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Chapter 6
Bonds (Debt) –
Characteristics
and Valuation
Essentials of Managerial Finance by S. Besley & E. Brigham
Slide 1 of 22
Background on Bonds
• Bonds represents long-term debt securities that are
issued by government agencies or corporations
• Interest payments occur annually or semiannually
• Par value is repaid at maturity
• Most bonds have maturities between 10 and 30 years
• Bearer bonds require the owner to clip coupons
attached to the bonds
• Registered bonds require the issuer to maintain
records of who owns the bond and automatically
send coupon payments to the owners
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Essentials of Managerial Finance by S. Besley & E. Brigham
Slide 2 of 22
Background on Bonds (cont’d)
• Bond yields
– The issuer’s cost of financing is measured by the yield to
maturity
• The annualized yield that is paid by the issuer over the life of
the bond
• Equates the future coupon and principal payments to the initial
proceeds received
• Does not include transaction costs associated with issuing the
bond
• Earned by an investor who invests in a bond when it is issued
and holds it until maturity
– The holding period return is used by investors who do not
hold a bond to maturity
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Essentials of Managerial Finance by S. Besley & E. Brigham
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Treasury and Federal Agency
Bonds
• The U.S. Treasury issues Treasury
notes or bonds to finance federal
government expenditures
– Note maturities are usually less than 10
years
– Bonds maturities are 10 years or more
– An active secondary market exists
– The 30-year bond was discontinued in
October 2001
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Essentials of Managerial Finance by S. Besley & E. Brigham
Slide 4 of 22
Treasury and Federal Agency
Bonds (cont’d)
• Trading Treasury bonds
– Bond dealers serve as intermediaries in the
secondary market and also take positions in the
bonds
– 30 primary dealers dominate the trading
• Profit from the bid-ask spread
• Conduct trading with the Fed during open market
operations
• Typical daily volume is about $200 billion
– Online trading
• TreasuryDirect program (http://www.treasurydirect.gov)
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Essentials of Managerial Finance by S. Besley & E. Brigham
Slide 5 of 22
Treasury and Federal Agency
Bonds (cont’d)
• Treasury bond quotations
– Published in financial newspapers
• The Wall Street Journal
• Barron’s
• Investor’s Business Daily
– Bond quotations are organized according to their maturity,
with the shortest maturity listed first
– Bid and ask prices are quoted per hundreds of dollars of par
value
– Online quotations at
• http://www.investinginbonds.com
• http://www.federalreserve.gov/releases/H15/
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Essentials of Managerial Finance by S. Besley & E. Brigham
Slide 6 of 22
Treasury and Federal Agency
Bonds (cont’d)
• Savings bonds
–
–
–
–
–
Issued by the Treasury
Have a 30-year maturity and no secondary market
Series EE bonds provide a market-based interest rate
Series I bonds provide a rate of interest tied to inflation
Interest on savings bonds is not subject to state and local
taxes
• Federal agency bonds
– Ginnie Mae issues bonds and purchases mortgages that are
insured by the FHA and the VA
– Freddie Mac issues bonds and purchases conventional
mortgages
– Fannie Mae issues bonds and purchases residential
mortgages
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Essentials of Managerial Finance by S. Besley & E. Brigham
Slide 7 of 22
Municipal Bonds
• Municipal bonds can be classified as either general
obligation bonds or revenue bonds
– General obligation bonds are supported by he municipal
government’s ability to tax
– Revenue bonds are supported by the revenues of the project
for which the bonds were issued
• Municipal bonds typically pay interest semiannually,
with minimum denominations of $5,000
• Municipal bonds have a secondary market
• Most municipal bonds contain a call provision
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Essentials of Managerial Finance by S. Besley & E. Brigham
Slide 8 of 22
Municipal Bonds (cont’d)
• Trading and quotations
– Investors can buy or sell munis by
contacting brokerage firms
– Electronic trading has become popular
• http://www.tradingedge.com
– Online quotations are available at
http://www.munidirect.com and
http://www.investinginbonds.com
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Essentials of Managerial Finance by S. Besley & E. Brigham
Slide 9 of 22
Corporate Bonds
• Corporations issue corporate bonds to borrow for long-term
periods
• Corporate bonds have a minimum denomination of $1,000
• Larger bonds offerings are achieved through public offerings
