A 1 2 3

Valuation of Bonds

4 Bonds are money loaned to corporations by investors. Bonds may be publicly traded, 5 usually in denominations of $1,000 principal. Publicly traded bonds usually make interest 6 payments twice a year, at the coupon rate which remains constant over the life of the bond. 7 Bonds may have a maturity of 10, 20, 30 or more years, and repay principal in full at maturity. 8 The value of a bond (or any financial asset) is the present value of the asset's expected future cash flows. The key inputs are (1) the expected cash flows and (2) the discount rate, which varies with the bond's risk, maturity, and other factors. Bonds can be analyzed in various ways. We will give 9 examples of these various ways below. 10 Bond valuation requires careful judgment regarding the riskiness of the bond, namely, what is the likelihood that the required payments of interest and principal will be made at the scheduled times? Also, investing in bonds requires implicit forecasts of future interest rates. For instance, we do not want to buy long-term bonds just before a sharp increase in interest rates. This spreadsheet does not deal with these important but subjective issues. Rather, it focuses on the actual calculations 11 used, given the inputs. 12 13 BOND VALUATION EXAMPLE A bond has a 20-year maturity, a 10% annual coupon, and a $1,000 par value. The required rate of return on the bond is 10%, given its risk, maturity, liquidity, and other interest rates in the economy. 14 What is a fair market price for the bond? 15 16 INPUT DATA 17 Years to Maturity 20 18 Coupon rate 10% 19 Annual interest $100 20 Par value $1,000 21 Required rate, rd 10% 22 23 Value of bond = ($1,000.00) Using the PV function. Note that the bond price is a negative number, 24 because it is a cash outflow to purchase the bond. Cash outflows are 25 entered as negative numbers in Excel functions. 26 This bond sells at its par value. That is always the case when the required rate of return is equal to 27 the coupon rate of interest. 28 What if the required rate of interest changed from 10%, falling or rising to a different level? How 29 would those changes affect the value of the bond? 30 We can set up a data table to show the bond's value at a range of rates. In other words, we can 31 show the sensitivity of the bond's market price to changes in interest rates. 32 Required 33 Positive Rate of 34 Bond Bond We need to convert 35 Return Value Value the bond values to 36 0% ($3,000.00) $3,000.00 positive amounts in order to plot them on the chart below.

A 37 38 39 40 41

B 5% 10% 15% 20%

C D ($1,623.11) $1,623.11 ($1,000.00) $1,000.00 $687.03 ($687.03) $513.04 ($513.04)

We need to convert the bond values to E F positive amounts in order to plot them on the chart below.

We can use the data table to construct a graph that shows the value of standard 10% annual 42 coupon, $1,000 face value bonds at a variety of interest rates. 43 44 45 $3,000.00 46 47 48 49 50 51 52 53 54 55 56 57 0% 58 59 60 61 62 YIELD TO MATURITY (YTM)

Bond Value

Value $

$1,623.11 $1,000.00 $687.03 5% 10% 15% $513.04 20%

Required Rate of Interest

The YTM is the rate of return that a bond earns if the issuer makes all required payments and the bond is held to maturity. The YTM is the same as the "required rate of return," or the return to investors if all promised payments are made. 63 64 65 EXAMPLE Suppose that you are offered a 16-year, 11% annual coupon, $1,000 par value bond at a price of 66 $1,344. What is the YTM of the bond? 67 68 Use the Rate function to solve the problem. 69 70 Years to Maturity 16 71 Coupon rate 11% 72 Annual interest $110.00 YTM = 7.29% 73 Current price $1,344.00 74 Par value = FV $1,000.00 75

76 77 78 YIELD TO CALL (YTC)

The YTM is valid only if (1) the probability of default is zero, and (2) the bond cannot be called. If there is any chance of default, then there is a chance some payments may not be made. In this case, the expected rate of return will be less than the promised YTM.

