Corporate Finance

Maximizing the value of a business in a responsible and sustainable way

Bonds valuation
What determines the value and return of a bond?

Fahmi Ben Abdelkader

1
What is a bond ?

Fahmi Ben Abdelkader

2
A BOND IS A TRADABLE DEBT CONTRACT
Fixed income investment

A Bond :
A tradable debt contract that represents a portion of a loan

The issuer = the borrower

Bonds are issued by companies, municipalities, states and sovereign governments to raise money

The Bondholder = the lender

The lender, receives a - contractually stated - Interest Rate (Coupon Rate) at regular, specified
intervals, and is reimbursed (Bond principal) at specified future date (Maturity date)

Contrary to a bank loan (with a unique lender), Bonds involve many lenders

Varieties of Bonds
Coupon Bonds, Zero-coupon Bonds, Convertible bonds, etc.

Fahmi Ben Abdelkader | Corporate finance 3

A BOND : A TRADABLE DEBT CONTRACT
An example

Fahmi Ben Abdelkader | Corporate finance 4

A BOND : A TRADABLE DEBT CONTRACT
An example

Fahmi Ben Abdelkader | Corporate finance 5

BOND MARKET
Trading debt

Equity market is larger than bond market

Agree Disagree

Fahmi Ben Abdelkader | Corporate finance 6

BOND MARKET
Trading debt

Equity market is not as important as we could expect

Fahmi Ben Abdelkader | Corporate finance 7

BOND MARKET
Trading debt

Fahmi Ben Abdelkader | Corporate finance 8

BOND MARKET
Trading debt

World total Equity market capitalization

Fahmi Ben Abdelkader | Corporate finance 9

BOND MARKET
Trading debt

Outstanding issued bonds by the French government and private corporations

Sources : AMF, Bloomberg.

Fahmi Ben Abdelkader | Corporate finance 10

BOND MARKET
Not only governments issue bond loans

Fahmi Ben Abdelkader | Corporate finance 11

WHAT WILL YOU LEARN AND PRACTICE
Detailed Outline

1. Identify the cash flows of a bond, and calculate its value

2. Calculate the yield to maturity of a bond, and interpret its meaning

3. Given coupon rate and yield to maturity, determine whether a coupon bond will sell at a
premium or a discount

4. Discuss the relation between a corporate bond’s expected return and the yield to maturity;
define default risk and explain how these rates incorporate default risk.

5. Assess the creditworthiness of a corporate bond using its bond rating; define default risk.

1. Discuss the effect of coupon rate to the sensitivity of a bond price to changes in interest
rates

2. Discuss the relation between a corporate bond’s expected return and the yield to maturity;
define default risk and explain how these rates incorporate default risk.

Fahmi Ben Abdelkader | Corporate finance 12

Fixed income is not a 100% guarantee of the income

Fahmi Ben Abdelkader

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BONDS ARE AN OLD STORY
An example : Bond loan to fund the building of the Panama Canal

In 1879, the French Compagnie Universelle du Canal

Interoceanique de Panama embarked on the project of cutting a
canal through Panama to connect the Atlantic and Pacific oceans.
This was a bold project but large canals had been built before and
one crossing Egypt at Suez had already transformed the world a
few years earlier. Further, the man in charge of this canal project
was the same as had succeeded at Suez, Ferdinand de Lesseps.

Fahmi Ben Abdelkader | Corporate finance 14

BONDS ARE AN OLD STORY
An example : Bond loan to fund the building of the Panama Canal

The completion of the Suez

Canal in 1869 turned the
world’s attention to the
prospects of a new canal in
Panama or Nicaragua to
create a channel
connecting the Atlantic and
Pacific. The Société Civile
Internationale du Canal
Interocéanique de
Darien was established in
Paris to explore such a
canal.

Fahmi Ben Abdelkader | Corporate finance 15

BONDS ARE AN OLD STORY
An example: Bond loan to fund the building of the Panama Canal

FRANCE’S PANAMA CANAL FAILURE

[Link]

(...)

Bankruptcy

Unfortunately, by 1889, the Compagnie Universelle had run out of money and was unable to raise more.
Only a bit less than half of the initial estimate of earth to be removed had been successfully excavated. It was
at this stage far from completion that the canal company became bankrupt in February 1889 and all work was
suspended that May. (…)

Lesson

Ferdinand de Lesseps was willing to present an optimistic plan for building a canal through Panama in order
to secure funding for his vision. What might have been the innocent bright vision of a national hero
embarking on a new project to the world’s benefit turned into an expensive and reputation-tarnishing
disaster. There was perhaps no better man than Lesseps to lead such a project though; after all, this would
be his second mammoth canal project. Wasn’t he the expert? Unfortunately, without sufficient scrutiny, there
isn’t such a thing as an ‘expert’ and Lesseps’ estimates and plans were not put to sufficient testing before
investors sent his Compagnie Universelle large sums of money.

