Warren Buffet

Bond Valuation

LEARNING OBJECTIVES

1. Understand basic bond terminology and apply the time value of money equation in pricing bonds.

2. Understand the difference between annual and semiannual bonds and note the key features of zero-coupon bonds.

3. Explain the relationship between the coupon rate and the yield to maturity.

4. Delineate bond ratings and why ratings affect bond prices.

5. Appreciate bond history and understand the rights and obligations of buyers and sellers of bonds.

6. Price government bonds, notes, and bills.

6.1 Key Components of a Bond

* Par value : Typically $1,000

* Coupon rate: Annual rate of interest paid.

* Coupon: Regular interest payment received by holder per year.

* Maturity date: Expiration date of bond when par value is paid back.

* Yield to maturity: Expected rate of return based on price of bond

Table 6.1 Bond Information

6.1 Key Components of a Bond

Example: Key components of a corporate bond

Let’s say you see the following price quote

for a corporate bond:

  Issue Price Coupon(%) Maturity YTM% Current Yld. Rating

Hertz Corp.91.50 6.35 15-Jun-2010 15.438 6.94 B

Price = 91.5% of $1,000.00 = $915.00

Annual coupon = 6.35% x $1,000.oo = $63.50

Maturity date = June 15, 2010

If bought and held to maturity, yield (YTM) = 15.438%

Current Yield = Annual Coupon / Price = $63.50 / $915.00 = 6.94%

6.1 Pricing a Bond in Steps

Since bonds involve a combination of an annuity (coupons) and a lump sum (par value) its price is best calculated by using the following steps:

6.1 Pricing a Bond in Steps

Example: Calculating the price of a corporate bond.

Calculate the price of an AA-rated, 20-year, 8% coupon (paid annually) corporate bond (Par value = $1,000) which is expected to earn a yield to maturity of 10%.

Year 0

1

$80

2

$80

3

$80

20

$80

$1,000

18

19

$80

$80

…

Annual coupon = PMT =...