The YTC is the rate of return investors will receive if their bonds are called. If the issuer has the right to call the bonds, and if interest rates fall, then it would be logical for the issuer to call the bonds and replace them with new bonds that carry a lower coupon. The YTC is found similarly to the YTM. The same formula is used, but years to maturity is replaced with years to call, and the 79 maturity value is replaced with the call price. 80 81 EXAMPLE 82 83 84 85 86 87 88 89 90 91 Suppose that you are offered a 16-year, 11% annual coupon, $1,000 par value bond at a price of $1,344. This bond is callable in 10 years. What is the bond's YTC? (Note, this is the same bond as the previous question except it is callable.) Years to call: Coupon rate: Annual Pmt: Current price: Call price = FV Par value 10 11% $110.00 $1,344.00 $1,100.00 $1,000.00

YTC =

6.86%

Note that the YTC is less than the YTM. The investor is likely to earn the YTC, not the YTM. 92 Why? Because the company will probably call the bonds, since the YTM < the coupon rate. That means the company can issue new bonds at a lower coupon rate than the existing 93 bonds. With a lower coupon rate the company saves money. 94 95 96 CURRENT YIELD The current yield is the annual interest payment divided by the bond's current price. The current yield provides information regarding the amount of cash income that a bond will generate in a given 97 year. 98 99 EXAMPLE What is the current yield on a $1,000 par value, 11% annual coupon bond that is currently selling for 100 $1,100? 101 Simply divide the annual interest payment by the price of the bond. Even if the bond made 102 semiannual payments, we would still use the annual interest. 103 104 Par value $1,000.00 105 Coupon rate 11% Current Yield = 10.00% 106 Annual Payment $110.00 107 Current price $1,100.00 108

A B C D 109 110 111 CHANGES IN BOND VALUES OVER TIME

112 113 114 Required rate of interest 115 Face value 116 117 118 Years to Coupon rate = 119 Maturity Price 120 1 $963.64 121 3 $900.53 122 5 $848.37 123 7 $805.26 124 9 $769.64 125 11 $740.20 126 13 $715.87 127 15 $695.76 128

Changes in interest rates tend to take place over time, often gradually. A useful example is to examine how identical bonds (but for their coupon rates) will behave over time. In general, bonds approach their par values as they get closer to their date of maturity. 10.00% $1,000.00

BOND VALUES OVER TIME

6% Coupon rate = Price $1,000.00 $1,000.00 $1,000.00 $1,000.00 $1,000.00 $1,000.00 $1,000.00 $1,000.00 10% Coupon rate = Price $1,036.36 $1,099.47 $1,151.63 $1,194.74 $1,230.36 $1,259.80 $1,284.13 $1,304.24

A B C D E F G H I 129 130 Note: 131 1. As bonds approach their date of maturity, their market prices approach closer to par. 132 2. As coupon rates of interest become higher, bond prices are higher. 133 3. Bond prices are a function of coupon rates of interest, years to maturity and 134 the required rate of interest (assuming that there are no defaults or calls). 135 4. In the real world, the required rate of interest rises as perceived risk of default rises. 136 137 138 BONDS WITH SEMIANNUAL COUPONS Since most bonds pay interest semiannually, we now look at the valuation of semiannual bonds. We must make three modifications to our original valuation model: (1) divide the coupon payment by 2, (2) multiply the years to maturity by 2, and (3) divide the nominal interest rate by 2.

