6: Valuation of Financial Assets—Bonds

Introduction

Bonds are essential financial instruments that allow governments, corporations, and other institutions to raise capital in the capital markets. From the issuer’s perspective, bonds provide a way to borrow large amounts of money without giving up ownership control. From the investor’s perspective, bonds offer an opportunity to earn relatively predictable income, reduce portfolio volatility, and balance risk exposure when compared to common stock.

Bonds matter in financial management because they sit at the intersection of three core ideas you have already studied: (1) how capital markets connect savers and borrowers (Chapter 2), (2) how financing choices shape a firm’s cost of capital and financial flexibility, and (3) how the time value of money converts future cash flows into a value today (Chapter 5). In other words, bond valuation is not a new topic as much as it is a powerful application of TVM logic to a real financial asset that is traded every day.

When a bond is issued, it represents a loan from investors (bondholders) to the issuer. The issuer promises two types of cash flows: (1) periodic interest payments (called coupon payments) and (2) repayment of the bond’s face value (also called par value or principal) at maturity. Because these payments occur over time, bond valuation follows directly from Chapter 5: a bond’s price equals the present value of its promised cash flows, discounted at a rate that reflects current market conditions and risk.

This chapter builds practical intuition around a few big ideas that drive nearly all fixed-income valuation: (a) bonds rarely trade exactly at par, (b) bond prices and interest rates move in opposite directions, and (c) longer-maturity bonds and lower-coupon bonds tend to be more sensitive to interest rate changes. These relationships are not just abstract. They affect corporate borrowing costs, government financing, retirement portfolios, and the performance of financial institutions.

We will explore how bonds are priced, how yields are calculated, and how interest rate fluctuations affect market value. In later sections, we will dive deeper into yield to maturity (YTM), current yield, and duration. Each of these measures answers a slightly different question: YTM summarizes the bond’s return if held to maturity under standard assumptions, current yield focuses on income relative to price, and duration helps quantify how sensitive a bond’s price is to changes in interest rates.

To visualize these relationships, imagine a bond cash-flow timeline with coupon payments arriving at regular intervals and the principal repayment at maturity. Once you can sketch the timeline, the valuation process becomes straightforward: discount each cash flow using an appropriate rate and sum the present values. That single idea will reappear repeatedly in more advanced valuation topics later in the course, including stock valuation and capital budgeting.

Throughout this chapter, we will use examples, tables, and calculator and spreadsheet workflows such as BA II Plus and Excel to show how to compute bond prices and yields under different market conditions. We will also connect these calculations to real-world contexts by briefly comparing how Treasury bonds, municipal bonds, and corporate bonds are issued, traded, and evaluated by investors.

By the end of the chapter, you should be able to translate bond features into cash flows, value those cash flows using time value of money logic, and explain why bond prices change when market interest rates change. These are foundational skills for understanding fixed-income markets and for making sound financing and investment decisions.