PArT 2: VALUATION, rISk AND reTUrN4-2 BOND PrICeS AND INTereST rATeS
Bonds are very important financial interests in the capital markets, allowing companies to borrow, as well
as lenders to sell their loans if they need to liquidate their investments. Bonds are also very ancient as
financial instruments – dating back almost to Sumerian times in some forms – so they have acquired a
special vocabulary to describe their elements. The next section provides a guide to the special terms for
bonds; we then examine the intricacies of finding out how to value bonds in later sections of part 4-2.4-2a BOND VOCABULArY
Fundamentally, a bond is just a loan. Unlike car loans and home mortgages, which require borrowers to
make regular payments, including both an interest component and some repayment of the original loan
amount or principal, bonds make interest-only payments until they mature. On the maturity date, a bond’s
life formally ends, and both the final interest payment and the original principal amount are paid to
investors. The principal value of a bond, also known as the bond’s face value or par value, is typically $100
for Australian corporate bonds. This conventional face value of corporate bonds in Australia is smaller
than the conventional face value of $1,000 in the US or for multinational companies issuing bonds on
international capital markets. In the UK, the conventional face value of a corporate bond is £100. The
smaller scale of the Australian corporate bond market, and the relatively smaller investor size here,
explains the smaller face value compared with that of US or UK bonds. Of course, the formulae used for
bond valuation are the same regardless of the face value.
Although bonds come in many varieties, most bonds share certain basic characteristics. First, many
bonds promise to pay investors a fixed amount of interest, called the bond’s coupon.^2 Most corporate
bonds make coupon payments every six months, or semiannually; Australian state and federal government
bonds usually pay quarterly. International bonds tend to pay annually because of the additional effort
involved in contacting and paying investors scattered around the globe. Because a bond’s cash flows are
contractually fixed, traders often refer to bonds as fixed-income securities. The legal contract between the
borrower who issues bonds and the investors who buy them, called the bond indenture, specifies the dollar
amount of the coupon and when the borrower must make coupon payments. Second, a bond’s coupon rate
equals its annual coupon payment divided by its par value. Third, a bond’s coupon yield (or current yield)
equals the coupon divided by the bond’s current market price (which does not always equal its par value).
To illustrate, suppose that a government entity or a company issues a bond with a $100 face value
and promises to pay investors $3.50 every six months until maturity. The bond’s coupon is $7 per year,
and its coupon rate is 7% ($7 ÷ $100). If the current market value of this bond is $98, then its coupon
(current) yield is 7.14% ($7 ÷ $98).
Bonds can have a variety of additional features, such as a call feature that allows the issuer to redeem
the bond at a predetermined price prior to maturity, or a conversion feature that grants bondholders the
right to redeem their bonds for a predetermined number of shares of equity in the borrowing company.
Chapter 14 discusses these and other features in detail. For now, we focus our attention on pricing
ordinary bonds. We will begin with the basic bond valuation equation, then describe its application to
risk-free and risky bonds.2 Historically, bond certificates were printed with coupons attached that the bondholder would literally clip and mail in to receive an interest
payment. That is the origin of the term ‘coupon’. Not all bonds make fixed coupon payments. Some bonds pay variable coupons that are tied
to an underlying interest rate (such as the rate on Australian government Treasury bonds) or to the rate of inflation.LO4.2principal
The amount borrowed on
which interest is paid
maturity date
The date when a bond’s
life ends and the borrower
must make the final interest
payment and repay the
principal
face value (bonds)
The nominal value of a bond,
which the borrower repays at
maturity
coupon
The periodic interest payment
that a bond pays to investors
indenture
A legal contract between the
borrower (issuer) and investor
stating the conditions under
which a bond has been issued
coupon rate
The rate derived by dividing
the bond’s annual coupon
payment by its face value
coupon yield
The amount obtained by
dividing the bond’s coupon
by its current market price
(which does not always equal
its face value). Also called
current yield