Valuation of Bonds

The face amount of a typical bond is $1,000. The market value of the bond could be more than $1,000,
and then it is selling at a premium. A bond with a market value less than $1,000 is selling at a discount,
and a bond, which is priced at its face value, is selling at par. The market price of a bond is usually
quoted as a percentage of its face value. For instance, a bond selling at 95 is really selling at 95% of its
face value, or $950. Figure 3.2 shows an advertisement that appeared in the Wall Street Journal of July
23, 1997. Dynex Capital, Inc. issued bonds with a total face value of $100 million in July 1997. The bonds
carried a coupon of 77/8%. This means that each bond pays $78.75 in interest every year. Actually, half
of this interest is paid every six months. The bonds will mature after 5 years, which is relatively short
time for bonds. They are senior notes in the sense that the interest on these bonds will be paid ahead of
some other junior notes. This makes the bonds relatively safer.

The price of these bonds is $999 for each $1,000 bond. Occasionally, the corporations may reduce the
price of a bond and sell them at a discount from their face value. This is true if the coupon is less than
the prevailing interest rates, or if the financial condition of the company is not too strong. The buyer
must also pay the accrued interest on the bond. If an investor buys the bond on July 25, 1997, he must
pay accrued interest for 10 days. When the bonds are publicly traded, they will be listed as “Dynex
77/8s02.” The information about the bonds is frequently displayed as: Madison Company 4.75s33. We
learn to interpret it as follows:

Madison Company: This is the name of the entity that issues the bonds

4.75: This is the coupon rate, or the annual rate of interest paid on the bonds, that is 4.75% per annum

s: This is just a separator between the two numbers

33: This is the year when the bond will mature, namely, 2033

The two companies listed at the bottom of the advertisement, Paine Webber Incorporated and Smith
Barney Incorporated, are the underwriters for this issue. Underwriters, or investment banking firms,
such as Merrill Lynch, will take a certain commission for selling the entire issue to the public.

Since the appearance of this advertisement, several changes have occurred. On November 3, 2000,
Paine Webber merged with UBS AG, a Swiss banking conglomerate. Smith Barney is now part of Morgan
Stanley Smith Barney. Corporations no longer use fractions in identifying the coupon rates, instead
decimals are used universally.

An important feature of every bond issue is the indenture. The indenture is a detailed legal contract
between the bondholders and the corporation that spells out the rights and obligations of both parties.
In particular, it gives the bondholders the right to sue the company and force it into bankruptcy, if the
company fails to pay the interest payments on time. This provides safety to the bondholders, and puts
serious responsibility on the corporation.

The two factors that determine the interest rate of a bond are the creditworthiness of the corporation
and the prevailing interest rates in the market. A company that is doing well financially, and has good
prospects in the future, will have to pay a lower rate of interest to sell bonds. A company that is close to
bankruptcy will have a hard time selling its bonds, and must attach a high coupon rate to attract the
investors.
The term sinking fund describes the amount of money that a company puts aside to retire its bonds. For
example, a company issues bonds with face value $50 million, which will mature in 20 years. During the
last five years of their existence, the company may set aside $10 million per year to buy back, or retire
their bonds. This $10 million is the sinking fund payment. This procedure spreads the loan repayment
over a five-year period and is easier for the company to manage.

To retire the bonds, the corporation may buy the bonds in open market if they are selling below par. The
corporation may also call the bonds, depending on the provisions of the indenture, by paying the more
than the face value of the bonds to the bondholders. Such bonds are called callable bonds.

We can evaluate a bond by finding the present value of the interest payments and that of the principal.
The proper discount rate that calculates the present value depends on the risk of the bonds. The risky
bonds have a relatively higher discount rate. Further, the discount rate is also the rate of return required
by an investor buying that bond. The basic financial principle is:

The present value of a bond is simply the present value of all future cash flows from the bond,
properly discounted.

We may express the above statement as follows

The first term on the right side is the present value of the coupon payments, or the interest payments in
dollars. The second term is the present value of the face amount of the bond in dollars.

