Chapter 6

Bond Valuation
&
YTM
 Learning Goals
1. Describe interest rate fundamentals, the term structure of
interest rates, and risk premiums.
2. Review the legal aspects of bond financing and bond cost.
3. Discuss the general features, quotations, ratings, popular
types, and international issues of corporate bonds.
4. Understand the key inputs and basic model used in the
valuation process.
5. Apply the basic valuation model to bonds and describe the
impact of required return and time to maturity on bond
values.
6. Explain the yield to maturity (YTM), its calculation, and the
procedure used to value bonds that pay interest
semiannually.
 Interest Rates & Required Returns

• The interest rate or required return represents the price of money.

• Interest rates act as a regulating device that controls the flow of
money between suppliers and demanders of funds.

• Interest rates represent the compensation that a demander of funds

must pay a supplier.

• When funds are lent, the cost of borrowing is the interest rate.
• When funds are raised by issuing stocks or bonds, the cost the
company must pay is called the required return, which reflects the
suppliers expected level of return.
 Nominal Vs. Real Interest Rates
• The nominal interest rate is the rate at which money can be borrowed or lent without any
adjustment for inflation.

It is the rate quoted in the market and is typically used for accounting and financial purposes.

• The expected inflation rate is the rate at which the general level of prices is expected to rise over
a given period, usually a year.

This rate is based on economic forecasts, market expectations, and other factors that influence
the level of inflation.

• We obtain the real interest rate by subtracting the expected inflation rate from the nominal
interest rate.

The real interest rate represents the true cost of borrowing or the true rate of return on
investment after adjusting for changes in the purchasing power of money due to inflation.

• The real interest rate is an important variable in macroeconomics and finance, affecting
households, businesses, and governments' consumption, investment, and saving decisions. It
also influences the demand for and supply of money in the economy and is a key monetary policy
tool.
 Risk-free rate
• The risk-free rate is typically defined as the rate of return on an investment that is considered
to be free from risk.

In practice, this is often measured by the yield on a government bond, such as a US Treasury bond.

• The real interest rate, on the other hand, is the rate of return adjusted for inflation. It
represents the actual increase in purchasing power that an investor receives from an
investment.

• Inflation is the rate of change in the general level of prices of goods and services in an
economy over a period of time.

It is typically measured by a price index such as the Consumer Price Index (CPI) or the Producer Price Index (PPI).

• Therefore, the relationship between the risk-free rate, real interest rate, and inflation is as
follows:

Risk-free rate = Real interest rate + Expected inflation premium

• The expected inflation premium is the additional return that investors require to compensate
for the expected inflation over the life of the investment.
 Interest Rates & Required Returns:
Nominal or Actual Rate of Interest (Return)

• The nominal rate of interest is the actual rate of interest charged by the
supplier of funds and paid by the demander.

• The nominal rate differs from the real rate of interest, k* as a result of two
factors:

–Inflationary expectations reflected in an inflation premium (IP), and

–Issuer and issue characteristics such as default risks and contractual provisions
as reflected in a risk premium (RP).
• Using this notation, the nominal rate of interest for security 1, k1 is given in equation
6.1, and is further defined in equations 6.2 and 6.3.
 rd = r* + IP + DRP + LP + MRP.
Here:

rd = Required rate of return on a debt security.

r* = Real risk-free rate.

IP = Inflation premium.

DRP= Default risk premium.(The additional amount a borrower must pay to compensate the
lender for assuming default risk.)

LP = Liquidity premium. (A premium that investors will demand when any given security
can not be easily converted into cash, and converted at the fair market value. When
the liquidity premium is high, then the asset is said to be illiquid, which will cause prices
to fall, and interest rates to rise)

MRP = Maturity risk premium. (Risk associated with interest rate uncertainty. The
longer the time to maturity, the higher the premium )
 Term Structure of Interest Rates

