BOND VALUATION
CONCEPTS
FIN 3403, 3404
PROF. DIGGLE
BOND CONCEPTS
What is a bond?
 How do corporate bonds differ from other
kinds of bonds?
 Priority of claim pyramid
 Characteristics of Corporate bonds
 What is a Municipal bond?
 Characteristics of muny bonds.
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RISK VS RETURN
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KINDS OF RISK--RECAP
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–
–
–
–
–
INFLATION RISK
BUSINESS OR DEFAULT RISK
MARKET RISK
LIQUIDITY RISK
INTR. RATE RISK
OTHER
» CURRENCY RISK
» POLITICAL RISK
» ETC.
BOND CONCEPTS AND
TERMS (see lec notes p. 34)
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TERMS
PAR
COUPON RATE
DOLLAR ANNUAL
COUPON
CURRENT YIELD
YIELD TO
MATURITY
INDENTURE
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DEBENTURE
DURATION
ACCRUED
INTEREST
CONCEPTS
IF INTEREST RATES
RISE WHAT
HAPPENS TO BOND
PRICES?
Current yield vs. YTM
THE BOND TVM TIME LINE
COUPON
COUPON
COUPON
COUPON COUPON ETC ETC
All bonds we will study pay SEMIANNUALLY (coupon every 6 months)
An 8% bond pays two coupons of $40 each
A 30 year bond has 60 interest coupons.
PAR AT MATURITY ($1000)
BOND VALUATION
SEE LEC NOTES PP. 35-38

A BOND IS IN TWO
PARTS:
– PRINCIPAL ($1000
PAR) -- LUMP SUM
AT MATURITY
– INTEREST coupons
(SEMIANNUAL)
(ANNUITY)
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The value of a bond is
the NPV of both
elements
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The price of a bond is,
therefore, another
TVM problem.
What is the discount
rate?
– The current MARKET
rate of bonds of similar
TYPE, QUALITY and
MATURITY
KINDS OF BONDS
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U.S. GOVERNMENT
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–
–
–
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U.S. TREASURY
Treasury series EE
U.S. AGENCY
MUNICIPAL
FOREIGN GOVT.
TAX
CONSIDERATIONS
– The Tax Equivalent
yield
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CORPORATE
– Mortgage
– Debenture
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ZERO COUPON
BONDS
STRIPS
INFLATION
ADJUSTED BONDS
CORPORATE BONDS
Issued by domestic corporations

ALL new corporate
bond issues are subject
to SEC review
– The Indenture
– Role of the Bond
Trustee
– How is a bond sold
– The “Shelf
registration”

What terms are in the
Indenture?
– Collateral and priority
of claim
– Coupon in percent and
dollars
– Maturity
– Call provisions
» sinking fund
» redemption
– Trustee
BOND “RATING” SERVICES
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
MOODY’S AND
STANDARD AND
POOR
RATING FROM AAA
(best) to BA (lowest
“investment” grade),
to below B (“junk
bonds.”
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The bond rating is a
measure of business
risk or risk of default
only.
Corporations and
municipalities must
pay a fee to have
bonds rated.
Therefore many bonds
are NR.
MUNY BONDS
Bonds issued by states, cities and
local authorities like airports
GO or General Obligation (supported
usually by real estate taxes)
 REVENUE AND IDR

– HOW DOES A CORPORATION DO AN IDR?
SINGLE, DOUBLE AND TRIPLE TAX
FREE MUNYS
 WHY ARE MUNY’S FREE OF FEDERAL
INCOME TAX?
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YIELD TO MATURITY
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YTM is the “Total
Return” on a bond.
This consists of:
– CURRENT YIELD
– CAPITAL GAINS
“YIELD”

If a bond is selling at a
PREMIUM (above
par), bondholder will
have a capital loss to
maturity.
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If a bond is selling at a
DISCOUNT, you have
a guaranteed capital
gain to maturity.
PREMIUM:
CURRENT YIELD >
THAN YTM WHY?
DISCOUNT
CURRENT YIELD <
YTM. WHY?
BOND PROELEM USING
YOUR CALCULATOR
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You buy a corporate
bond on 12-1-98
The coupon is 7.5%
The bond matures on
May 15, 2015
(Millennium problem
does not affect
calculator)
The market yield is
6%. Compute PRICE
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THIS IS SDT
$75 PER YEAR or
$37.50 per coupon
Matures at par. Par is
expressed in % in your
calculator. Therefore
$1000 par is entered
as 100 or 100%
YLD = 6
TIBA 2+ CALCULATOR BOND
WORKSHEET
SDT enter 12.0198
 CPN
enter 7.5
 RDT enter 5.1515
 RV = 100% OF PAR
OR $1000
 ACT (for corporates)
and 360 for Treasuries
 2/Y (semiannual pay)
LEAVE YOUR TI BA2
AT ACT AND 2/Y
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YLD = market yield
on bonds of similar
type, quality and
maturity = 6
SOLVE FOR PRI
(price -- push CPT)
MAY ALSO SOLVE
FOR YTM where
price is given
AI = accrued interest
WHAT DOES THE BOND
WORKSHEET DO?
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THE PRICE OF A BOND IS THE NET
PRESENT VALUE OF:
– THE LUMP SUM OF $1000 PAR RECEIVED
AT MATURITY
– THE ANNUITY OF COUPON INTEREST
RECEIVED SEMIANNUALLY OVER
REMAINING LIFE OF BOND (P/Y = 2)

