Bonds and Their Valuation

After reading this chapter, students should be able to: List the four main classifications differentiate among them. of bonds and

Identify the key characteristics common to all bonds. Calculate the value of a bond with annual or semiannual interest payments. Explain why the market value of an outstanding fixed-rate bond will fall when interest rates rise on new bonds of equal risk, or vice versa. Calculate the current yield, the yield to maturity, and/or the yield to call on a bond. Differentiate between interest rate risk, reinvestment rate risk, and default risk. List major types of corporate bonds and distinguish among them. Explain the importance of bond ratings and list some of the criteria used to rate bonds. Differentiate among the following liquidation, and reorganization. terms: Insolvent,

Read and understand the information provided on the bond market page of your newspaper

Characteristics of Bonds
A bond is a long-term contract under which a borrower (the issuer) agrees to make payments of interest and principal, on specific dates, to the holders (creditors) of the bond. Bearer bond - Bonds that are not registered on the books of the issuer. Such bonds are held in physical form by the owner, who receives interest payments by physically detaching coupons from the bond certificate and delivering them to the paying agent. Registered bond - A bond whose issuer records ownership and interest payments. Differs from a bearer bond, which is traded without record of ownership and whose possession is the only evidence of ownership.

Par value - Also called the maturity value or face value; the amount that an issuer agrees to pay at the maturity date. Coupon interest rate - With bonds, notes, or other fixed income securities, the stated percentage rate of interest, usually paid twice a year (semiannually). Coupon payments - A bond's dollar interest payments. Maturity date - Date on which the principal amount of a bond or other debt instrument becomes due and payable. Call provision - An embedded option granting a bond issuer the right to buy back all or part of an issue prior to maturity. Bond indenture - Contract that sets forth the promises of a corporate bond issuer and the rights of investors. Sinking fund - A fund to which money is added on a regular basis that is used to ensure investor confidence that promised payments will be made and that is used to redeem debt securities or preferred stock issues. Sinking fund provision - A condition included in some corporate bond indentures that requires the issuer to retire a specified portion of debt each year. Convertible bond - General debt obligation of a corporation that can be exchanged for a set number of common shares of the issuing corporation at a prestated conversion price. Warrant - A security entitling the holder to buy a proportionate amount of stock at some specified future date at a specified price, usually one higher than current market price. Warrants are traded as securities whose price reflects the value of the underlying stock. Corporations often bundle warrants with another class of security to enhance the marketability of the other class. Warrants are like call options, but with much longer time spans-sometimes years. And, warrants are offered by corporations, while exchange-traded call options are not issued by firms.

Bond Valuation
The value of any financial asset - a stock, a bond, etc., or even a physical asset - is simply the present value of the cash flows (discounted at the assets required rate of return) which the asset is expected to generate over its lifetime.

CF3 CF1 CF2 CFn + + + ... + = VALUE = PV = 1 2 3 (1 + k) (1 + k) (1 + k) (1 + k)n

Bond terminology:

(1 + k) .
t= 1 t

CFt

kd = the bonds market rate of interest or required rate of return; also called the yield to maturity (YTM); (can change many times over the bonds life). N = the number of years before the bond matures. M = the par, or maturity, value of the bond (usually $1,000). CIR = the coupon interest rate (does not change over the bonds life). INT = the dollar amount of interest the bond pays per year (INT = CIR x M). Note: Always discount the bonds cash flows with kd. Bond valuation model with annual coupons:

VB = (1 + k )
t= 1 d

INT

M (1 + kd)N

INT(PVIFA kd,n) + M(PVIF kd,n)

Bond valuation model with semi-annual coupons:

VB =

2N

t=1

INT/2 t (1 + kd/2)

M 2N (1 + kd /2)
kd/2,2n)

INT/2(PVIFA kd/2,2n) + M(PVIF

Zero Coupon bond valuation model:

VZero = M/(1 + kd)n = M(PVIFkd,n)

Bond Valuation: Important Relationships

A decrease in interest rates (required rates of return) will cause the value of a bond to increase; an interest rate increase will cause a decrease in value. The change

in value caused by changing interest rates is called interest rate risk. A bondholder owning a long-term bond is exposed to greater interest rate risk than when owning a short-term bonds. The market value of the bond will always approach its par value as its maturity date approaches, provided the firm does not go bankrupt. If the bondholder's required rate of return (current interest rate) equals the coupon interest rate, the bond will sell at "par," or maturity value. If the current interest rate exceeds the bond's coupon rate, the bond will sell below par value or at a "discount." If the current interest rate is less than the bond's coupon rate, the bond will sell above par value or at a "premium."

