Chapter 5

Bond Valuation
MINI CASE 45 points

Sam Strother and Shawna Tibbs are vice-presidents of Mutual of Seattle Insurance
Company and co-directors of the company's pension fund management division. A major
new client, the Northwestern Municipal Alliance, has requested that Mutual of Seattle
present an investment seminar to the mayors of the represented cities, and Strother and
Tibbs, who will make the actual presentation, have asked you to help them by answering
the following questions. Because the Boeing Company operates in one of the league's cities,
you are to work Boeing into the presentation.

a. What are the five key features of a bond?

The five key features of a bond:

a) Par Value: The $1,000 that the bond issuer guarantees to return when the bond
matures is known as the par value, or face value.
b) Coupon Interest Rate: The interest rate applied to the bond's face value by the issuer.
When the principal is repaid, the bond reaches its maturity date.
c) Yield to maturity, or YTM, is the total return on a bond that is expected to be held to
maturity.
d) Market Price: The price at which the bond is currently trading, which could be more
or less than its par value.
e) Maturity Date: Bonds generally have a specified maturity date on which the par
value must be repaid.

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b. What are call provisions and sinking fund provisions? Do these provisions make
bonds more or less risky?

Call Provisions: Allow the issuer of the bond to make an early repayment of the principal
amount. Bonds containing these clauses carry more risk since, in the unlikely event that the
bond is called, investors would have to reinvest in bonds bearing lesser yields.

Sinking Fund Provisions: Require the issuer to retire a specific portion of the bond issue on a
regular basis. The promised progressive repayment usually lowers the risk for investors.

d. How is the value of a bond determined? What is the value of a 10-year, $1,000
par value bond with a 10 percent annual coupon if its required rate of return is
10 percent?

Bond valuation: A bond's value is calculated by discounting the needed rate of return (r) from the present value o

e. 1. What would be the value of the bond described in part d if, just after it had been
issued, the expected inflation rate rose by 3 percentage points, causing investors
to require a 13 percent return? Would we now have a discount or a premium
bond?

Bond Value Affected by Inflation: 3% Increase in Inflation (13%) = Bond Value Will Fall as a
result of the Required Rate of Return Being Higher Than Coupon Rate. Presently, the bond is
a discount bond. The bond's value will rise when inflation falls (needed return = 7%) since the
necessary return is lower than the coupon rate. The relationship turns into a high-grade bond.

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e. 2. What would happen to the bonds' value if inflation fell, and r d declined to 7
percent? Would we now have a premium or a discount bond?

Bond Value Over Time: If the required rate of return maintains at 13%, the bond's value will
gradually rise as it approaches maturity and eventually reach its par value.
If a 7% return is needed, the bond's price will decrease toward par value as maturity approaches.
The yield to maturity, or YTM, is the interest rate at which the bond's current price and the
present value of its future payments are equal.

f. 1. What is the yield to maturity on a 10-year, 9 percent annual coupon, $1,000 par
value bond that sells for $887.00? That sells for $1,134.20? What does the fact
that a bond sells at a discount or at a premium tell you about the relationship
between rd and the bond's coupon rate?

For the selling of a ten-year bond with a $1,000 par value and a 9% yield at $887:
The bond is offered at a discount, which causes the yield to be higher than the coupon rate.
The bond is selling at a premium, therefore the yield to maturity (YTM) for the identical bond,
trading for $1,134.20, is lower than the coupon rate.

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f. 2. What are the total return, the current yield, and the capital gains yield for the
discount bond? (Assume the bond is held to maturity and the company does not
default on the bond.)

Total Return, Current Yield, and Capital Gains Yield: To get the current yield on a bond, divide
its annual coupon by its current price. The capital gains yield is the rate at which the bond's
price changes as it gets closer to maturity. The product of the current yield and the capital gains
yield is the total return.

h. Suppose a 10-year, 10 percent, semiannual coupon bond with a par value of

$1,000 is currently selling for $1,135.90, producing a nominal yield to maturity
of 8 percent. However, the bond can be called after 5 years for a price of $1,050.

h. 1. What is the bond's nominal yield to call (YTC)?

Semiannual Bond Payments: Modify the coupon payment, needed rate of return, and number
of periods when payments are made semiannually: 𝐶 / 2, 𝑟 / 2, 𝑛 / 2 C/2, r/2, and 2n
Yield to Call (YTC): For a callable bond, yield to call (YTC) is calculated using the call price
and the remaining time until the call date instead of the par value and maturity date.

Semi Annual Coupon Bond Rate: 10% Annually, SemiAnnually = 10%*1000(par value)/2
= $50
Time to Call = 5 years = 10 SemiAnnual periods
Call Price = $1,050(future value)
Current Price = $1,135.90(present value)

Formula: Price = t =110(1+2YTC)t50+(1+2YTC)101,050

Calculated on Excel: = RATE(10,50,1135.90,1050)×2 = 7.08%

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h. 2. If you bought this bond, do you think you would be more likely to earn the YTM
or the YTC? Why?

Because the issuer has a significant incentive to call the bond after five years and refinance at
lower rates due to the high coupon rate in comparison to current market interest rates, you are
more likely to receive the Yield to Call (YTC) of 7.08% rather than the Yield to Maturity
(YTM) of 8%.

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