registered with the SEC
• Secondary market activity varies
• Financial and nonfinancial institutions as well as individuals are
common purchasers
• Most corporate bonds have maturities between 10 and 30 years
• Interest paid by corporations is tax-deductible, which reduces
the corporate cost of financing with bonds
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Essentials of Managerial Finance by S. Besley & E. Brigham
Slide 10 of 22
Corporate Bonds (cont’d)
• Corporate bond yields and risk
– Interest income earned on corporate represents
ordinary income
– Yield curve
• Affected by interest rate expectations, a liquidity
premium, and maturity preferences of corporations
• Similar shape as the municipal bond yield curve
– Default rate
• Depends on economic conditions
• Less than 1 percent in the late 1990s
• Exceeded 3 percent in 2002
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Essentials of Managerial Finance by S. Besley & E. Brigham
Slide 11 of 22
Corporate Bonds (cont’d)
• Corporate bond yields and risk (cont’d)
– Investor assessment of risk
• Investors may only consider purchasing corporate bonds after
assessing the issuing firm’s financial condition and ability to
cover its debt payments
• Investors may rely heavily on financial statements created by
the issuing firm, which may be misleading
– Bond ratings
• Bonds with higher ratings have lower yields
• Corporations seek investment-grade ratings, since commercial
banks will only invest in bonds with that status
• Rating agencies will not necessarily detect any misleading
information contained in financial statements
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Essentials of Managerial Finance by S. Besley & E. Brigham
Slide 12 of 22
Corporate Bonds (cont’d)
• Corporate bond characteristics (cont’d)
– Call provisions:
• Require the firm to pay a price above par value
when it calls its bonds
– The difference between the call price and par value
is the call premium
• Are used to:
– Issue bonds with a lower interest rate
– Retire bonds as required by a sinking-fund provision
• Are a disadvantage to bondholders
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Essentials of Managerial Finance by S. Besley & E. Brigham
Slide 13 of 22
Corporate Bonds (cont’d)
• Trading corporate bonds
– Bonds are traded through brokers, who communicate orders
to bond dealers
– A market order transaction occurs at the prevailing market
price
– A limit order transaction will occur only if the price reaches
a specified limit
– Bonds listed on the NYSE are traded through the automated
Bond System (ABS)
– Online trading is possible at:
• http://www.schwab.com
• http://www.etrade.com
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Essentials of Managerial Finance by S. Besley & E. Brigham
Slide 14 of 22
Corporate Bonds (cont’d)
• Corporate bond quotations
– More than 2,000 bonds are traded on the
NYSE with a market value of more than $2
trillion
– Corporate bond prices are reported in
eighths
– Corporate bond quotations normally
include the volume of trading and the yield
to maturity
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Essentials of Managerial Finance by S. Besley & E. Brigham
Slide 15 of 22
Corporate Bonds (cont’d)
• Junk bonds
– Junk bonds have a high degree of credit risk
– About two-thirds of junk bonds are used to finance takeovers
– Size of the junk bond market
• Currently about 3,700 junk bond offerings exist with a market
value of $80 billion
– Participation in the junk bond market
• 70 large issuers of junk bonds each have more than $1 billion
in debt outstanding
• Primary investors in junk bonds are mutual funds, life insurance
companies, and pension funds
• The junk bond secondary market consists of 20 bond traders
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Essentials of Managerial Finance by S. Besley & E. Brigham
Slide 16 of 22
Basic Valuation
• The (market) value of any investment asset is simply
the present value of expected cash flows.
• The interest rate that these cash flows are discounted
at is called the asset’s required return.
• The higher expected cash flows, the greater the
asset’s value.
• It makes sense that an investor is willing to pay
(invest) some amount today to receive future benefits
(cash flows).
Essentials of Managerial Finance by S. Besley & E. Brigham
Slide 17 of 22
Basic Valuation Model
V0 =
CF1
+
(1 + k)1
CF2 + … +
(1 + k)2
CFn
(1 + k)n
Where:
V0 = value of the asset at time zero
CFt = cash flow expected at the end of year t
k = appropriate required return (discount rate)
n = relevant time period
Essentials of Managerial Finance by S. Besley & E. Brigham
Slide 18 of 22
The basic bond valuation model
B0 =
I1
+
(1+k)1
I2
+ … +
(1+k)2
(In + Mn)
(1+k)n
Using the above model, find the (market) price of a
10% coupon bond, 3 years to maturity if market
interest rates are currently 10%(par value= 100).