139 140 141 EXAMPLE What is the price of a 20-year, 12% semiannual coupon, $1,000 par value bond if the required rate of 142 interest is 8%? 143 144 Periods to maturity = 20 2 = 40 145 Coupon rate: 12% 146 Semiannual interest = $120/2 = $60.00 147 Periodic rate = 8%/2 = 4.0% 148 Current price: $1,395.86 Using the PV function 149 150 151

A B C D E F G H I 152 ASSESSING A BOND'S RISKINESS Interest rate risk is the risk of a drop in a bond's price due to an increase in the market required rate of interest. Bond price sensitivity to interest rates is greater (1) the longer the maturity and (2) the lower the coupon payment. Thus, if two bonds have the same coupon, the bond with the longer maturity will have more interest rate sensitivity, and if two bonds have the same maturity, the one 153 with the smaller coupon payment will have more interest rate sensitivity. 154 155 EXAMPLE Compare the interest rate risk of two bonds, both of which have a 11% annual coupon and a $1,000 156 face value. The first bond matures in 6 years, the second in 29 years. Required return is 10% 157 158 Coupon rate 11% 159 Interest payment $110.00 160 Par value $1,000.00 161 Years to Maturity 6 162 Required rate = rd 10% 163 164 Value of bond: $1,043.55 Using the PV function 165 First, we solve for the value of the 6-year bond, and then set up a 2-variable Data Table, where we let 166 both rd and years to maturity change, as shown below. 167 168 Required Market Price of the Bond Under Various Conditions 169 Interest Years to Maturity 170 Rate rd 6 10 15 20 25 30 171 0% $1,000.00 $1,000.00 $1,000.00 $1,000.00 $1,000.00 $1,000.00 172 5% $746.22 $613.91 $481.02 $376.89 $295.30 $231.38 173 10% $564.47 $385.54 $239.39 $148.64 $92.30 $57.31 174 15% $432.33 $247.18 $122.89 $61.10 $30.38 $15.10 175 20% $334.90 $161.51 $64.91 $26.08 $10.48 $4.21 176 We can show the prices of bonds by different maturities at various required rates of interest. See the chart below.

$800 $600 $400

Bond Price

177 178 179 180 181 182 183 184 185 186 187 188 189 190 191 192

Bond Prices
$1,200 $1,000

A 193 194

Bond Price

$400 $200

Examples of Bond Prices

1 A bond that matures in 10 years has a par value of $1,000, an annual coupon payment of $70, and a market interest rate of 8%. What is its price? Years to Maturity Annual Payment Par value Required rate, rd Value of bond = 10 $70 $1,000 8% $932.90

2 A bond that matures in 15 years has a par value of $1,000, an annual coupon of 12%, and a market interest rate of 7%. What is its price? Years to Maturity Coupon rate Annual Payment Par value Required rate, rd Value of bond = 3 15 12% $120 $1,000 7% $1,455.40

A zero coupon bond pays no interest until it matures in 20 years. It matures at par of $1,000. The required rate of interest is 9%. What is the price of this bond? 20 0% $0 $1,000 9% $178.43

Years to Maturity Coupon rate Annual Payment Par value Required rate, rd Value of bond =

4 The British government has bonds named consols. These bonds pay annual interest of say 8% but never mature. They have infinite life. The required rate of interest is 10%. What is the price of this perpetual consol bond? Years to Maturity Coupon rate Annual Payment Par value Required rate, rd Value of bond =

8% $80 $1,000 10% $800.00

Infinity

which is simply the annual interest of $80 divided by the 10% required rate of interest.

rest of say 8% but the price of this

ded by the 10% required

Examples of Bond Yields

James Enterprises bonds currently sell for $875. They have a 6-year maturity, an annual coupon of $100, and a par value of $1,000. What is their yield to maturity? Years to Maturity Annual Payment Current price Par value = FV YTM: The current yield? Annual Payment Current price Current yield: $100.00 $875.00 11.43% 6 $100.00 $875.00 $1,000.00 13.14%

Joyce Company bonds currently sell for $1,387. They pay a $130 annual coupon and have a 20year maturity, but they can be called in 5 years at $1,100. What is their YTM and their YTC? Years to Maturity Annual Payment Current price Par value = FV YTM 20 $130 $1,387 $1,000 8.82% Years to Call Annual Payment Current price Call price YTC 5 $130 $1,387 $1,100 5.68%

Which yield is more likely for investors to earn? YTM YTC More likely yield = YTC 8.82% 5.68% 5.68%