09

$31.875  1  $1,000
PV = 1 − 16 
+ 16
= $1,087.75
.05 2  (1.025)  (1.025)
 Example of Bond valuation for different
Yields
• Suppose a bond was issued 20 years ago
and now has 10 years to maturity.
Assume a10% coupon payment paid
annually with a par value of $1,000.
What would happen to its value over
time if the required rate of return (yield-
to-maturity) is 10%, 13%, or 7%?
Example of Bond valuation for different Yields

At 10% discount rate, the value is:

PV coupon payment $= 614.46

PV par value = 385.54
Value of bond $1,000.00
=

INPUT
S 10 10 100 1000
N I/YR PV PMT FV
OUTP -1,000
UT
What would happen if the discount rate is
13%?

INPUT
S 10 13 100 1000
N I/YR PV PMT FV
OUTP -837.21
UT

When discount rate rises, above the

coupon rate, the bond’s value falls
below par, so it sells at a discount.
What would happen if discount
rate is at 7%?

INPUT
S 10 7 100 1000
N I/YR PV PMT FV
OUTP -1,210.71
UT

If coupon rate > discount rate, price

rises above par, and bond sells at a
premium.
Bond Value ($) vs. Years remaining to
Maturity

1,372 r = 7%.
1,211

r = 10%. M
1,000

837 r = 13%.
775

30 25 20 15 10 5 0
 Bond Concepts
1. Bond prices and market interest rates move in opposite
directions.
2.
2. When coupon rate = YTM, price = par value.
 When coupon rate > YTM, price > par value (premium
bond)
 When coupon rate < YTM, price < par value (discount
bond)

 YTM and Bond Value
$1400

When the YTM < coupon, the bond

Bond Value

1300 trades at a premium.

1200

1100 When the YTM = coupon, the

bond trades at par.
1000

800
0 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09 0.1
6 3/8 Discount Rate
When the YTM > coupon, the bond trades at a discount.
 Determinants of Bond Price Volatility

• The maturity effect

– The longer the time to maturity, the greater
a bond’s price sensitivity
– Price volatility increases at a decreasing
rate with maturity
• The coupon effect
– The greater the coupon rate, the lower a
bond’s price sensitivity
 Determinants of Bond Price Volatility

• The yield level effect

– For the same change in basis point yield,
there is greater price sensitivity of lower
yield bonds
• Some trading implications
– If the interest rate forecast is for lower
rates, invest in bonds with the greatest
price sensitivity, and do the opposite if
we expect higher interest rates
Maturity and Bond Price Volatility
Bond Value
Consider two otherwise identical bonds.
The long-maturity bond will have much more
volatility with respect to changes in the
discount rate

Par

Short Maturity Bond

C Discount Rate
Long Maturity
Bond
Coupon Rate and Bond Price Volatility
Bond Value Consider two otherwise identical bonds.
The low-coupon bond will have much more
volatility with respect to changes in the
discount rate

High Coupon Bond

Discount Rate
Low Coupon Bond
 Determinants of Bond Price Volatility
 Five bond relationships:
1. Bond prices move inversely to bond yields (interest rates)
2. For a given change in yields, longer maturity bonds post larger
price
 changes, thus bond price volatility is directly related to maturity
3. Price volatility increases at a diminishing rate as term to
maturity
 Increases
4. Price movements resulting from equal absolute increases or
decrease in yield are not symmetrical
5. Higher coupon issues show smaller percentage price
fluctuation for a given change in yield, thus bond price volatility is
inversely related to coupon
 Determinants of Bond Price Volatility

• The Duration Measure

– Since price volatility of a bond varies
inversely with its coupon and directly with
its term to maturity, it is necessary to
determine the best combination of these
two variables to achieve objective
– A composite measure considering both
coupon and maturity would be beneficial,
and that’s what this measure provides
Determinants of Bond Price Volatility
T Ct (t ) T ( Par )
∑ +
t =1 (1 + R ) t (1 + R )T
D=
T Ct ( Par )
∑ +
t =1 (1 + R ) t (1 + R )T