Bond Yields
Yield to maturity - The percentage rate of return paid on a bond, note, or other fixed income security if the investor buys and holds it to its maturity date. The calculation for YTM is based on the coupon rate, length of time to maturity, and market price. It assumes that coupon interest paid over the life of the bond will be reinvested at the same rate. Estimated YTM = INT + [(M VB)/n] -------------------------(M + 2VB)/3

Current yield - The annual interest payment on a bond divided by the bond's current price. Current yield = INT/VB Capital gains (loss) yield - The price change portion of a bond's return. Capital gains (loss) yield = (VB+1 - VB)/VB Therefore, the total return on a bond is equal to the bond's YTM, and the YTM = Current yield + Capital gains (loss) yield. YTM = INT/VB + (VB+1 - VB)/VB

Yield to call - The percentage rate of return on a bond or note if the investor buys and holds the security until the call date. This yield is valid only if the security is called prior to maturity. Generally bonds are callable over several years and normally are called at a slight premium. The calculation of yield to call is based on coupon rate, length of time to call, call price and market price. Estimated YTC = INT + [(Call Price VB)/Years to Call] ----------------------------------------(Call Price + 2VB)/3

Yield to maturity on a zero coupon bond:

YTMZero = (M/VZero)1/n

1.0

Types of bonds
Treasury bonds - Debt obligations of the US Treasury that have maturities of 10 years or more. Municipal bond - State or local governments offer muni bonds or municipals, as they are called, to pay for special projects such as highways or sewers. The interest that investors receive is exempt from some income taxes. Foreign bond - A bond issued on the domestic capital market of another country. Corporate bonds - Debt obligations issued by corporations. 1. 2. 3. Mortgage bond - A bond in which the issuer has granted the owner a lien against the pledged assets. Debenture - Any debt obligation backed strictly by the borrower's integrity, e.g. an unsecured bond. A debenture is documented in an indenture. Subordinated debenture bond - An unsecured bond that ranks after secured debt, after debenture bonds, and often after some general creditors in its claim on assets and earnings.

Bond Ratings
Bond ratings are critical to a company's ability to issue debt at an acceptable interest rate. 5

1. What is the purpose of rating debt? Answer: Unrated debt is extremely difficult, if not impossible to sell. Corporations desiring to sell bonds must submit their proposals to an independent rating company like Moody's Investor Service or Standard & Poors Corporation for the debt to be assigned a rating. This rating, coupled with market rates of interest and the special features of the debt, will determine how much the company will have to pay in interest. 2. Why would a company's debt rating be changed subsequent to issue? Answer: Any time new information relevant to the company's ability to repay the debt (i.e. changes in the company's financial health) is discovered and determined to be of sufficient impact, that company's debt rating might be changed. Obviously, good information should result in a better rating or upgrade and bad information should result in a downgrade. 3. What impact would a change in debt rating have on the value of an outstanding bond? Answer: Bonds of companies that suffered downgrades would decline in value to equate the yield to the new level of risk. Conversely, bonds that were upgraded should increase in price. Bond ratings are important for firms raising capital via a debt offering. Companies that are financially sound enough to get a higher rating will be able to sell debt with lower interest payments than their riskier counterparts. Bond rating agencies also actively monitor outstanding debt they have rated for changes in status. Companies placed on watchlists are companies who are facing potential changes in the rating of their debt. Junk bond - A bond with a speculative credit rating of BB (S&P) or Ba (Moody's) or lower. Junk or high-yield bonds offer investors higher yields than bonds of financially sound companies.

Bond Quotations
1 Bonds Chiquita 10 1/2 04 K Mart 6.2s97 Disney zr05 2 Cur Yld 10.7 cv 3 Vol 144 50 414 4 Close 98 1/4 91 45 3/4 5 Net Change + 3/8 + 1/4 + 3/4

Column 1: Bond, Coupon Rate, Date of Maturity A bond issued by Chiquita which matures in 2004 has a coupon rate of 10 1/2. This stated interest rate represents the 10.5 percent paid on the bond's $1,000 face value. The holder of this bond will receive $105 annually. The "s" in the K Mart quotation separates the 6.2 percent rate from the 1997 maturity rate. Note this bond is listed in fractions of 10s instead of 8s. The Disney bonds are zero coupon bonds as indicated by the "zr." They do not pay annual interest. Column 2: Current Yield At this day's price, the holder of a Chiquita bond annually will receive 10.7 percent or $10.70 for every $100 invested. The current yield is calculated by dividing the annual interest by the closing price. "cv" indicates the K Mart bond is convertible and can be exchanged for K Mart stock. Column 3: Volume On this day, 500,000 K Mart bonds were sold. The number 50 has been multiplied by 10,000. Columns 4 & 5: Close, Net Change The final price for Chiquita bonds was $982.50 which was $3.75 more than the final price on the day before.