• The term structure of interest rates relates the interest rate to

the time to maturity for securities with a common default risk
profile.
• Typically, treasury securities are used to construct yield
curves since all have zero risk of default.
• However, yield curves could also be constructed with AAA or
BBB corporate bonds or other types of similar risk securities.
Term Structure of Interest Rates (Cont’d)
 Corporate Bonds
• A bond is a long-term debt instrument that pays the
bondholder a specified amount of periodic interest rate over a
specified period of time.
• The bond’s principal is the amount borrowed by the
company and the amount owed to the bond holder on the
maturity date.
• The bond’s maturity date is the time at which a bond
becomes due and the principal must be repaid.
• The bond’s coupon rate is the specified interest rate (or $
amount) that must be periodically paid.
• The bond’s current yield is the annual interest (income)
divided by the current price of the security.
• The bond’s yield-to-maturity is the yield (expressed as a
compound rate of return) earned on a bond from the time it is
acquired until the maturity date of the bond.
• A yield curve graphically shows the relationship between the
time to maturity and yields for debt in a given risk class.
 Legal Aspects of Corporate Bonds

• The bond indenture is a legal document that specifies both

the rights of the bondholders and the duties of the issuing
corporation.
• Standard debt provisions in the indenture specify certain
record keeping and general business procedures that the
issuer must follow.
• Restrictive debt provisions are contractual clauses in a
bond indenture that place operating and financial constraints
on the borrower.
 Corporate Bonds: Cost of Bonds to the Issuer

• In general, the longer the bond’s maturity, the higher the

interest rate (or cost) to the firm.
• In addition, the larger the size of the offering, the lower will be
the cost (in % terms) of the bond.
• Also, the greater the risk of the issuing firm, the higher the
cost of the issue.
• Finally, the cost of money in the capital market is the basis
form determining a bond’s coupon interest rate.
 Corporate Bonds: General Features
• The conversion feature of convertible bonds allows bondholders to
exchange their bonds for a specified number of shares of common
stock.
• Bondholders will exercise this option only when the market price of the
stock is greater than the conversion price.
• A call feature, which is included in most corporate issues, gives the
issuer the opportunity to repurchase the bond prior to maturity at the
call price.
• In general, the call premium is equal to one year of coupon interest
and compensates the holder for having it called prior to maturity.
• Furthermore, issuers will exercise the call feature when interest rates
fall and the issuer can refund the issue at a lower cost.
• Issuers typically must pay a higher rate to investors for the call feature
compared to issues without the feature.
 Valuation Fundamentals
• 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 required return is a function of the expected rate of inflation and
the perceived risk of the asset.
• Higher perceived risk results in a higher required return and lower
asset market
 Bond Valuation: Bond Fundamentals

• A noted earlier, bonds are long-term debt instruments used by

businesses and government to raise large sums of money,
typically from a diverse group of lenders.
• Most bonds pay interest semiannually at a stated coupon
interest rate, have an initial maturity of 10 to 30 years, and have
a par value of $1,000 that must be repaid at maturity.
 Bond Valuation: Basic Bond Valuation
• Mills Company, a large defense contractor, on January 1, 2007, issued
a 10% coupon interest rate, 10-year bond with a $1,000 par value that
pays interest semiannually
Bond Valuation: Bond Fundamentals (Cont’d)
• It is also important to note that a bond’s price will approach par value
as it approaches the maturity date, regardless of the interest rate and
regardless of the coupon rate.
 Yield to Maturity (YTM)
• The yield to maturity measures the compound annual return to an investor and
considers all bond cash flows. It is essentially the bond’s IRR based on the current
price.

• Note that the yield to maturity will only be equal if the bond is selling for its face value
($1,000).

• And that rate will be the same as the bond’s coupon rate.

• For premium bonds, the current yield > YTM.

• For discount bonds, the current yield < YTM.

 Coupon Effects on Price Volatility
• The amount of bond price volatility depends on three basic factors:

i. length of time to maturity

ii. risk

iii. amount of coupon interest paid by the bond

• First, we already have seen that the longer the term to maturity, the greater is a bond’s
volatility
• Second, the riskier a bond, the more variable the required return will be, resulting in
greater price volatility.
• Finally, the amount of coupon interest paid also impacts a bond’s price volatility.
• Specifically, the lower the coupon, the greater will be the bond’s volatility, because it
will be longer before the investor receives a significant portion of the cash flow from his
or her investment.
 Current Yield
• The Current Yield measures the annual return to an investor based on the
current price.
Current = Annual Coupon Interest
Yield Current Market Price

For example, a 10% coupon bond which is currently selling at $1,150 would have
a current yield of:

Current = $100 = 8.7%

Yield $1,150