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5 Keys to Bond Valuation

5 Keys to Bond Valuation. Chapter 6. Bonds . Used by corporations and government Method for borrowing money Normally interest only loans , meaning the borrower only pays interest every period, but no principle Principle is completely repaid at the end of the loan’s life Usually long-term

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5 Keys to Bond Valuation

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  1. 5 Keys to Bond Valuation Chapter 6

  2. Bonds • Used by corporations and government • Method for borrowing money • Normally interest only loans, meaning the borrower only pays interest every period, but no principle • Principle is completely repaid at the end of the loan’s life • Usually long-term • We will generally work with longer term bonds

  3. Face Value/Par Value • Face Value (also, par value): The principal amount of a bond that is repaid at the end of the term • Newly issued bonds generally sell at par value. • Corporate bonds normally have a par value of $1,000, but this amount can be much greater for government bonds. • PAR VALUE IS NOT THE PRICE OF THE BOND • If the future value or par value (same thing) are not given in a problem, assume it is $1,000

  4. Coupon (The Interest Rate) • Coupon payment: The stated interest payment made on a bond. It is the amount the bondholder will receive as interest payments. • You can find the coupon rate by dividing the annual coupon payment by the face value • Coupon rate = annual coupon payment/face value • Most bonds pay interest every 6 months (semiannually), but it’s possible for them to pay monthly, quarterly or annually. • The coupon is expressed as a percentage of the par value. • e.g. You have a bond that pays a coupon of 10% annually, and it has a par value of $1,000. The bondholder will receive $100 in interest payments a year. • Coupon Rate = 10% • Coupon Payment = $100

  5. Coupon (The Interest Rate) Cont… • Fixed-rate bond: A rate that remains a fixed percentage of the par value throughout the life of the bond • Floating-rate bond: An adjustable interest payment that usually fluctuates based on a reference rate

  6. Maturity • Maturity: The date in the future that the principal amount of a bond is repaid to the investor. • Maturity dates can range from 1 day to 30 years (there has even been terms of 100 years issued.) • A bond that matures in one year is much more predictable and thus less risky, than a bond that matures in 20 years.

  7. Issuer’s Credit Worthiness and Liquidity • It is crucial to consider the issuer of a bond, their stability is your main guarantee for getting paid back. • The U.S. government is far more secure than any corporation. • Due to the higher risk associated with corporate bonds, a higher yield must be offered to entice investors (the risk/return tradeoff.)

  8. There are bond rating systems that help investors determine a company’s credit risk. You can think of a bond rating as the report card for a company’s credit rating. Blue-chip firms, safer investments, have a high rating, and risky companies have a low rating. Notice that if the company falls below a certain credit rating, its grade changes from investment quality to junk status. **Not all bonds are inherently safer than stocks. Certain types of bonds can be just as risky, if not riskier, than stocks.**

  9. Yield to Maturity • Yield to Maturity (YTM): • The rate required in the market on a bond. It shows the total return you will receive if you hold a bond to maturity. • It is equal to all the interest payments you will receive (assuming you reinvest the interest payment at the same rate as the current yield on the bond) plus any gain (if you purchased at a discount) or loss (if you purchased at a premium.) • ***YTM is more accurate and enables you to compare bonds with different maturities and coupons.***

  10. Sample Question 1. Mateljan corp. offers an 11 percent coupon bond with annual payments. The yield to maturity is 6.3% and the maturity date is 10 years. What is the market price of a $1,000 face value bond? (1) Input 10 and press N (2) Input 6.3 and press I/Y (3) Input 110 and press PMT (4) Input 1000 and press FV (5) Press CPT and press PV, then you will get −1341.06

  11. Sample Question 2. Marcus corp. offers a 9 percent bond with a current market price of $905.35. The yield to maturity is 10.34 percent. The face value is $1,000. Interest is paid semi-annually. How many years is it until the bond matures? (1) Input 5.17 (=10.34/2) and press I/Y (2) Input −905.35 and press PV (3) Input 45 (=90/2) and press PMT (4) Input 1000 and press FV (5) Press CPT and press N, you will get 26 Since this is SEMI-ANNUAL, 13 (=26/2) years are left until maturity

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