Developed by Frederick R. Macaulay,1938

Where:

t = time period in which the coupon or principal payment occurs

C = interest or principal payment that occurs in period t

t
R= yield to maturity on the bond

 Determinants of Bond Price Volatility

• Characteristics of Macaulay Duration

– Duration of a bond with coupons is always less
than its term to maturity because duration gives
weight to these interim payments
• A zero-coupon bond’s duration equals its maturity
– There is an inverse relation between duration and
the coupon rate
– A positive relation between term to maturity and
duration, but duration increases at a decreasing
rate with maturity
 Determinants of Bond Price Volatility

• Characteristics of Macaulay Duration

– There is an inverse relation between YTM
and duration
– Sinking funds and call provisions can have
a dramatic effect on a bond’s duration
 Duration and Bond Price Volatility

• An adjusted measure of duration can be

used to approximate the price volatility
of a bond
Macaulay duration
Modified duration =
R
1+
Where: m
m = number of payments a year
R = nominal YTM
 Duration and Bond Price Volatility
 Bond price movements will vary
proportionally with modified duration for
small changes in yields:

∆P
× 100 = − Dmod × ∆R
Where:
P
P = change in price for the bond
P = beginning price for the bond
Dmod = the modified duration of the bond
Ym = yield change in basis points divided by 100
 Trading Strategies Using Duration

• Longest-duration security provides the maximum

price variation
– If you expect a decline in interest rates, increase
the average duration of your bond portfolio to
experience maximum price volatility
– If you expect an increase in interest rates, reduce
the average duration to minimize your price
decline
• Duration of a portfolio is the market-value-
weighted average of the duration of the
individual bonds in the portfolio
 Semiannual Bonds

1. Multiply years by 2 to get periods = 2n.

2. Divide nominal rate by 2 to get periodic
rate = r/2.
3. Divide annual INT by 2 to get PMT =
INT/2.
INPUT
S 2n r/2 OK INT/2 OK
N I/YR PV PMT FV
OUTP
UT
Value of 10-year, 10% coupon,
semiannual bond if r = 13%.

INPUT 2(10) 13/2 100/2

S 20 6.5 50 1000
N I/YR PV PMT FV
OUTP -834.72
UT
 Rate of Return on a Bond

Annual coupon pmt

Current yield = Current price

Capital gains yield = Change in price

Beginning price

Exp total = YTM = Exp + Exp cap

return Curr yld gains yld
r = r* + IP + DRP + LP + MRP.

Here:


 r = Required rate of return on a debt

security.
 r* = Real risk-free rate.
 IP = Inflation premium.
DRP = Default risk premium.
 LP = Liquidity premium.
MRP = Maturity risk premium.
 What is the nominal risk-free
rate?
• rRF = (1+r*)(1+IP)-1
 = r*+ IP + (r*xIP)
 ≈ r*+ IP. (Because r*xIP is small)
• rRF = Rate on Treasury securities.
 Bond Ratings Provide
One Measure of Default Risk
Investment Grade Junk Bonds

Moody’s Aaa Aa A Baa Ba B Caa C

S&P AAA AA A BBB BB B CCC D

 Bond Ratings and Bond
Spreads (YahooFinance, 2006)
Long-term Bonds Yield Spread
U.S. Treasury 5.25%
AAA 6.26 1.01%
AA 6.42 1.17
A 6.54 1.29
BBB 6.60 1.35
BB 7.80 2.55
B 8.42 3.17
CCC 10.53 5.28
 What factors affect default risk
and bond ratings?
• Financial performance
– Debt ratio
– Coverage ratios, such as interest coverage
ratio or EBITDA coverage ratio
– Current ratios

(More…)
What factors affect default risk and
bond ratings?
• Other factors
– Earnings stability
– Regulatory environment
– Potential product liability
– Accounting policies
 The Maturity Risk Premium
• Long-term bonds: High interest rate risk, low
reinvestment rate risk.
• Short-term bonds: Low interest rate risk, high
reinvestment rate risk.
• Nothing is riskless!
• Yields on longer term bonds usually are greater
than on shorter term bonds, so the MRP is
more affected by interest rate risk than by
reinvestment rate risk.
 Term Structure Yield Curve
• Term structure of interest rates: the
relationship between interest rates (or
yields) and maturities.
• A graph of the term structure is called the
yield curve.
 Hypothetical Treasury Yield
Curve
14%
12%
I nterest Rate

10%
8% MRP
IP
6%
r*
4%
2%
0% 13

15

17
1

9
11

19
Years to Maturity