School of Business

Department of Banking and Finance

Business Finance – BFIN300

Chapter 7

Bonds and Their Valuation

Fall 2021 - 2022

BFIN300 - Chapter 7
Topics
• Key features of bonds
• Bond valuation
• Measuring yield
• Assessing risk

BFIN300 - Chapter 7
What is a bond?
 A long-term debt instrument in which
a borrower agrees to make payments
of principal and interest, on specific
dates, to the holders of the bond.

BFIN300 - Chapter 7 7-3

Bond markets
 Primarily traded in the over-the-counter (OTC) market.
 Most bonds are owned by and traded among large financial
institutions.
 Full information on bond trades in the OTC market is not
published, but a representative group of bonds is listed and
traded on the bond division of the NYSE.

BFIN300 - Chapter 7 7-4

Key Features of a Bond
 Par value (M) – face value of the bond, which is paid
at maturity (assume $1,000).
 Coupon interest rate (CR) – stated interest rate
(generally fixed) paid by the issuer. Multiply by par
to get dollar payment of interest.
 Maturity date (n) – years until the bond must be
repaid.
 Issue date – when the bond was issued.
 Yield to maturity (YTM) - rate of return earned on
a bond held until maturity (also called the “promised
yield”).

BFIN300 - Chapter 7 7-5

Callable bonds: Effect of a call
provision
 Allows issuer to refund the bond issue
if interest rates decline (helps the
issuer, but hurts the investor).
 Borrowers are willing to pay more,
and lenders require more, for
callable bonds.
 Most bonds have a deferred call and a
declining call premium.

BFIN300 - Chapter 7 7-6

 Other types (features) of bonds
 Convertible bond – may be exchanged for common stock
of the firm, at the holder’s option.
 Warrant – long-term option to buy a stated number of
shares of common stock at a specified price.
 Puttable bond – allows holder to sell the bond back to
the company prior to maturity.
 Income bond – pays interest only when interest is
earned by the firm.
 Indexed bond – interest rate paid is based upon the rate
of inflation.

BFIN300 - Chapter 7 7-7

The value of financial assets
0 1 2 n
k ...
Value CF1 CF2 CFn

CF1 CF2 CFn

Value  1
 2
 ...  n
(1  k) (1  k) (1  k)

BFIN300 - Chapter 7 7-8

Bond Valuation

0 1 2 n
Market interest (i)
...
VB = ? PMT PMT PMT + M

1
1− M
൫1 + 𝑖)𝑛 
VB = 𝑃𝑀𝑇
𝑖 (1  i ) n

BFIN300 - Chapter 7 7-9

What is the value of a 10-year, 10% annual
coupon bond, if kd = 10%?
𝑃𝑀𝑇 = 𝐶𝑅 × 𝑀
=0.1*1000
0 1 2 =$100 10
i
...
VB = ? 100 100 100 + 1000
1
1− 1000
൫1.1)10 
VB = 100 10
0.1 (1.1)
VB  $1,000

BFIN300 - Chapter 7 7-10

The price path of a bond
 What would happen to the value of this bond if
its required rate of return remained at 10%, or
VB at 13%, or at 7% until maturity?

1,372 kd = 7%.
1,211
kd = 10%.
1,000
837
775 kd = 13%.
Years
to Maturity
30 25 20 15 10 5 0
7-11
Bond values over time
 At maturity, the value of any bond must
equal its par value.
 If kd remains constant:
 The value of a premium bond would
decrease over time, until it reached
$1,000.
 The value of a discount bond would
increase over time, until it reached
$1,000.
 A value of a par bond stays at $1,000.

BFIN300 - Chapter 7 7-12

What is the YTM on a 10-year, 9%
annual coupon, $1,000 par value bond,
selling for $887?

𝑴 − 𝑽𝑩
𝑷𝑴𝑻 + ( ቁ
𝒀𝑻𝑴(𝐴𝑝𝑝𝑟𝑜𝑥𝑖𝑚𝑎𝑡𝑒) = 𝑵
𝑴 + 𝑽𝑩
𝟐
1000 − 887
90 + ( ቁ
𝑌𝑇𝑀 = 10
1000 + 887
2
𝑌𝑇𝑀 = 10.74%

BFIN300 - Chapter 7 7-13

Definitions
Annual coupon payment
Current yi eld (CY) 
Current price

Change in price
Capital gains yield (CGY) 
Beginning price

 Expected  Expected
Expected total return  YTM      
 CY   CGY 
BFIN300 - Chapter 7 7-14
An example:
Current and capital gains yield
 Find the current yield and the capital
gains yield for a 10-year, 9% annual
coupon bond that sells for $887, and
has a face value of $1,000.

