9th letter to friends of Brunei (Bond's valuation [part 1])

Let's talk about bonds. One of the oldest financial instrument around. The concept is simple.

A has a great business idea but is short of money. B has money. A borrows money from B, and in return promises to pay B a fixed interest for 10 years, and returns the capital to B(also at 10th year). A uses the cash flow generated from the business to pay the fixed interest to B. Here we go, we have just structured a 10 year bond product.

C learns about the contract between A and B. C proposes to B to buy over the contract at a premium or discount over the capital borrowed by A. This is the secondary market of bond.

Before we go into the mathematics, one has to know which value will change, which value will not change.

a. The par value is the maturity value of the bond. This will not change.

b. The fixed interest rate (i.e. the coupon rate) is a function of the par value will not change.

c. The market price of the bond will change, depending on the market factors like interest rate, inflation, demand and supply etc.

1. Coupon rate (or coupon yield)

Coupon rate is the annual coupon amount divided by the bond's par value.

Coupon Rate = Annual Coupon / Par Value

Example 1: What's the coupon rate of a bond with par value of $1000, paying $80 p.a.?

a. 8.0%

b. 12.5%

c. 10.0%

d. 5.0%

Example 2: Coupon rate will not change. True or false?

a. True.

b. False, coupon rate can change depending on market situation.

*For whatever reason, the bond's lingo uses "yield" instead of "return" (commonly used by equity valuation). You will see alot of "yield" in our discussion of bond valuation.