1 Bonds USAir 16 1/4 09 IBM zr13 CBS 9.8s20

2 Cur Yld 14.5 cv

3 Vol 15 20 32

4 Close 111 7/8 42 1/8 109 1/2

5 Net Change - 3/4 +2

1. How many transactions of USAir bonds were made? _________ 2. What year are each of these bonds due? USAir __________ CBS __________

3. What is the stated coupon interest paid to the bondholder for each of these bonds? USAir _______________ IBM _______________ CBS _______________

4. If you bought the following bonds at these prices, what would your yield to maturity be? USAir _________________ IBM _________________

5. What was the closing price for these bonds on the previous day? USAir _________________ CBS _________________

Bond Value ($)

1,800

Interest Rate Price Risk for 10 percent Coupon Bonds with Different Maturities

1,400

1,000

600

1-Year 5-Year 10-Year 20-Year 30-Year

10

11

Interest Rate (%)

12

13

14

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An Investor's Guide to the Many Meanings of Yield

Let us assume that you are reading the financial pages of your favorite newspaper. You read that even though stock returns have been dismal for the last two years, bond returns have been very good. In fact, you read that over the past two years, many bond funds returned well over 15%. While the returns look pretty darn good relative to stocks, you may wonder: Does that mean I can expect to earn 15% next year if I buy bonds? If the answer is not obvious, read on. The direction of interest rates is one of the chief determinants of bond prices. A strong market for bonds is one in which interest rates are declining. That causes bond prices to go up. A weak market is one in which interest rates are going up. That causes bond prices to decline. Clearly, then, since changes in interest rate levels affect bond prices, they also affect what you earn from investments in bonds. But that is only the beginning. In order to understand what you actually earn from bonds, you need to understand two different concepts: yield and total return. When you buy an individual bond, you can expect to receive coupon payments (usually every six months) for most bonds. When you buy a bond fund, you can expect a monthly payout of the income earned by the bond fund. That stream of income is variously described as the bonds yield. But you also have to bear in mind that when you sell or redeem your bond (or bond 9

fund), you may sell at a higher or at a lower price than the price you paid. That difference can be an additional source of earnings, or it may result in a loss. That change in price is one of the main factors that determines a bonds total return. What may be confusing, however, is that the term yield has a number of different meanings. Even more confusing is the fact that these meanings are not directly comparable for individual bonds and for bond funds. Moreover, individual bonds are usually sold to investors and are discussed primarily in terms of yield, not returns. But discussions of bond funds often focus on total return. Yield When you buy an individual bond, you derive income from three different sources: Simple interest, Interest on interest, and Return of principal at maturity, or proceeds from the sale of the bond at an earlier date. Simple interest consists of the bonds coupons, which are usually paid twice a year. Let us say you invest $10,000 in a four-year bond, paying 8% a year, semiannually. In return, you will receive two coupon (or interest) payments of $400 each, at six-month intervals every year. If you hold the bond until it matures, you will receive eight coupons that total $3,200. Those eight coupons are the simple interest. If the coupon payments are spent, only the simple interest is earned. But if the coupons are reinvested, they produce additional interest; subsequently, if those earnings are reinvested, you earn interest on that interest, and so on. That entire income stream is called, logically enough, interest-oninterest, or compounded interest. Both interest income, and interest-on-interest, in different combinations, lie behind the different meanings of yield. Yield appears in a number of phrases: coupon yield, current yield and yield to maturity. Each has a very precise meaning. Lets look at each in turn. Coupon Yield Coupon yield is set when a bond is issued. It is the interest rate paid by the bond (for example, 5%,7%), and it is listed as a percentage of par, or face value, which is the principal amount that will be owed at maturity.