Fahmi Ben Abdelkader | Corporate finance 16

TAKE AWAY
Fixed income is not a 100% guarantee of the income

A bond is tradable in the market

It has a market price determined by buyers and sellers

The price of a fixed income contract could change over time and may face some volatility

Bonds can be sold before maturity

Because the market price can change, the bondholder who decides to sell can incur a capital loss

Fixed income is not a 100% guarantee of the income

The bankruptcy of the bond issuer (the borrower) could lead to a capital loss

Fahmi Ben Abdelkader | Corporate finance 17

The DNA of a bond

Fahmi Ben Abdelkader

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THE MAIN FEATURES OF A BOND
The Characteristics of a Bond loan are stated in the « Bond Certificate »

Face Value
Notional amount used to compute the interest payments
+ principal amount that is paid back

Issue price (which may be different from the face value)

The price at which investors buy the bonds when they are first issued

Maturity Date
Final repayment date

Coupon Rate
Determines the amount of each coupon payment, expressed as an APR

Coupon Rate
Coupon = Face Value
Number of coupon payments per year

Example : Consider a bond with a €1,000 face value and a 10% coupon rate. Coupons are paid every
semester. Calculate the value of the coupon.

10%
Coupon = 1000 * = €50
2
Fahmi Ben Abdelkader | Corporate finance 19
THE MAIN FEATURES OF A BOND
An example of corporate bond: Lufthansa

Coupons

Face Value

Fahmi Ben Abdelkader | Corporate finance 20

THE MAIN FEATURES OF A BOND
An example of US bond

Fahmi Ben Abdelkader | Corporate finance 21

BOND CASH FLOWS
Fixed income

FRANCE: Utility Engie has issued the largest green hybrid bond to fund renewable
energy or energy efficiency projects, as well as research and development investment in
these areas. (May 2014)

ENGIE issued a green bond for €2,5 Billion with a 9-year maturity and 2.4% coupon rate. The face value is
€1000 and coupons are paid annually.

The bond has been rated Baa1, BBB and BBB+ from Moody’s, S&P and Fitch respectively.
What cash flows will you receive if you hold the bond until maturity?

Coupon Rate
Coupon = Face Value
Number of coupon payments per year

2.4%
Coupon = 1000 * = €24
1

0 1 2 9
…
€24 €24 €24
+ €1000

Fahmi Ben Abdelkader | Corporate finance 22

BOND CASH FLOWS
Fixed income

FRANCE: Utility Engie has issued the largest green hybrid bond to fund renewable
energy or energy efficiency projects, as well as research and development investment in
these areas. (May 2014)

ENGIE issued a green bond for €2,5 Billion with a 9-year maturity and 2.4% coupon rate. The face value is
€1000 and coupons are paid annually.

The bond has been rated Baa1, BBB and BBB+ from Moody’s, S&P and Fitch respectively.
What cash flows will you receive if you hold the bond until maturity?
1200

1000 1000
1000

800

600

400

200
24 24 24 24 24 24 24 24 24
0
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9

Fahmi Ben Abdelkader | Corporate finance 23

The expected return of a bond

Fahmi Ben Abdelkader

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BOND RETURN
Yield to Maturity

Yield to maturity
The discount rate that sets the present value of the promised bond payments equal to the current
market price of the bond

YTM sets NPV = 0

The YTM indicates :

The theoretical annual return for current bondholder…

… if he holds his bond until maturity

…and receives all promised bond payments (no default assumption)

Fahmi Ben Abdelkader | Corporate finance 25

BOND RETURN
Yield to Maturity

Game
The US treasury has just issued a 5-year, $1000 bond with a 5% coupon and annual coupon payments.
What cash flows will you receive if you hold the bond until maturity?
If this bond is currently trading for a price of $957, would you expect a higher or a lower YTM than the coupon
rate (5%)?

5%
= $1,000 ∗ = $50
1

0 1 2 5
…
50 $ 50 $ 50 $ + 1000 $

Fahmi Ben Abdelkader | Corporate finance 26

BOND RETURN
Yield to Maturity

Game
The US treasury has just issued a 5-year, $1000 bond with a 5% coupon and annual coupon payments.
What cash flows will you receive if you hold the bond until maturity?
If this bond is currently trading for a price of $957, would you expect a higher or a lower YTM than the
coupon rate (5%)?

