BOND VALUATION

by Sarah M. Balisacan, CPA

GENERAL FEATURES OF A BOND

PAR VALUE
Face value of a bond EXAMPLE:

COUPON INTEREST RATE A five-year bond with a face value of P1,000

pays 10% interest annually and matures on
Stated annual interest rate on a bond December 31, 2025. The bond was
originally issued on December 31, 2020 at
MATURITY DATE face value.
The date when the debt (par value of
bonds) should be repaid ISSUER = SELLER = DEBTOR

ISSUE DATE BONDHOLDER = BUYER = CREDITOR

The date when the bonds are issued

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COMMON TYPES OF BONDS

A bond whose interest rate is fixed for its

 Its interest rate fluctuates with shifts in
entire life.
general level of interest rates.
 A bond whose interest is pegged to a
benchmark, such as a T-bill rate, and
adjusted periodically.
 A bond that pays no annual interest
but is sold at a discount below par  Prices of floating rate bond remain relatively
stable because neither a capital gain nor a
 Its compensation is not in the form of
capital loss occurs as market interest rates
interest, but in the form of capital
go up or down.
appreciation.

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 BOND VALUATION

 The value of any financial asset is the PV of

0 1 2 n
the cash flows it is expected to generate. k
...
Value CF1 CF2 CFn
 There are mainly two cash flows of a bond:
Principal and Interest
CF1 CF2 CFn
Value    ... 
Bond Value = PV of interest + PV of principal
(1  k)1 (1  k)2 (1  k)n
Pbond = INT (PVIFA) + M (PVIF)

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DISCOUNT BONDS vs PREMIUM BONDS

Discount Par Premium

Sold for less Sold for more

Sold for equal
Price of Bond than face
to face value
than face
value value

Required Higher than Equal to Less than

Return coupon rate coupon rate coupon rate

Generally, the coupon rate is set to equal required

return when bond issued. So they generally sell at par.

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 CHANGES IN PRICE

 Over time the required return changes EXAMPLE:

(changes in market interest rates,
Bond that pays Required return Bond that pays
inflation, recession, etc). Thus, the price increases after
of the bond will change. * *
one year

For 3 years
 Note there is an INVERSE relationship For 2 years
between required return (i.e., interest rate) Investors prefer
and price the higher
interest rate of
12%, hence
price of 8% bond
will go down.
*Assuming coupon rates are set to equal
the required return on the date of issue

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BOND YIELDS

YIELD TO MATURITY
TOTAL YIELD
 The rate of return earned on a bond if it is
Total Yield = Current Yield
held to maturity.
+ Capital Gains Yield
 The discount rate which forces the PV of
all the cash flows to equal the price paid
for the bond CURRENT YIELD OR
 Solving for k (or for the i) INTEREST YIELD
Current Yield = Annual Int.
YIELD TO CALL PMT/Bond’s Current Price
The rate of return earned on a bond if it is
called before its maturity date.
CAPITAL GAINS YIELD
FV − PV CGY = (P1 – Po) / Po
INT +
YTM or YTC = N
.40FV + .60PV 7
YIELD CURVE

 The Yield Curve is a graphical representation

of the interest rates on debt for a range of
maturities

 It is typically upward-sloping.

 Two common explanations for upward trend:

 Anticipated rise in risk-free rate
 Risk premium due to longer duration

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CALL PROVISION

 Gives the issuer the right to refund the bonds when

interest rates decline

 The issuer must pay the bondholders an amount

greater than the par value if the bonds are called.
The additional sum is termed a call premium.

 Most bonds have a deferred call provision and a

declining call premium.
o Deferred call – bonds cannot be called until after Call provision allows issuer to
several years after issuance refinance at lower rates.
o Declining call premium – the value of call
premium decreases as the bond nears maturity

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EFFECTIVE ANNUAL INTEREST RATE
(EAR)

Effective annual interest is used to compare bonds with

different compounding frequencies e.g. annual, semi-annual,
etc.
𝑟 𝑚
Effective rate = 1 + −1
m
r = Annual nominal rate of interest
m = Number of compounding periods in a year

For continuous compounding:

Effective rate = 𝑒 𝑟 − 1
e ≈ 2.718

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 RISK ASSOCIATED WITH A BOND

The concern that rising interest rates Short-term and/or Long-term and/or
will cause the value of a bond to fall. high coupon bonds low coupon bonds

Interest rate
Low High
risk

Reinvestment
High Low
The concern that interest rates will fall, rate risk
and future CFs will have to be reinvested
at lower rates, hence reducing income.

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 DEFAULT RISK

 If an issuer defaults, investors receive Investment Grade Junk Bonds

less than the promised return.
Moody’s Aaa Aa A Baa Ba B Caa C
 Default risk is influenced by the issuer’s
financial strength and the terms of the S&P AAA AA A BBB BB B CCC D
bond contract.

 Types of corporate bonds: Bond ratings are designed to reflect the probability of a
o Mortgage bonds bond issue going into default
o Debentures
o Subordinated debentures Higher ratings = higher prices = lower yields
o Investment-grade bonds Cheaper to raise capital
o Junk bonds

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