Chapter 6
Bonds and their Valuation

OVERVIEW

This chapter presents a discussion of the key characteristics of bonds, and then uses time value of money concepts to determine bond values. Bonds are one of the most important types of securities to investors, and are a major source of financing for corporations and governments. The value of any financial asset is the present value of the cash flows expected from that asset. Therefore, once the cash flows have been estimated, and a discount rate determined, the value of the financial asset can be calculated. A bond is valued as the present value of the stream of interest payments (an annuity) plus the present value of the par value, which is the principal amount for the bond, and is received by the investor on the bond’s maturity date. Depending on the relationship between the current interest rate and the bond’s coupon rate, a bond can sell at its par value, at a discount, or at a premium. The total rate of return on a bond is comprised of two components: interest yield and capital gains yield. The bond valuation concepts developed earlier in the chapter are used to illustrate interest rate and reinvestment rate risk. In addition, default risk, various types of corporate bonds, bond ratings, and bond markets are discussed.

Outline

A bond is a long-term contract under which a borrower agrees to make payments of interest and principal, on specific dates, to the holders of the bond. There are four main types of bonds: Treasury, corporate, municipal, and foreign. Each type differs with respect to expected return and degree of risk.

■ Treasury bonds, sometimes referred to as government bonds, are issued by the Federal government and are not exposed to default risk.

■ Corporate bonds are issued by corporations and are exposed to default risk. Different corporate bonds