Arizona State University
Fundamentals of Finance
Chapter 7: Bonds and Their Valuation
Instructor: Christian Ramirez
The goal of this chapter is to introduce you to bonds.
Some of the time value of money
techniques we learned in the past two lectures will be applied to bond valuation. We
begin our lecture with a discussion of the different types of bonds and their characteristics.
Then we move on to how bond values are valued using our discounted cash flow procedure,
how yields are determined, the effects of changing interest rates on bond prices, and the
riskiness inherent in different types of bonds.
Corporations and governments issue bonds to raise capital to finance their day to day
operations and/or expansion plans.
When you buy a bond, you are loaning your money
for a certain period of time to the issuer, be it Coca Cola
or the U.S. Government. In
the borrower or issuer promises to pay you interest every year and to return your
principal at "maturity," when the loan comes due, or at "call" if the bond is of the type
that can be called earlier than its maturity (more on this later). The length of time to
maturity is called the "term."
is a long-term debt contract where a
borrower or issuer agrees to make payments of interest and a final principal payment at
the end of the life of the bond to the holders of these bonds. Another way to look at bonds
is as an interest-only loan, where the borrower will pay the interest every period, but none
of the principal will be repaid until the end of the loan. For example, suppose that Wal-
Mart issues $1,000 bonds with a maturity or duration of 30 yrs.
Say, Wal-Mart offers to
pay an interest of 10% per year. In this case, Wal-Mart will pay $1,000 x 10% = $100 in
interest to the bond holder every year. At the end of 30 years, Wal-Mart will repay the
$1,000 principal amount.
Based on the example above, we may think that bonds can be
seen as a fairly simple financing instrument, where the borrowers pay interest every year
and then repay the principal at the end of the term. However, other variables come into
play which affect the value that these bonds have on the secondary market.
Types of Bonds
When it comes to investment in bonds, the bond investment options are mainly classified
into four categories: U.S. Treasury Bonds, Corporate Bonds, Municipal Bonds (aka
Munis), and Foreign Bonds. Each different bond option offers a different risk which
ultimately determines its expected rate of return.