Bonds and Their Valuation: Key Features of Bonds Bond Valuation Measuring Yield Assessing Risk
Bonds and Their Valuation: Key Features of Bonds Bond Valuation Measuring Yield Assessing Risk
Bonds and Their Valuation: Key Features of Bonds Bond Valuation Measuring Yield Assessing Risk
7-2
Types
Groupings are based on the issuer type. Bonds differ
with respect to risk and consequently the expected
return.
1.Treasury bonds
2.Municipal bonds
3.Corporate bonds
4.Foreign bonds
7-3
1. Treasury bonds: Issued by the federal government and so no default
risk. Interest rate risk still present.
3. Municipal bonds: Bonds issued by the state and local governments. Like,
corporates munis are exposed to some default risk. One advantage
however is that munis are exempt from taxes.
7-4
Bond markets
Primarily traded in the over-the-counter
(OTC) market.
Most bonds are owned by and traded among
large financial institutions.
Full information on bond trades in the OTC
market is not published, but a representative
group of bonds is listed and traded.
7-5
Key Features of a Bond
Par value – face amount of the bond, which
is paid at maturity (assume $1,000).
Par value generally represents the amount of money the firm
borrows and promises to repay on the maturity date.
For example, Allied's bonds have a $ 1000 par value, and they
have 10% coupon interest rate. The bond's coupon
payment is $ 100.
7-6
Maturity date – years until the bond must be repaid.
It is a specified date on which the par value of a bond must be repaid.
Example: Allied bonds which were issued on Jan 3, 2012 will mature
on Jan 2, 2027. Thus they had a 15-year maturity at the time they
were issued.
Effective maturity and original maturity?
7-7
Call provisions
a provision in a bond that gives the issuer the right to
redeem the bonds under specified terms prior to the
normal maturity date. The call provision generally states
that the issuer must pay the bond holders an amount
greater than the par value if called. The additional sum,
which is called call premium, is often equal to one year's
interest.
For example, the call premium on a 10-year bond with a
10% annual coupon and a par value of $ 1000 might be
$100. Which means the issuer will have to pay $1100 to
investors to call back the bonds.
7-8
Effect of a call provision
Allows issuer to refund the bond issue
if rates decline (helps the issuer, but
hurts the investor).
Borrowers are willing to pay more,
and lenders require more, for callable
bonds.
Most bonds have a deferred call and a
declining call premium.
7-9
What is a sinking fund?
Provision to pay off a loan over its life
rather than all at maturity.
Similar to amortization on a term
loan.
Reduces risk to investor, shortens
average maturity.
But not good for investors if rates
decline after issuance.
7-10
How are sinking funds executed?
Call x% of the issue at par, for sinking
fund purposes.
Likely to be used if rd is below the coupon
rate and the bond sells at a premium.
Buy bonds in the open market.
Likely to be used if rd is above the coupon
rate and the bond sells at a discount.
7-11
Other types (features) of bonds
Convertible bond – may be exchanged for
common stock of the firm, at the holder’s
option.
Warrant – long-term option to buy a stated
number of shares of common stock at a
specified price.
Putable bond – allows holder to sell the bond
back to the company prior to maturity.
Income bond – pays interest only when interest
is earned by the firm.
Indexed bond – interest rate paid is based
upon the rate of inflation. 7-12
The value of financial assets
0 1 2 n
r
...
Value CF1 CF2 CFn
7-13
What is the value of a 10-year, 10%
annual coupon bond, if rd = 10%?
0 1 2 n
r
...
VB = ? 100 100 100 + 1,000
7-15
An example:
Increasing inflation and rd
Suppose inflation rises by 3%, causing rd =
13%. When rd rises above the coupon rate,
the bond’s value falls below par, and sells at
a discount.
7-16
An example:
Decreasing inflation and rd
Suppose inflation falls by 3%, causing rd =
7%. When rd falls below the coupon rate,
the bond’s value rises above par, and sells
at a premium.
7-17
The price path of a bond
What would happen to the value of this bond if
its required rate of return remained at 10%, or
VB
at 13%, or at 7% until maturity?
1,372 rd = 7%.
1,211
rd = 10%.
1,000
837
775 rd = 13%.
Years
to Maturity
30 25 20 15 10 5 0 7-18
Bond values over time
At maturity, the value of any bond must
equal its par value.
If rd remains constant:
The value of a premium bond would
7-19
What is the YTM on a 10-year, 9%
annual coupon, $1,000 par value bond,
selling for $887?