5%
= $1,000 ∗ = $50
1

0 1 2 5
…
-957.35 $ 50 $ 50 $ 50 $ + 1000 $

YTM higher than the coupon rate

YTM lower than the coupon rate

We don’t have enough information

Fahmi Ben Abdelkader | Corporate finance 27

BOND RETURN
Yield to Maturity

Game
The US treasury has just issued a 5-year, $1000 bond with a 5% coupon and annual coupon payments.
What cash flows will you receive if you hold the bond until maturity?
If this bond is currently trading for a price of $957, would you expect a higher or a lower YTM than the
coupon rate (5%)?

Fahmi Ben Abdelkader | Corporate finance 28

BOND RETURN
Yield to Maturity

Game
The US treasury has just issued a 5-year, $1000 bond with a 5% coupon and annual coupon payments.
What cash flows will you receive if you hold the bond until maturity?
If this bond is currently trading for a price of $957, what is the bond’s yield to maturity?

YTM sets NPV= 0 :

0 1 2 5
…
-957.35 $ 50 $ 50 $ 50 $ + 1000 $

50 1 1,000
= 957 1 =0
1 1

YTM = 6%

Fahmi Ben Abdelkader | Corporate finance 29

BOND RETURN
Yield to Maturity

Game
The US treasury has just issued a 5-year, $1000 bond with a 5% coupon and annual coupon payments.
What cash flows will you receive if you hold the bond until maturity?
If this bond is currently trading for a price of $957, what is the bond’s yield to maturity?

1200
1000 Face value

1000 Capital gain

Market price 957
800

600

400

200
50 50 50 50 50
0
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

Fahmi Ben Abdelkader | Corporate finance 30

BOND RETURNS
Not only coupons but also capital gain or … loss

Fahmi Ben Abdelkader | Corporate finance 31

The value of a coupon Bond

Fahmi Ben Abdelkader

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THE VALUE OF A COUPON BOND
Quick check question

It is almost useless to calculate the value of a bond, its price is predetermined and does
not change over time

Agree Disagree

Fahmi Ben Abdelkader | Corporate finance 33

THE VALUE OF A COUPON BOND
Quick check question

It is almost useless to calculate the value of a bond, its price is predetermined and does
not change over time

Agree Disagree

Fahmi Ben Abdelkader | Corporate finance 34

THE VALUE OF A COUPON BOND
Reminder: Value is driven by future cash flows

In theory:
The required return (time premium + risk premium)

0 1
V0 CF

= (( # ) ℎ( + , ) - . /- .0 ℎ ,
-/ ) - .0 ℎ # 1 /# - # #

$
!"
=
1 # "
"%&

Fahmi Ben Abdelkader | Corporate finance 35

THE VALUE OF A COUPON BOND
Reminder: Value is driven by future cash flows

= (( # ) ℎ( + , ) - . /- .0 ℎ ,
-/ ) - .0 ℎ # 1 /# - # #

Future cash flows of a coupon bond

2 - = ( 03 ! ) )

Fahmi Ben Abdelkader | Corporate finance 36

THE VALUE OF A COUPON BOND
Reminder: Value is driven by future cash flows

Game (Cont’d)
Consider again the US treasury has just issued a 5-year, $1000 bond with a 5% coupon and annual coupon
payments.
Suppose you are told that its yield to maturity has increased to 6.30%. In theory, would you expect the bond
to be trading at a price …

higher than the issue price ($957)

lower than the issue price ($957)

We don’t have enough information

Fahmi Ben Abdelkader | Corporate finance 37

THE VALUE OF A COUPON BOND
Reminder: Value is driven by future cash flows

Game (Cont’d)
Consider again the US treasury has just issued a 5-year, $1000 bond with a 5% coupon and annual coupon
payments.
Suppose you are told that its yield to maturity has increased to 6.30%. In theory, would you expect the bond
to be trading at a price …

higher than the issue price ($957)

lower than the issue price ($957)

We don’t have enough information

Fahmi Ben Abdelkader | Corporate finance 38

THE VALUE OF A COUPON BOND
Reminder: Value is driven by future cash flows

Game (Cont’d)
Consider again the US treasury has just issued a 5-year, $1000 bond with a 5% coupon and annual coupon
payments.
Suppose you are told that its yield to maturity has increased to 6.30%. In theory, what price is the bond
trading for now?