HOW WOULD YOU COMPUTE THE
PRICE OF A ZERO COUPON BOND?
WHAT IS CALL?
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Why would a
company or
municipality call a
bond?
Why do investors
dislike callable bonds?
If a bond is not
callable for 5 years
this is called call
protection.
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REDEMPTION
CALL
SINKING FUND
CALL
CALCULATING
YIELD TO CALL ON
YOUR
CALCULATOR
ACCRUED
INTEREST
BOND PROBLEM
A. YOU BUY A BOND
TODAY MATURING
IN 30 YEARS.
 YOU PAY 1030
(103% of par)
 THE COUPON IS
7.33%
 WHAT IS THE
YIELD TO
MATURITY?
B. YOU BUY A BOND
TODAY MATURING
IN 25 YEARS THAT
IS CALLABLE IN 15
YEARS AT 105
 ALL FACTS ON
LEFT SIDE ARE THE
SAME.
 COMPUTE YIELD
TO CALL.
DURATION VS MATURITY
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SEE TEXT
MATURITY IS A
FIXED DATE IN
TIME
DURATION IS A
MEASURE OF
BOND CASH FLOW
COMBINING
MATURITY AND
COUPON INCOME
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A HIGH COUPON
BOND WILL HAVE
A SHORTER
DURATION THAN A
LOWER COUPON
ISSUE THAT IS
IDENTICAL IN ALL
OTHER RESPECTS
ACCRUED INTEREST
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You buy a bond on
March 10. Coupons
are paid on Jan 1 and
June 30.
What is the accrued
income? Who pays it
and why?
Accrued income is
added to the amount
received by the
SELLER
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Who will receive the
June 30 coupon? THE
BUYER.
The buyer must pay
the seller accrued
interest for the time he
owned the bond since
the last coupon. This
is done on settlement
date.
TRADE DATE AND
SETTLEMENT DATE
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Corporate securities
settle in 3 business
days after trade date.
You buy a bond on
Friday. Monday is a
Holiday. When is
corporate settlement?
This is when good
funds must be
available to pay for
bond or stock.
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Government
(TREASURY) bonds
are next day settlement
(next business day).
SDT on your financial
calculator is settlement
date.
RDT (redemption
date) is maturity or
call date.
CONVERTS & ZEROS:
FIN 3404--FIN 3404
STUDENTS not responsible
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A convert is a bond
with additional
contractual provisions
in the indenture
providing for
conversion of the bond
into common stock.
A convert is “Quasi
Equity.” It behaves
like common stock.
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TERMINOLOGY
– CONVERSION
PRICE
– CONVERSION
RATIO
– THEORETICAL
VALUE
– PREMIUM OVER
THEORETICAL
VALUE
CONVERTS CONTD.
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Why would a
company include
convertibility as a
“sweetener” in the
indenture?
What happens if a
convertible bond is
called by the
company?
– 2 situations
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Are converts a good
investment? Why or
why not?
Should you buy a
callable convert
selling above call
price? Why or why
not?
CONVERT PROBLEM
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A convert is
convertible into 20
shares of common.
This is the conversion
ratio.
This means the
conversion price is
$50 ($1000 par / 20)
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When a convert is
issued, the conversion
price is usually 15% or
so below common
price. Why?
Assume the common
price is $40 when the
bond is floated.
CONVERT PROBLEM CONTD

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Assume now it is 3
years later and the
common is selling for
$65 per share.
What is the theoretical
value of the convert?
Conv ratio = number
of common shares per
bond X stock price
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TV = 20 x $65 =
$1300
Assume the call price
set in the indenture is
103 ($1030). What
happens if this bond is
called?
CONVERTS CONTD
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Why do most converts
sell at a PREMIUM
over conversion or
theoretical value?
Priority of claim
Current yield on bond
vs dividend yield on
stock

Say the bond we are
looking at carried a
coupon of 8%. The
burrent yield at a price
of $1300 = 6.15%.
Assume the common
dividend is $2.00. The
dividend yield is 2/65
or 3.1%. Which would
you rather own?
WHAT ARE ZERO COUPON
BONDS?
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Bond in which
coupons have been
stripped off.
Price is simply the
NPV of the par value
($1000) at maturity.
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What reasons can you
think of for investors
to own zero coupon
treasuries?
Compute the price of a
Treasury maturing in
30 years when the
yield on coupon conds
of similar type and
quality is 6.4%