Security Analysis
Bond Valuation
Background on Bonds
 Bonds represent long-term debt securities
 Contractual
 Promise to pay future cash flows to investors
 The issuer of the bond is obligated to pay:
 Interest (or coupon) payments periodically usually
semiannually
 Par or face value (principal) at maturity
 According to ownership structure:
 Bearer bonds
 Registered bonds
How Bond Markets Facilitate the Flow of
Funds
Source: Madura, J.: Financial Markets and Institutions, 9th Edition
Source: Madura, J.: Financial Markets and Institutions, 9th Edition
Bond Yields
 Yield from the Issuer’s Perspective
 Cost of financing
 Yield to maturity
 annualized yield that is paid by the issuer over the life of
bond
 Annualized discount rate that equates the future coupon
and principal payments
 Based on assumption that coupon can be reinvested at the
same yield
Bond Yields
An investor can purchase a ten-year, $1000 par
value bond with an 8 percent annualized coupon
rate for $936. Determine the yield to maturity for
this bond.
N I PV PMT FV
10 –936 80 1000
Bond Yield
 Yield from the Investor’s Perspective
 Investor holds it until maturity
 Yield to maturity
 Investor does not hold until maturity
 Holding period return HPR
 Less than one year – HPR = coupons + difference between selling
and purchasing price
 Over one year – HPR = annualized discount rate that equates
payments received to the initial investments
 Selling price of the bond is uncertain if the bond is not hold to
maturity
 An investment on bond is subject to the risk that the holding
period return will be less than expected
U. S. Treasury Bonds
 Issued by the U.S. Treasury to finance
federal government expenditures
 Maturity
 Notes, < 10 Years
 Bonds, > 10 to 30 Years
 Active OTC Secondary Market
 Semiannual Interest Payments
 Benchmark Debt Security for Any Maturity
Kinds of Treasury Bonds
 Coupon Bonds
 Interest paid semiannually
 To registered bondholders
 Stripped Treasury Bonds
 Zero-coupon securities are sold with claims on U. S. Treasury bonds held in
a trust
 One security represents the principal payment (np) at maturity
 Other securities represents the interest payments (ci) at interest paying dates
 Inflation-Indexed Treasury Bonds
 Intended for investors who seek inflation protection with their investments
 Coupon rates less than other Treasuries
 Principal value adjusted for the U.S. inflation rate (CPI) every 6 months
 Coupon income increases with inflation
Municipal Bonds
 State and local government obligations
 Revenue bonds vs. general obligation Bonds
 Investor interest income exempt from federal
income tax
 Tax Reform Act of 1986 placed limitations on
tax-exempt bond issuance for private
purposes
Corporate Bonds
 When corporations want to borrow for longterm
periods they issue corporate bonds
 Usually pay semiannual interest
 Most have maturities between 10-30 years
 Public offering vs. private placement
 Limited exchange, larger OTC secondary market
 Investors seek safety of principal and steady
income
Corporate Bond Offerings
 Public Offering
 Investment bank to underwrite the bonds
 Syndicate of investment banks
 Determine selling price
 Prospectus of bond issuance+
 Registration of SEC
 Used by institutional investors
 Private Placement
 Not registered by SEC
 For small amounts of funds ($30 million) easy to find an
institutional investor
 Disclosure of financial date
 Security firms
 No active secondary market
 Institutional investor can trade bonds with each other
Corporate Bond Terminology
 Indenture
 Legal document specifying rights and obligations of issuer and
bondholder
 Trustee
 Represents bondholders to assure compliance with indenture
 Sinking Fund Provision
 Requirement that the firm retire a certain amount or number of
bonds each year
 Protects investors with principal reduction
 Protective Covenants
 Places restrictions on the firm to protect bondholders
 Examples: limits dividends and officer salaries, restricts additional
debt
Corporate Bond Terminology
 Call provisions: Ability to pay bonds off early
 Call premium
 Advantage to issuers; disadvantage to investor
 Bond collateral
 Usually consists of a mortgage on real property
 Unsecured bonds are called debentures and are
backed only by the general credit of the issuing
firm
Corporate Bond Terminology
 Low-coupon and zero-coupon bonds
 Provide investors known rate of return
 Imputed interest income taxed if not in taxsheltered
investment plan
 Attractive to pension funds with expected payouts
 Variable-rate bonds
 Convertible bonds
 Junk bonds
Junk Bonds
 Junk Bonds
 Junk bonds are also called high-yield bonds or
noninvestment rated bonds
 Popularized in the direct finance boom of the
1980s
 The risk premium is between three and seven
percent above Treasury bonds and susceptible to
contagion effects
 Secondary market supported by dealer market
Other Types of Long-Term Debt
Securities
 Structured notes
 Exchange Traded Notes
 Auction-Rate Securities
Bond Valuation and Risk
Bond Valuation and Risk
 Bonds are debt obligations with long-term
maturities issued by governments or
corporations to obtain long-term funds
 Commonly purchased by financial institutions
that wish to invest funds for long-term periods
 Bond price (value) = present value of cash
flows to be generated by the bond
Impact of the Discount Rate on Bond
Valuation
 Critical for accurate valuation
 The appropriate discount rate
 Yield that could be earned on alternative
investments with similar risk and maturity
 Higher return on riskier securities -> higher
discount rates