Current yield = $90 / $887

= 0.1015 = 10.15%

BFIN300 - Chapter 7 7-15

Calculating capital gains yield
YTM = Current yield + Capital gains yield

CGY = YTM – CY
= 10.91% - 10.15%
= 0.76%

Could also find the expected price one year from now and divide
the change in price by the beginning price, which gives the
same answer.
BFIN300 - Chapter 7 7-16
What is interest rate (or price) risk?
 Interest rate risk is the concern that rising kd
will cause the value of a bond to fall.

% change 1 yr kd 10yr % change

+4.8% $1,048 5% $1,386 +38.6%
$1,000 10% $1,000
-4.4% $956 15% $749 -25.1%

The 10-year bond is more sensitive to interest

rate changes, and hence has more interest rate
risk.
BFIN300 - Chapter 7 7-17
What is reinvestment rate risk?
 Reinvestment rate risk is the concern that kd
will fall, and future CFs will have to be
reinvested at lower rates, hence reducing
income.

EXAMPLE: Suppose you just won

$500,000 playing the lottery. You
intend to invest the money and
live off the interest.
BFIN300 - Chapter 7 7-18
 Semiannual bonds
1. Multiply years by 2 :
Number of periods = 2 * n.

2. Divide nominal rate by 2 :

Periodic rate = YTM / 2.

3. Divide annual coupon by 2 :

PMT = annual coupon / 2.

BFIN300 - Chapter 7 7-19

 What is the value of a 10-year, 10%
semiannual coupon bond, if kd = 13%?

1. Multiply years by 2 : N = 2 * 10 = 20.

2. Divide nominal rate by 2 : I/YR = 13 / 2 = 6.5.
3. Divide annual coupon by 2 : PMT = 100 / 2 = 50.

INPUTS 20 6.5 50 1000

N YTM PV PMT M
OUTPUT -834.72

BFIN300 - Chapter 7 7-20

What is the Yield to Call (YTC) on a 10-year, 9%
annual coupon, $1,000 par value bond, selling for
$887? Call price=$1,050 and call date is 5 years

𝒄𝒂𝒍𝒍 𝒑𝒓𝒊𝒄𝒆 − 𝑽𝑩
𝑷𝑴𝑻 + ( ൰
𝒄𝒂𝒍𝒍 𝑫𝒂𝒕𝒆
𝒀𝑻𝑪 =
𝒄𝒂𝒍𝒍 𝒑𝒓𝒊𝒄𝒆 + 𝑽𝑩
𝟐

1050 − 887
90 + ( ൰
5
𝑌𝑇𝐶 =
1050 + 887
2

𝑌𝑇𝐶 = 12.66%

BFIN300 - Chapter 7 7-21

When is a call more likely to occur?

 In general, if a bond sells at a premium, then coupon

rate > YTM, and a call is more likely.
 So, expect to earn:
 YTC on premium bonds.
 YTM on par & discount bonds.

BFIN300 - Chapter 7 7-22

Default risk
 If an issuer defaults, investors receive
less than the promised return.
Therefore, the expected return on
corporate and municipal bonds is less
than the promised return.
 Influenced by the issuer’s financial
strength and the terms of the bond
contract.

BFIN300 - Chapter 7 7-23

Types of bonds
 Mortgage bonds
 Debentures
 Subordinated debentures
 Investment-grade bonds
 Junk bonds

BFIN300 - Chapter 7 7-24

Evaluating default risk:
Bond ratings
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 are designed to reflect the

probability of a bond issue going into
default.

BFIN300 - Chapter 7 7-25

Factors affecting default risk and bond ratings
 Financial performance
 Debt ratio
 TIE ratio
 Current ratio
 Bond contract provisions
 Secured vs. Unsecured debt
 Senior vs. subordinated debt
 Guarantee and sinking fund provisions
 Debt maturity
BFIN300 - Chapter 7 7-26
Priority of claims in liquidation
1. Secured creditors from sales of
secured assets.
2. Trustee’s costs
3. Wages, subject to limits
4. Taxes
5. Unfunded pension liabilities
6. Unsecured creditors
7. Preferred stock
8. Common stock
BFIN300 - Chapter 7 7-27