CHAPTER 12
BOND FUNDAMENTALS AND VALUATION
12.1 Basic Features of a Bond
▪ Public bonds – long-term, fixed-obligation debt securities packaged in convenient, affordable
denominations for sale to individuals and financial institutions
12.1.1 Bond Characteristics
1. Intrinsic Features
▪ Coupon
– The income that the bond investor will receive over the life (or holding period) of
2. Types of Issues
▪ Secured (senior) bonds – backed by legal claim on some specified property
3. Indenture Provisions
4. Features Affecting a Bond’s Maturity
▪ Call features
– Freely callable, noncallable, deferred call
12.2 The Global Bond Market Structure (Exhibit 12.1)
12.2.1 Participating Issuers (Exhibit 12.2)
2. Quasi-governments (Agencies) and Foreign Governments
4. Corporations
12.2.2 Participating Investors
▪ Individual Investors
12.2.3 Bond Ratings
▪ Primary risk that a bondholder faces is that the borrower will not be able to pay the promised
coupons and principal refunding. When this occurs, the borrower is said to be in default on
the loan.
12.3 Survey of Bond Issues
12.3.1 Domestic Government Bonds (Exhibit 12.4)
1. United States – Treasury Inflation Protected Securities (TIPS) (Exhibit 12.5)
3. United Kingdom – Gilts
12.3.2 Government Agency Issues (Exhibit 12.6)
12.3.3 Municipal Bonds
▪ Types: general obligation bonds (GOs) and revenue bonds
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▪ Equivalent taxable yield (ETY)
▪ Municipal bond insurance – irrevocable over life of issue
12.3.4 Corporate Bonds (Exhibit 12.7)
1. U.S. Corporate Bond Market – includes utilities, industrials, rail and transportation, and
financial issues
▪ Debentures
▪ First-mortgage issues
12.3.5 Nontraditional Bond Coupon Structures
12.3.6 High-Yield Bonds (Exhibits 12.8, 12.9)
12.3.7 International Bonds
1. United States
2. Japan
3. United Kingdom
4. Eurozone
▪ Growth of eurobonds
12.4 Bond Yield Curves
12.4.1 The Determinants of Bond Yields
2. The Impact of Bond Characteristics
▪ Factors impacting risk premium:
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− Foreign bond risk, including exchange rate risk and country risk
▪ Credit spread
12.4.2 Yield Curves and the Term Structure of Interest Rates
▪ Term structure of interest rates – yield curve
▪ Relates the term to maturity to the yield to maturity for a sample of bonds at a given point
12.4.3 Par versus Spot Yield Curves (Exhibit 12.12)
12.4.4 Yield Curves for Credit-Risky Bonds (Exhibit 12.13)
12.4.5 Determining the Shape of the Term Structure
1. Expectations Hypothesis
▪ Any long-term interest rate simply represents the geometric mean of current and future
2. Liquidity Preference (Term Premium) Hypothesis
The bond’s call price plus a small premium that increases with time to call holds that
3. Segmented-Market Hypothesis
12.5 Bond Valuation
12.5.1 Par versus Spot Bond Valuation
12.5.2 Bond Valuation and Yields with Semiannual Coupons
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variables to a periodic basis.
1. The Yield Model
▪ Expected yield on the bond – use the observed current market price and the promised cash
12.5.3 Relationship between Bond Yields, Coupon Rates, and Bond Prices (Exhibit 12.14)
▪ When the yield to maturity is less than the coupon rate, the bond will be priced at a
premium to its par value.
1. Bond Characteristics and Price Change Magnitude (Exhibit 12.15)
▪ A bond’s value is inversely related to its yield to maturity.
▪ Bonds with a fixed coupon rate and no embedded options (such as a call feature) will
12.5.4 Bond Valuation between Coupon Dates (Exhibits 12.16, 12.17)
▪ When an investor acquires a bond from an existing owner between coupon dates, they
12.5.5 Computing Other Bond Yield Measures
1. Current Yield
2. Yield to Call
▪ Whenever a bond with a call feature is selling for a price above par equal to or greater
than its call price, a bond investor should consider valuing the bond in terms of YTC
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▪ Crossover price – approximately the bond’s call price plus a small premium that
increases with time to call
▪ If an issue has multiple call dates at different prices, it will be necessary to compute
which of these scenarios provides the lowest yield – yield to worst.
3. Realized (Horizon) Yield