= (( # ) ℎ( + , ) - . /- .0 ℎ ,
-/ ) - .0 ℎ # 1 /# - # #

0 1 2 5
…
V0? 50 $ 50 $ 50 $ + 1000 $

50 1 1,000
5 = 1 = $945
6,3% 1 6,3% 1 6,3%

Fahmi Ben Abdelkader | Corporate finance 39

Dynamic Behavior of market Price and Return

Fahmi Ben Abdelkader

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DYNAMIC BEHAVIOR OF BOND PRICES
Discounts and Premiums

The face Value or Issue price or

trading price
Contractually stated in
the bond certificate :
called also the par Market price ; change over
time

Fahmi Ben Abdelkader | Corporate finance 41

 DYNAMIC BEHAVIOR OF BOND PRICES
Discounts and Premiums

Bond price = Face value Bond price < Face value Bond price > Face value

=> The bond trades « at par » => The bond trades « below => The bond trades « above
par » or « at a discount » par » or « at a premium »

Market
price
Capital loss
Market Face Face Face
price value Capital gain value value
Market
price

9:; = <=>?=@ ABCD 9:; > <=>?=@ ABCD 9:; < <=>?=@ ABCD

Fahmi Ben Abdelkader | Corporate finance 42

DYNAMIC BEHAVIOR OF BOND PRICES
Discounts and Premiums

ENGIE Example (Cont’d)

ENGIE issued a green bond for €2,5 Billion with a 9-year maturity and 2.4% coupon rate. The face value is
€1000 and coupons are paid annually.

Today, 8 years after the bond issue, the bond is trading at €1010. the last coupon will be paid in one year.

1. If you buy ENGIE Bond today, would you expect a higher or a lower YTM than the coupon rate (2.4%)?

YTM higher than the coupon rate

YTM lower than the coupon rate

Fahmi Ben Abdelkader | Corporate finance 43

DYNAMIC BEHAVIOR OF BOND PRICES
Discounts and Premiums

ENGIE Example (Cont’d)

ENGIE issued a green bond for €2,5 Billion with a 9-year maturity and 2.4% coupon rate. The face value is
€1000 and coupons are paid annually.

Today, 8 years after the bond issue, the bond is trading at €1010. the last coupon will be paid in one year.

1. If you buy ENGIE Bond today, would you expect a higher or a lower YTM than the coupon rate (2.4%)?

Fahmi Ben Abdelkader | Corporate finance 44

DYNAMIC BEHAVIOR OF BOND PRICES
Discounts and Premiums

ENGIE Example (Cont’d)

ENGIE issued a green bond for €2,5 Billion with a 9-year maturity and 2.4% coupon rate. The face value is
€1000 and coupons are paid annually.

Today, 8 years after the bond issue, the bond is trading at €1010. the last coupon will be paid in one year.

1. If you buy ENGIE Bond today, would you expect a higher or a lower YTM than the coupon rate (2.4%)?
2. Calculate the YTM.

0 1 2 8 9
…

- €1 010 €24
+ €1000

$24
YTM = = 2.37%
$1010

ERROR : actually, the bondholder will not be repaid $1010 at maturity but the face value $1000

Fahmi Ben Abdelkader | Corporate finance 45

DYNAMIC BEHAVIOR OF BOND PRICES
Discounts and Premiums

ENGIE Example (Cont’d)

ENGIE issued a green bond for €2,5 Billion with a 9-year maturity and 2.4% coupon rate. The face value is
€1000 and coupons are paid annually.

Today, 8 years after the bond issue, the bond is trading at €1010. the last coupon will be paid in one year.

1. If you buy ENGIE Bond today, would you expect a higher or a lower YTM than the coupon rate (2.4%)?
2. Calculate the YTM.

0 1 2 8 9
…

- €1 010 €24
+ €1000

The YTM will be lower than the coupon rate (2.4%) because the bond is trading at a premium (above Par)

1 024
YTM sets NPV = 0 NPV = −1 010 + =0 YTM = 1.38%
1 + YTM

The YTM is an estimation of the current cost of debt of ENGIE

Fahmi Ben Abdelkader | Corporate finance 46

YTM AND BOND PRICES
What kind of relationship ?

Fahmi Ben Abdelkader | Corporate finance 47

YTM AND BOND PRICES
What kind of relationship ?

A bond with high YTM reflects good financial health of the issuer (ie. the borrower)

Agree Disagree

Fahmi Ben Abdelkader | Corporate finance 48

YTM AND BOND PRICES
What kind of relationship ?

A bond with high YTM reflects good financial health of the issuer (ie. the borrower)

Agree Disagree

Fahmi Ben Abdelkader | Corporate finance 49

YTM AND BOND PRICES
What kind of relationship ?