Perpetual bonds have an infinite life span. In essence, they are perpetuities. The bondholders continue
to receive interest payments and if they want to, they can always sell the bonds to other investors. Since
the bond is never going to mature, the implicit assumption is that the investors will never receive the
face amount of such a bond.

Some companies try to conserve cash and they may sell zero-coupon bonds. These bonds make no
periodic interest payments and they pay the entire accumulated interest and the principal at the
maturity of the bond. Because of this feature, these bonds sell at a substantial discount from their face
value. For instance, General Motors issued zero coupon bonds in 1996 due to mature in 2036. In January
2007, these bonds were selling at 38.11, or $381.10 per $1000 bond. For zero-coupon bonds, the first
term in (3.1) is zero because C is zero. This leaves only the second term for the valuation of zero-coupon
bonds as follows:

Occasionally, a company may issue convertible bonds. A bondholder, at his discretion, can exchange a
convertible bond for a fixed number of shares of stock of the corporation. For example, the bondholder
may get 50 shares of stock by giving up the bond. If the price of the stock is $10 a share, then the
conversion value of the bond will be $500, that is, the bond can be converted into $500 worth of stock.
The market value of the bond will always be more than the conversion value. If the price per share rises
to $25, then the price of the bond will be at least 50(25) = $1250. Thus, the convertible bonds are
occasionally trading above their face value.
At times, the financial health of a company deteriorates quite a bit. The company may even stop paying
interest on the bonds, and there is little hope of recovery of principal of these bonds. Such bonds, with
extremely high investment risk, are frequently labeled as "junk" bonds. An investor buys a bond for its
rate of return, or its yield. We define the current yield, y, of a bond as follows.

The annual interest payment of the bond equals cF, where c is the coupon rate, and F is the face value of
the bond. With B being the market value of the bond, we may write

This represents the return on the investment provided the bond is held for a short period.

Holding a bond to maturity, one receives money in the form of interest payments, plus there is a change
in the value of the bond. The annual interest payment of the bond is cF, as seen before. If you have
bought the bond at a discount, it will rise in value reaching its face value at maturity. Or, the bond may
drop in price if it has been bought at a premium. In any case, it should be selling for its face value at
maturity. The total price change for the bond is F − B, where F is the face value of a bond and B is its
purchase price. This change may be positive or negative depending upon whether F is more, or less,
than B. On the average, the price change per year is (F − B)/n, where n is the number of years until
maturity. On the average, the price of the bond for the holding period is (F + B)/2. Thus the yield Y, of a
bond is given, approximately, by dividing the annual return by the average price. This is given by:

Let us define b as the market value of the bond expressed as a fraction of its face value. For
instance, if a bond is selling at 90% of its face value, or $900 per $1000 bond, then b = .9. With this
definition, it is possible to write (3.5) as

For a bond selling at par, b = 1, meaning the bond is selling at its face value. In that case, (3.5a) gives
Y = c.

In equation (3.1), the discount rate r is also equal to the yield to maturity, Y. The reason for the
approximation in the equation (3.5) is that the value of a bond does not reach the face amount
linearly with time, as seen in Figure 3.3.

Consider a bond that has 8% coupon, pays interest semiannually, and will mature after 10 years.
Assume that the investors require 10% return on these bonds. Then the current value of the bond is
As the bond approaches maturity, its value reaches $1,000. This is shown in Fig. 3.3. Notice that the
curve is not a straight line. The bond value rises slowly at first and then more rapidly when it is close
to maturity

Table 3.4 shows a sampling of bonds available in the market in January 2007. They are arranged in
terms of their quality rating, the least risky bonds are the top and the riskiest ones at the bottom.

Normally, when a buyer buys a bond he has to pay the accrued interest on the bond. This is the
interest earned by the bond since the last interest payment date. Occasionally some bonds trade
without the accrued interest and they are thus dealt in flat. Some corporations gradually get deeper in
financial trouble. As they come closer to bankruptcy, their bonds lose their value drastically. Finally,
they become junk bonds.