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The coupon yield designates a fixed dollar amount that never changes through the life of the bond. If a $1,000 par value bond is described as having a 10% coupon, that coupon will always be $100 for each bond, paid out in two $50 increments for the entire life of the bondno matter what happens to the price of the bond, or to interest rates. That is the reason bonds are called fixed-income securities. Current Yield Almost as soon as a bond starts trading in the secondary market, it ceases to trade at par due to changing interest rates. A bonds current yield is its coupon divided by its market price. To illustrate, let us assume you purchased three bonds: the first you bought at par, for $1,000; the second you bought at a premium to par, and paid $1,200; the third you bought at a discount to par, for $800. Each bond has a 10% coupon, and so each pays $100 in annual coupons. Dividing the coupon ($100) by the price results in a current yield of 10% for the par bond; 8.33% for the premium bond; and 12.5% for the discount bond. Thus, the current yield is equal to coupon yield for the par bond; the current yield is lower than the coupon yield for the premium bond; and the current yield is higher than the coupon yield for the discount bond. Current yield is quoted for fixedincome securities of any maturity, whether short or long. Yield to Maturity You can see from the above description that current yield is based only on the coupon and the current market price. Current yield, therefore, fails to measure two important sources of income that investors earn from bonds: interest-on-interest and capital gains or losses. Yield to maturity (YTM) is a more comprehensive measure of potential earnings than current yield. It estimates the total amount that a bond will earn over the entire life of an individual bond, from all possible sources of income coupon income, interest-on-interest, and capital gains or losses due to the difference between the price paid when the bond was purchased and par, the return of principal at maturitybased on a number of assumptions regarding the holding period, reinvested income and interest rates over the life of the bond. Yield to maturity calculations are not easily made using paper

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and pencil, but they can easily be determined using either a financial calculator, or by using the various calculators available on the Internet. YTM is the measure most widely quoted by brokers when selling individual bonds. However, it is not a prediction of what you will actually earn on a bond. Your actual return is likely to differ from the YTM, perhaps considerably, because the YTM will only be realized under certain conditions, which are: That you hold the bond to maturity; That the coupons are reinvested (rather than spent); and That coupons are reinvested at an interest rate equal to the yield-to-maturity.

Lets look briefly at each assumption: -Holding to Maturity: The YTM quote is based on the redemption price of par (that is, $1,000). If you sell a bond before it matures at a price other than par, then the capital gain or loss will considerably alter what you actually earn. -Reinvesting Coupons: YTM calculations are based on the assumption that coupons are never spent; they are always reinvested. If you spend coupons, then you do not earn the interest-on-interest, and your return would be less than the anticipated YTM. How much less depends both on how many coupons you spend and on the maturity of the bonds. -Coupons are Reinvested at an Interest Rate Equal to the YTM: This may sound like double talk, but it means that if a bond has a YTM of 7%, it is assumed that each and every coupon is reinvested at a rate of 7%. However, if in reality you reinvest coupons at a higher rate than 7%, you will earn more than the bonds stated YTM, while if you reinvest coupons at lower rates than 7%, you will earn less. Reinvestment Risk Reinvestment risk is the risk that coupons may have to be reinvested at a lower interest rate, in which case an investors actual return would then be lower than the YTM quoted at the time of purchase. On the other hand, the reinvestment risk may work in your favor if coupons are reinvested at a higher rate, and that would increase the actual return above the YTM quoted at the time of purchase. If YTM does not predict your actual return, what does it tell 12

you? The chief usefulness of YTM quotes is that they allow you to compare different kinds of bondsthose with dissimilar coupons, different market prices relative to par (for instance, bonds selling at premiums or discounts), and different maturities. Default Risk The risk that an issuer of a bond may be unable to make timely principal and interest payments.

Zero Coupon Bonds

Zero coupon bonds result from the separation of coupons from the body of a security. Zeros sell at deep discounts from face value. The difference between the purchase price of the zero and its face value when redeemed is the investor's return. Zeros can be purchased from private brokers and dealers, but not from the Federal Reserve or any government agency.

Creating Zeros by Coupon Stripping - Coupon stripping is the act of detaching the interest payment coupons from a note or bond and treating the coupons and the body as separate securities. Each coupon, or interest payment, entitles its owner to a specified cash return on a specific date; the body of the security calls for repayment of the principal amount at maturity. The body of the stripped securities and the separate coupons are known as "zero coupons" or "zeros" because there are no periodic interest payments on each instrument. After stripping, the body and coupons are sold at a deep discount from their face values. An owner benefits only from the difference between the purchase price and the payment received upon sale or at maturity. For example, a 20 year bond with a face value of $20,000 and a 10% interest rate could be stripped into its principal and its 40-semi-annual interest payments. The result would be 41 separate zero coupon instruments, each with its own maturity date. The principal would be worth $20,000 upon maturity, and each interest coupon $1,000, or one-half the annual interest of 10% on $20,000. Each of the 41 securities, now possessing a distinct ID number, could be traded separately until its maturity date at prices determined by the market.