B0 =
€10
€10
+
(1+.10)1
+
(1+.10)2
(€10 + €100)
(1+.10)3
It can also be calculated by finding the present
value of the annuity
B0 = 10 * (1 - [1/(1+.10)3]) + 100 * [1/(1+.10)3] =
.10
Essentials of Managerial Finance by S. Besley & E. Brigham
Slide 19 of 22
Valuation of a bond using Excel
For example, find the price of a 10% coupon bond
with three years to maturity if market interest rates
are currently 10%.
Valuation of a Bond using Excel
Coupon Interest (€)
Maturity (periods)
Face Value (€)
Market Interest Rate (%)
Market Price (€)
Essentials of Managerial Finance by S. Besley & E. Brigham
10
3
100
10%
100
Note: the equation
for calculating
price is
=PV(rate,nper,pmt,fv)
Slide 20 of 22
Changes in bond values over time
In the previous example, what would happen to the
bond’s price if interest rates drop from 10% to 8%?
When interest rate falls below the coupon rate,
then the bond would sell at a premium
Valuation of a Bond using Excel
Coupon Interest (€)
Maturity (periods)
Face Value (€)
Market Interest Rate (%)
Market Price (€)
Essentials of Managerial Finance by S. Besley & E. Brigham
10
3
100
8%
105
When the interest
rate goes down, the
bond price will
always go up
Slide 21 of 22
Changes in bond values over time
In the previous example, what would happen to the
bond’s price if interest rates increase from 10% to 12%?
When interest rate increases above the coupon rate,
then the bond would sell at a discount
Valuation of a Bond using Excel
Coupon Interest (€)
Maturity (periods)
Face Value (€)
Market Interest Rate (%)
Market Price (€)
Essentials of Managerial Finance by S. Besley & E. Brigham
10
3
100
12%
95
When the interest
rate goes up, the
bond price will
always go down
Slide 22 of 22
Bond value–interest rate relationship
Essentials of Managerial Finance by S. Besley & E. Brigham
Slide 23 of 22
Bond Return
kd
Rate of
return
=
INT
Vd
=
Current
yield
Essentials of Managerial Finance by S. Besley & E. Brigham
+
Vd1 – Vd0
Vd0
+
Capital
gains yield
Slide 24 of 22
Bond Valuation – Change in value
over time
Bond Characteristics: M = €1,000.00, INT = €60.00, kd = 8%
Years to
Maturity
End of Year
Value, Vd
5
€920.15
4
2
933.76
948.46
964.33
1
0
3
Current Yield
= INT/Vd0
Total
Return
1.48%
1.57
1.67
6.52%
6.43
6.33
8.00%
8.00
8.00
981.48
1.78
6.22
8.00
1,000.00
1.89
6.11
8.00
Essentials of Managerial Finance by S. Besley & E. Brigham
Capital Gain =
(Vd1-Vd0)/Vd0
Slide 25 of 22
Market value converges at par
value to maturity
Essentials of Managerial Finance by S. Besley & E. Brigham
Slide 26 of 22
Finding the Yield to Maturity on a
Bond
• The yield to maturity measures the compound annual
return to an investor and considers all bond cash flows.
PV =
I1
(1+k)1
I2 + … +
+
(1+k)2
(In + Mn)
(1+k)n
Note that this is the same equation of the Basic
Valuation Model. The only difference now is that we
know the market price but are solving for return.
Essentials of Managerial Finance by S. Besley & E. Brigham
Slide 27 of 22
Valuation with semi-annual
compounding
Example: M = €1,000, C = 5%, Yrs to maturity
= 8, kd = 6%
16
3
?
25
1000
N
I
PV
PMT
FV
-931,23
• Adjustments to computations
– N = # years x m; m = # of interest
payments per year
– i = kd/m
– INT = interest payment per period = Annual
INT/m
Essentials of Managerial Finance by S. Besley & E. Brigham
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