WFU Law School
Law & Valuation
4.2 Bond Valuation

4.2.1 Bond Fundamentals

Bonds are long-term debt instruments used by business firms and governments to raise money. Most bonds pay interest semiannually at a stated interest rate with an initial maturity of 10 to 30 years with a face value of $1,000 that must be repaid at maturity.

A company sells its bonds, in the sense that it gives a promise of future payments in return for current cash.

Private issues are sold to a small group of investors, often big institutional investors like mutual funds and insurance companies. These bonds can trade among institutional investors in private markets. Under the federal securities laws, formal disclosure is not required for privately-issued bonds.

Public issues are sold to dispersed investors, usually through an underwriting syndicate of securities firms. These bonds often trade in public markets, such as the NYSE. The federal securities laws require that publicly-issued bonds be registered with the SEC, and issuers must provide investors an extensive disclosure document known as a "prospectus".


There are different types of bonds:
  • Mortgage bonds are backed by real assets pledged as security.
  • Debentures are not backed by any security.
  • Subordinate bonds can only be paid after senior obligations are satisfied.
  • Convertible bonds offer the investor the option to convert bonds to shares of the firm's equity.
  • Income bonds are so named because interest payments are only made if the company generates sufficient income.
  • Zero coupon bonds pay no coupons, and their return is purely from purchasing at a discount.
  • Floating rate bonds are so named because the coupon rate is tied to some basic rate such as T-bill rates. These provide protection against inflation and interest rate risk and keep bonds selling close to their par values.
  • Puttable bonds offer the option of returning the bonds at face value.
  • Junk bonds are high risk, high return bonds. Typically, these are issued by lower-rated entities and are often tied to mergers or leveraged buyouts.

Nature of corporate bonds. Most bonds state that the issuer (sometimes called the “borrower” or “seller”) agrees to pay the buyer (sometimes called the “investor” or “lender”) a series of fixed interest payments. Usually these payments are to be made every six months (semiannually) until the bond matures. To determine the amount of interest that a bond pays, simply multiply its coupon rate times the bond’s par value (sometimes called its “face value” or "principal”).This par value is usually $1,000 and is printed on the bond.The coupon rate is also printed on the bond and does not change during the bond’s life.

For example, if General Electric issues a bond whose coupon rate is 10%, this means that the bond pays the buyer 0.10 × 1,000 or $100 per year. Because the interest payment is made semiannually, the buyer actually receives $50 every six months.Despite the fact of semiannual payment, the coupon rate is always stated on annual basis.

The bond will also state its maturity date.On that date the issuer will make the last interest payment and also pay the buyer the par value or principal. If the General Electric bond matures in 10 years and has a 10% coupon rate, the company will pay the buyer $50 every six months for 10 years plus $1,000 at the end of the tenth year (or 20th period).

What price will the buyer pay for this stream of interest payments and single principal payment? Don’t assume that price will be the par value.Rather, the bond will be sold for the prevailing market price—that is, how much the buyer is willing to pay for the particular issuer’s promise to make the bond payments.This will be a present value calculation, and its determination will depend on several factors, primarily the risk of the investment as perceived by the bond purchasers.General Electric, with its long history of profitability and quality management, will have a better credit rating than the newly founded “Jack’s Light Bulb and Jet Engine Company.” Because bricks and mortar booksellers are currently more profitable and stable than online booksellers, Barnes & Noble will be seen as a safer investment than Amazon. Accordingly, the buyer will likely value GE’s and Barnes & Noble’s bonds more highly than Jack’s or Amazon’s bonds.


Government bonds. The same comparisons can be made in the public sector. Governments that are fiscally disciplined and well managed are seen as better credit risks.This is why you’ll often hear elected officials touting their government’s “AAA” or otherwise high credit rating.They’re simply referring the power of their city, state, or other entity to raise public money through bonds on the most favorable terms.

Bond Terminology

Coupon rate ...
... is another name for interest rate. This terms comes from when interest was paid by clipping a coupon from the bottom of the bond certificate.
Notes ...
... refer to shorter-term debt instruments, with maturities typically less than five years; bills refer to shorter-term debt instruments issued by governments, the most famous being U.S. Treasury bills.
Par value ...
... is the bond's face value (or principal); under older corporate law, it refers to the uniform price all investors must pay for the bond.
Maturity...
... .is the date the firm promises to repay the par value of the bond. The bond ceases to exist at the maturity date.
Par value ....
... is the bond's face value or principle amount. This is the amount the firm promises to pay at maturity (usually $1,000). Under older corporate law, it refers to the uniform price all investors must pay for the bond.
Indenture...
...is the debt contract that includes the details of the issue such as the repayment provisions and restrictive covenants.
Debt ratings ...

.....are the "grades" assigned to a bond issue reflecting an assessment of that issue's risk. The most prevalent rating agencies are Moody's and Standard and Poor's. For example, Moody's rates issues from Aaa (the best) to C, which means the issue has "an extremely poor prospect of every attaining any real investment standing."

See the attached description of Moody's rating system.

Debt ratings. Are debt ratings worth it? See Frank Partnoy, The Siskel and Ebert of Financial Markets: Two Thumbs Down for the Credit Rating Agencies, 77 Wash U L Q 619-712 (1999).

This paper critiques the role of credit ratings and credit rating agencies in providing information about bonds. The dominant "reputational capital" view of credit rating agencies is that the agencies have survived and prospered since the early 1900s based on their ability to accumulate and retain reputational capital (i.e., good reputations) by providing valuable information about the bonds they rate. The paper argues that this view fails to explain, and is inconsistent with, certain types of market behavior including: the estimation of credit spreads, the number of credit ratings-driven transactions, and the explosion in use of credit derivatives.

In place of the reputational capital view, the paper offers a "regulatory license" view of rating agencies as generating value, not by providing valuable information, but by enabling issuers and investors to satisfy certain regulatory requirements. The paper concludes that regulators should eliminate regulatory dependence on credit ratings by substituting a regime based on market-determined bond credit spreads (i.e., the difference between the yield on a bond and the yield on a risk-free bond of comparable maturity). Such credit spreads reflect all available information, including credit ratings, and therefore are more accurate and reliable than credit ratings.

See also Frank Partnoy, The Paradox of Credit Ratings (2001).

The SEC is planning to issue a concept release on information flow, conflicts of interest as they affect credit rating agencies.

 
4.2 Bond Valuation

©2003 Professor Alan R. Palmiter

This page was last updated on: March 30, 2004