Must find the rd that solves this model.
INT INT M
VB ...
(1 rd )1
(1 rd ) N
(1 rd ) N
90 90 1,000
$887 ...
(1 rd )1
(1 rd )10
(1 rd )10
7-20
Using a financial calculator to
find YTM
Solving for I/YR, the YTM of this bond is
10.91%. This bond sells at a discount,
because YTM > coupon rate.
7-21
Find YTM, if the bond price was
$1,134.20.
Solving for I/YR, the YTM of this bond is
7.08%. This bond sells at a premium,
because YTM < coupon rate.
7-22
Definitions
Annual coupon payment
Current yi eld (CY)
Current price
Change in price
Capital gains yield (CGY)
Beginning price
Expected Expected
Expected total return YTM
CY CGY
7-23
An example:
Current and capital gains yield
Find the current yield and the capital
gains yield for a 10-year, 9% annual
coupon bond that sells for $887, and
has a face value of $1,000.
= 0.1015 = 10.15%
7-24
Calculating capital gains yield
YTM = Current yield + Capital gains yield
CGY = YTM – CY
= 10.91% - 10.15%
= 0.76%
Interest
Low High
rate risk
Reinvestment
High Low
rate risk
7-32
Semiannual bonds
1. Multiply years by 2 : number of periods = 2n.
2. Divide nominal rate by 2 : periodic rate (I/YR) =
rd / 2.
3. Divide annual coupon by 2 : PMT = ann cpn / 2.
INPUTS 2n rd / 2 OK cpn / 2 OK
N I/YR PV PMT FV
OUTPUT
7-33
What is the value of a 10-year, 10%
semiannual coupon bond, if rd = 13%?
Assignment
7-34
What is the value of a 10-year, 10%
semiannual coupon bond, if rd = 13%?
7-35
A 10-year, 10% semiannual coupon bond
selling for $1,135.90 can be called in 4 years
for $1,050,
7-36
A 10-year, 10% semiannual coupon bond
selling for $1,135.90 can be called in 4 years
for $1,050, what is its yield to call (YTC)?
7-37
Yield to call
3.568% represents the periodic
semiannual yield to call.
YTCNOM = rNOM = 3.568% x 2 = 7.137%
is the rate that a broker would quote.
The effective yield to call can be
calculated
YTCEFF = (1.03568)2 – 1 = 7.26%
7-38
If you bought these callable bonds, would
you be more likely to earn the YTM or YTC?
7-39
When is a call more likely to occur?
In general, if a bond sells at a premium,
then (1) coupon > rd, so (2) a call is
more likely.
So, expect to earn:
YTC on premium bonds.
YTM on par & discount bonds.
7-40
7-41
7-42
Default risk
If an issuer defaults, investors receive
less than the promised return.
Therefore, the expected return on
corporate and municipal bonds is less
than the promised return.
Influenced by the issuer’s financial
strength and the terms of the bond
contract.
7-43
Types of bonds
Mortgage bonds
Debentures
Subordinated debentures
Investment-grade bonds
Junk bonds
7-44
What is the opportunity cost of
debt capital?
The discount rate (rd) is the
opportunity cost of capital, and is the
rate that could be earned on
alternative investments of equal risk.
rd = r* + IP + MRP + DRP + LP
7-45
Evaluating default risk:
Bond ratings
Investment Grade Junk Bonds
7-46
Factors affecting default risk and
bond ratings
Financial performance
Debt ratio
TIE ratio
Current ratio
Bond contract provisions
Secured vs. Unsecured debt
Senior vs. subordinated debt
Guarantee and sinking fund provisions
Debt maturity
7-47
Other factors affecting default risk
Earnings stability
Regulatory environment
Potential antitrust or product liabilities
Pension liabilities
Potential labor problems
Accounting policies
7-48
Assignment
What is PACRA? How does PACRA allocates
ratings to a corporation?
7-49
Bankruptcy
Reorganization
Liquidation
7-50
Bankruptcy
7-51
Priority of claims in liquidation
7-52
Reorganization
In a liquidation, unsecured creditors
generally get zero. This makes them more
willing to participate in reorganization even
though their claims are greatly scaled back.
Various groups of creditors vote on the
reorganization plan. If both the majority of
the creditors and the judge approve,
company “emerges” from bankruptcy with
lower debts, reduced interest charges, and
a chance for success.
7-53