 A high-risk securities have a lower value than a
low risk securities even though both have the
same expected cash flow
 Higher risk
 Higher discount rates
 Lower bond prices
 Lower risk
 Lower discount
rates
 Higher bond prices
Note Inverse Relationship
Between Risk, required returns
and Bond Prices
Bond Risks and Prices
Bond Valuation Process
Source: Madura, J.: Financial Markets and Institutions, 9th Edition
Relation between Discount Rate and
Present Value of Payment
Source: Madura, J.: Financial Markets and Institutions, 9th Edition
Impact of the Timing of Payments on
Bond Valuation
 The market price is affected by the timing of
the payments made to bondholders
 Sooner can be reinvested to earn additional
returns
 Dollar received sooner has a higher present value
than one to be received later
Valuation of Bonds with Semiannual
Payments
Relation between Time of Payment and
Present Value of Payment
Source: Madura, J.: Financial Markets and Institutions, 9th Edition
Relations between Coupon Rate, Required
Return and Bond Price
 Discount bonds
 Larger required rate of return = the larger discount
 1. coupon rate < required rate of return (market
value)
 PV below its par value
 2. coupon rate = required rate of return (market
value)
 PV equals its par value
 3. coupon rate > required rate of return (market
value)
 PV above its par value
 Low coupon bond prices more sensitive to change in
interest rates
 PV of face value at maturity a major proportion of the price
0 5 8 10 12 15 20
0
1,800
1,600
1,400
1,200
1,000
800
600
400
200
5-Year Bond
10-Year Bond
20-Year Bond
Required Return (Percent)
Explaining Bond Price Movements
 The price of a bond should reflect the present
value of future cash flows discounted at a
required rate of return
 The required return on a bond is primarily
determined by
 Prevailing risk-free rate
 Risk premium
Factors that affect the risk-free rate
 Changes in returns on real investment
 Financial investment an alternative to real investment
 Opportunity cost of financial investment is the returns
available from real investment
 Federal Government deficits/surplus position
 Inflationary expectations
 Consumer price index
 Federal Reserve monetary policy position
 Oil prices and other commodity prices
 Exchange rate movements
Factors that affect the credit or default risk
premium
 Strong economic growth
 High level of cash flows
 Investors bid up bond prices; lower default premium
 Weak economic growth
 Lower profits and cash flows
 Impact on specific industries varied
 Investors flee from risky bonds to Treasury bonds
 Bond prices fall; default premiums increase
Comparison of Bond Yields
Source: Madura, J.: Financial Markets and Institutions, 9th Edition
U.S.
Fiscal
Policy
U.S.
Monetary
Policy
Long-Term
Risk-Free
Interest Rate
(Treasury
Bond Rate)
Risk
Premium
of Issuer
U.S.
Economic
Conditions
Issuer’s
Industry
Conditions
Required
Return
on the
Bond
Bond Price
Issuer’s
Unique
Conditions
Source: Madura, J.: Financial Markets and Institutions, 7th Edition
Sensitivity of Bond Prices to Interest Rate
Movements
 Depends on the bond’s characteristics
 Indicates the potential damage to bond
holdings in response to and increase in
interest rates
 BOND PRICE ELASTICITY
 DURATION
Bond Price Elasticity
 Bond Price Elasticity = Bond price sensitivity
for any % change in market interest rates
 Bond Price Elasticity =
(% Change In Price)/(% Change In Interest Rates)
 Increased elasticity means greater price risk
Bond Price Elasticity
 Price-Sensitive Bonds
 Longer maturity—more price variation for a
change in interest rates
 Lower coupon rate bonds are more price sensitive
(the PV is a greater % of current value)
 Zero-coupon bonds most sensitive, approaching –
1 price elasticity
 Greater for declining rates than for increasing
rates
Sensitivity of Bonds with Different
Coupon Rates to Interest Rate Changes
Source: Madura, J.: Financial Markets and Institutions, 9th Edition
Duration
 Measure of bond price sensitivity
 Measures the life of bond on a PV basis
 Duration = Sum of discounted, time-weighted
cash flows divided by price
 The longer a bond’s duration, the greater its
sensitivity to interest rate changes
 The duration of a zero-coupon bond = bond’s term
to maturity
 The duration of any coupon bond is always less
than the bond’s term to maturity
Duration
Source: Madura, J.: Financial Markets and Institutions, 9th Edition
Modified duration
 Modified duration is an easily calculated
approximate of the duration measure
 DUR*= DUR/(1+k)
Bond Investment Strategies
 Matching Strategy
 Create bond portfolio that will generate income that will match
their expected periodic expenses
 Used to provide retirement income from savings accumulation
 Estimate cash flow needs then select bond portfolio that will
generate needed income
 Laddered Strategy
 Funds are allocated evenly to bonds in several different maturity
classes
 Example: ¼ funds invested in bonds with 5 years until maturity, ¼
in10-year bonds, ¼ in 15-year bonds, and ¼ in 20-year bonds
 Investor receives average return of yield curve over time as
maturing bonds are reinvested
Bond Investment Strategies
 Barbell Strategy
 Allocated funds to short-term bonds and long-term bonds
 Short-term bonds provide liquidity from maturity
 Long-term bonds provide higher yield
 Interest Rate Strategy
 Funds are allocated in a manner that capitalizes on interest
rate forecasts
 Example: if rates are expected to decline, move into longerterm
bonds
 Problems:
 High transaction costs because of higher trading
 Difficulty in forecasting interest rates