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Proliferation of Treasury STRIPS - Some Treasury securities were traded in the secondary market without one or more of their interest coupons in the late 1970s. Stripped securities offered investors a financial instrument that had abundant supply, no default risk, and low incidence of being "called," or paid off, before their maturity date. However, their popularity raised fears within the Treasury Department that zeros would result in a sizable loss of tax revenues. Detached coupons and the body of the security were sold at deep discounts, $.05 or $.10 on the dollar. After purchase, an investor claimed a capital loss on the difference between the sale price of the security and its face value, thus reducing the investor's overall tax liability. The Tax Equity and Fiscal Responsibility Act (TEFRA) of 1982 adjusted the tax treatment of stripped securities to reduce their tax advantage. The Treasury Department then withdrew its objections to coupon stripping, prompting several securities dealers to create new products incorporating receipts for stripped debt securities. TEFRA also required the Treasury to begin issuing all of its securities in book-entry (electronic)form only, beginning on January 1, 1983. This provision eliminated Treasury issues of bearer notes and bonds with coupons attached. Physical stripping would no longer be possible. In response, bond dealers began to market receipts that evidenced ownership of Treasury zeros held by a custodian. The first of these "receipt products" were named Treasury Investment Growth Receipts, or TIGRS. Similar products appeared in 1984, such as Certificates of Accrual on Treasury Securities (CATS) and Treasury Receipts (TRs). However, most of these securities were not exchangeable with other stripped securities, and thus lacked the liquidity customers had come to expect from "zero" instruments. In February 1985, the Treasury took a more active role by introducing its own coupon stripping program called STRIPS, an acronym for Separate Trading of Registered Interest and Principal of Securities. The STRIPS program was intended primarily to reduce the cost of financing the public debt "by facilitating competitive private market initiatives." Under the STRIPS program, U.S. government issues with maturities of ten years or more became eligible for transfer over Fedwire.

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The process involves wiring Treasury notes and bonds to the Federal Reserve Bank of New York and receiving separated components in return. This practice also reduced the legal and insurance costs customarily associated with the process of stripping a security. In May 1987, the Treasury began to allow the reconstitution of stripped securities. Part of a Balanced Portfolio - Stripped securities can be purchased only from private dealers and brokers. Although the Federal Reserve provides services to the zero coupon market, it does not actually sell these securities for the Treasury. Financial services companies decide when and what portion of an eligible security are stripped and sold. Because their increase in value is taxable yearly as it accrues, zeros have become most popular for investments on which taxes can be deferred, such as individual retirement accounts and pension plans, or for nontaxable accounts. However, their known cash value at specific future dates enables savers and investors to tailor their use to a wide range of portfolio objectives.

Problems

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1) The bonds of the Nordy Company have a coupon interest rate of 9%. The interest on the bonds is paid semiannually, the bonds mature in 8 years, and their par value is $1,000. If the required rate of return, kd = 8%, what is the value of each bond? What is the value of each bond if the interest is paid annually? 2) You own a bond that pays $100 in interest annually, has a par value of $1000, and matures in 15 years. What is the value of the bond if your required rate of return is 12%? What is the value of the bond if your required rate of return (a) increases to 15% or (b) decreases to 8%? Now, recompute all three answers assuming that the bond matures in 5 years instead of 15 years. 3) Dullco Company bonds are selling in the market for $1,045 (104.50). These bonds will mature in 15 years and pay $70 in interest annually. If the bonds are purchased at the market price, what is the (a) coupon rate, (b) current yield, (c) approximate yield to maturity and (d) capital gains yield? 4) Apex Company is planning to issue zero coupon bonds that will mature at $1,000 in 20 years. If your required rate of return on these bonds is 9.35%, what are you willing to pay for the bonds? If these bonds are currently selling for $213.50, what is their yield to maturity (YTM)?

Answers
1) $1,058.26; $1,057.47 2) $863.78; (a)$707.63; (b)$1,171.19 $927.90; (a)$832.39; (b)$1,079.85 3) (a)7%; (b)6.70%; (c)6.50%; Exact YTM = 6.5208%; (d)-0.20%; Exact CGY = -0.1792% 4) $167.35; 8.03%

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