Not all that shines is made of gold

Fahmi Ben Abdelkader | Corporate finance 50

YTM AND BOND PRICES
What kind of relationship ?

Example: Greece Government bonds during the sovereign debt crisis …

Fahmi Ben Abdelkader | Corporate finance 51

YTM AND BOND PRICES
What kind of relationship ?

The YTM can be negative

Agree Disagree

Fahmi Ben Abdelkader | Corporate finance 52

Corporate bonds and credit spread

Fahmi Ben Abdelkader

53
CORPORATE BONDS
How the risk of default impacts Bond’s return ?

Investors pay less for bonds with credit risk than they would for an otherwise identical default-free bond.
The yield of bonds with credit risk will be higher than that of otherwise identical default-free bonds.

Risk of Default
A bond’s expected return will be less than the yield to maturity if there is a risk of default.
A higher yield to maturity does not necessarily imply that a bond’s expected return is higher.

Table 6.3 (B&DM) Price, Expected Return, and Yield to Maturity of a One-Year Coupon Avant
Bond with Different Likelihoods of Default

Fahmi Ben Abdelkader | Corporate finance 54

BOND RATINGS
Investment Grade Bonds versus Speculative Bonds
Increasing default risk

Fahmi Ben Abdelkader | Corporate finance 55

BOND RATINGS
Investment Grade Bonds versus Speculative Bonds

Fahmi Ben Abdelkader | Corporate finance 56

BOND RATINGS
Some examples

[Link]

Fahmi Ben Abdelkader | Corporate finance 57

BOND RATINGS
General Motors example

New bond issue: General Motors issued international bonds for USD 750.0m
maturing in 2048 with a 5.4% coupon.
August 03, 2017 | Cbonds

General Motors issued international bonds for USD 750.0m maturing in 2048 with a 5.4% coupon.

Bonds were sold at a price of 99.927%.

Bookrunner: Bank of America Merrill Lynch, Deutsche Bank, Goldman Sachs, JP Morgan, Morgan Stanley.

See more: [Link]

MOODY'S RATING FOR GENERAL MOTORS FINANCIAL CO. INC. BOND

Fahmi Ben Abdelkader | Corporate finance 58

BOND RATINGS
Ford example

The automaker raised $8 billion of unsecured bonds in

three parts. The longest maturity, a 10-year security,
will yield 9.625%, after initially being marketed around
11%, (...). It’s the company’s first debt offering since
losing its investment-grade ratings on March 25,
becoming the largest fallen angel of the current
downgrade cycle.

Fahmi Ben Abdelkader | Corporate finance 59

CORPORATE BOND DEFAULTS
Sad famous examples

Fahmi Ben Abdelkader | Corporate finance 60

CORPORATE YIELD CURVES
The credit spread

Default Spread
Also known as Credit Spread
The difference between the yield on corporate bonds and Treasury yields

Fahmi Ben Abdelkader | Corporate finance 61

CORPORATE YIELD CURVES
The credit spread

Figure 6.3 (B&DM) Corporate Yield Curves for Various Ratings, August 2015

Fahmi Ben Abdelkader | Corporate finance 62

CORPORATE BONDS
Critical thinking questions

1. How is a bond like a loan?

2. How does an investor receive a return from buying a bond?

3. Explain why the yield of a bond that trades at a discount exceeds the bond’s
coupon rate

4. Explain why the expected return of a corporate bond does not equal its yield to
maturity

5. What is the relationship between a bond’s price and its yield to maturity?

Fahmi Ben Abdelkader | Corporate finance 63

CORPORATE BONDS
Critical thinking question

Why does the expected return of a corporate bond not equal its yield to maturity?

A. The expected return is greater than the yield because the IRR of the investment in
the bond exceeds the yield.
B. The expected return is the actual return, but the IRR of the investment opportunity
is not the yield.
C. The expected return is what is expected, while the yield is what you actually get.
D. The expected return of a bond with risk is less than the bond's yield to maturity
because the yield is calculated using the promised cash flows, which are not
necessarily the actual or expected cash flows.

Fahmi Ben Abdelkader | Corporate finance 64

CORPORATE BONDS
Critical thinking question

Companies with higher bond ratings can borrow money at a ……………….rate.

A. lower
B. prime
C. higher
D. Fed funds

Fahmi Ben Abdelkader | Corporate finance 65

CORPORATE BONDS
Critical thinking question

Unrated debt typically carries a higher interest rate because investors assume it must
be :

A. higher risk
B. a better investment
C. lower risk
D. risk free

Fahmi Ben Abdelkader | Corporate finance 66