Examples

3.1. An investor wants to buy a bond with face value $1,000 and coupon rate 12%. It pays interest
semiannually and it will mature after 5 years. If her required rate of return is 18%, how much should
she pay for the bond?
The present value of a bond is the sum of the present value of its interest payments plus the present
value of its face value. The annual interest on the bonds is .12(1000) = $120, and thus the semiannual
interest payment is $60. The annual required rate is 18%, or 9% semiannually. This is the discount
rate. There are 10 semiannual periods in 5 years. Put n = 10, r = .09, F = 1000 in (3.1), which gives
She should pay $807.47 for the bond.

3.2. American Airlines bonds pay interest on January 15 and July 15, and they will mature on July
15, 2017. Their coupon rate is 11%. Because of the risk characteristics of American Airlines, you
require a return of 15% annually on these bonds. How much should you pay for a $1,000 bond on
January 16, 2011?
The bonds will mature in 6.5 years and you will receive 13 interest payments of $55 each. obtained
by setting n = 13, r = .075, F = 1000 in (3.1), which gives the PV of these interest payments, plus the
discounted face value as

3.3. A zero coupon bond with face value $1,000 and 6.25 years until maturity is available in the
market. Because of its risk characteristics, you require a 11.5% return, compounded annually, on this
bond. How much should you pay for it?

3.4. Canopus Corporation's 9% coupon bonds pay interest semiannually, and they will mature in 10
years. You pay 30% tax on interest income, but only 15% on capital gains. Your after-tax required
rate of return is 12%. Assume that you pay taxes once a year. What is the maximum price you are
willing to pay for a $1,000 Canopus bond?

Suppose you pay x dollars for a $1,000 bond. The annual interest is $90; or $45 every six months.
For semiannual cash flows, the discount rate is 6%, which is one-half of the annual required rate of
return. In ten years, you will get 20 semiannual payments.

The annual tax on $90 interest income is .3(90) = $27.

After 10 years, you receive the face value of bond, $1,000, and you have a capital gain of (1000–x).
However, you have to pay tax on the capital gain, which comes to (.15)(1000–x) = 150 – .15x. The
after-tax amount is thus 1000–(150 – .15x) = 850 + .15x.

Apply the financial principle:

3.5. You have bought a $1,000 bond for $450, with a coupon of 5%, which has 10 years until
maturity. The interest is paid semiannually. Find the yield to maturity for this bond.

3.6. Bareilly Corporation bonds will mature after 3 years, and carry a coupon rate of 12%. They pay
interest semiannually. However, due to poor financial condition of the company, you believe that
there is a 30% probability Bareilly will go bankrupt in any given year. In case of bankruptcy, you
expect that the company will make the interest payments for that year, and also pay only 20% of the
principal at the end of that year. If your required rate of return is 12%, find the value of this bond.

Organize the calculation as follows.

3.7. Compton Company bonds pay interest semiannually, and they will mature after 10 years. Their
current yield is 8%, whereas their yield to maturity is 10%. Find the coupon rate and the market
value of these bonds. Hint: use (3.1) and (3.4).

Since we have to find the value of two unknown quantities, the coupon rate, c and the market value
of the bond, B, we need to develop two equations. Recall that the yield to maturity of a bond is the
same as the required rate of return r. Assume semiannual interest payments.

Semiannual required rate of return or the discount factor, r = .05,

The number of interest payments of the bond, n = 20,
The face value of the bond, F = 1000,
The dollar value of each interest payment, C = cF/2 = 500c, in (3.1)

Or, with some simplification B = 6231.105171c + 376.8894829 (1)

This is the first equation. To get the second equation, put y = .08 in (3.4). This gives

.08 = c(1000)/B (2)

Solving (2) for c, we find c = (.08/1000)B

Substituting the above value of c in (1), we get

B = 6231.105171(.08/1000)B + 376.8894829

Or, B = .4984884137B + 376.8894829

Or, B(1 − .4984884137) = 376.8894829
Or, B
Going back to (2), c = (.08/1000) 751.5070303 =
This gives the coupon rate as 6.012%, and the market value of the bond to be $751.51.