1 / 47

Chapter 6 - Bonds

Chapter 6 - Bonds. Bonds. Definition : A bond is a type of annuity A bond is a long or short term debt instrument (a loan) issued by corporations and municipal, state and federal agencies. A bond is a contract; it’s an IOU

aron
Download Presentation

Chapter 6 - Bonds

An Image/Link below is provided (as is) to download presentation Download Policy: Content on the Website is provided to you AS IS for your information and personal use and may not be sold / licensed / shared on other websites without getting consent from its author. Content is provided to you AS IS for your information and personal use only. Download presentation by click this link. While downloading, if for some reason you are not able to download a presentation, the publisher may have deleted the file from their server. During download, if you can't get a presentation, the file might be deleted by the publisher.

E N D

Presentation Transcript

  1. Chapter 6 - Bonds

  2. Bonds • Definition: • A bond is a type of annuity • A bond is a long or short term debt instrument (a loan) issued by corporations and municipal, state and federal agencies. • A bond is a contract; it’s an IOU • When a corporation or government agency issues bonds (request a loan, borrows money), it is said to be issuing debt • When you buy a bond, you become a creditor to the issuing agency which, in turn, becomes a debtor to you

  3. Bonds • Bonds are issued in uniform denominations (i.e. $1,000, $10,000, etc.); most corporate and gov’t bonds are $1,000 • Bonds are traded (bought and sold); mostly OTC • Bonds are the most predominate method for financing business and government projects • Bonds are a fundamental investment class

  4. Bonds - Terminology • Principal, Face Value, Maturity Value, and Par Value:The amount of money the firm borrows and promises to repay at some future date, usually at the maturity date • Coupon Interest Rate: rcpn , the stated annual rate of interest paid on a bond. • Coupon Payment: • The specified number of dollars of interest paid each period. Bonds most commonly pay semiannual interest. • It’s called a “coupon” because…….. • Original Maturity:The number of years (or months) to maturity at the time the bond is issued. Also referred to as the“term”. Some bonds have been issued with 100 year original maturities.

  5. Bonds - Terminology cont. • Maturity Date:A specified date on which the par value of a bond must be repaid. • “Maturity”: The time left until a bond matures. • What do you call a 10-year original maturity bond that was issued 8 years ago and thus has only 2 years left to maturity? Answer:

  6. Bonds - Coupon Interest Rate • Coupon Interest Rate • This is the cost of debt to the issuer (borrower) • A coupon bond pays periodic interest • A zero-coupon bond pays interest only once (simple interest) (more on this later); applies mainly to short-term bonds • For both types of bonds, the principle is repaid at maturity • Coupon Payment • Example: a $10,000 face value bond has a coupon rate of 5% per annum, paid annually. How much is the coupon payment? • Cpn = Face Value*(rcoupon) = $10,000(0.05) = $500 • Example: a $10,000 face value bond has a coupon rate of 5% per annum, paid semiannually. How much is the coupon payment? • Cpn = Face Value(rcoupon)/m = $10,000(0.05)/2 = $250

  7. Bonds - Ratings • Bond from companies with similar risk characteristics are grouped together into categories as shown below Risk / rd Lower Higher Higher risk, higher rd

  8. Bonds • Each of the rating categories above will have a different term structure of interest rates (see next slide) • Each rating category is also referred to as a “bond market” (i.e. all AAA bonds are traded in the AAA “bond market”) • The cost of debt for a particular maturity in a particular bond market is called the “market interest rate” • All bonds in the same bond market and having the same maturity have the same market interest rate (“Law of One Price” from Ch 3) • The current market interest rate is also called the “spot rate” • Standard & Poors and Moody’s are two firms that provide these bond ratings. Another bond rating firm is Fitch

  9. Bonds - Interest Rate Term Structure for Different Bond Ratings Bonds in different rating category but with the same maturity will have a different rd. Why? Answer:

  10. Bonds- WSJ Bond Yields (as of 14 Jul 2009)

  11. Bonds • The Market Interest Rate (rd) is the Required ROR for all bonds of the same rating and maturity • Main Types of Bonds (By Issuers): • Treasury Bonds: issued by the U.S. Government; also known as “treasuries” or “government bonds”; three types (by maturity): • T-bills: orig. maturity of 1 year or less • Treasury Notes: 1 > orig. maturity < 10 years • Treasury Bonds: 10 > maturity; the maximum maturity currently available for new bonds is 30 years • Corporate Bonds: issued by private firms • Municipal Bonds: • issued by state and local govt’s; called “munis”; • interest earned on most munis is tax deductible • Foreign Bonds: • Subject to all risk/reward characteristics of domestic bonds • Additional risk due to currency exchange rate fluctuation

  12. Bonds - Issues or Series • Companies don’t issue one bond at a time • They issue several million $ worth at a time with each bond usually having a $1,000 Face/Maturity Value • Example: Intel issues $50m worth of bonds on 1 Sep 2004, each bond has a Maturity Value of $1,000; that equates to 50,000 bonds • This single grouping of bonds is called a bond “issue” or “series” • All bonds in a series have the same bond rating and YTM (more on YTM later)

  13. Bonds - Zero Coupon Bonds • Recall that a zero-coupon bond pays interest only at maturity (simple interest), it does not pay periodic interest • this is true for some types of zero-coupon bonds • In reality most zero-coupon bonds pay no interest • they are, instead, sold at a discount; they are issued as Original Issue Discount (OID) bonds • the cost of borrowing money using a zero-coupon bond is reflected by the issue price, which is significantly lower than par value • At issue, the coupon rate is usually equal to rd • Bonds are valuated using the TVM principles and techniques we learned in Ch 4

  14. Bonds • Example 1: A firm with a BB bond rating wants to issue a 1-year $1,000 zero-coupon bond. This will be an OID bond What is the price of the bond at issue if rd for 1-year BB bonds is 3.0000%? FV = $1000 rd = 3% 0 1 PV = ?

  15. Bonds - Coupon Bonds • Coupon Bonds can be modeled as simple present value problems • Example: Consider a $1,000 face value bond that pays annual interest and has a maturity of 5 years.

  16. Bonds - Valuation • T: the number of years left until maturity • n: the number of years or months or days, etc. (number of compounding periods/payments) until the bond matures; n = m x T • FV : Face Value; the principle; the Par Value • Coupon Rate(rcoupon): This is the interest the borrower promises to pay the lender. It is an APR.

  17. Bonds - Valuation • Coupon Payment (CPN): This is the interest payment (periodic or simple) CPN = Face Value*(rCPN) • rd: The current market interest rate • it is the current cost of money for all bonds of the same maturity and risk category (bond rating) • it is the current ROR for bonds thus it is an opportunity cost/best investment opportunity WRT risk, i.e. it is the Opportunity Cost of Capital • since our investment will grow at this rate we must also use it as the discount rate to compute PV

  18. Bonds - Valuation • Fair Market Value : • This is the theoretical value of a bond; it is the PV of the bond’s future cash flows Why? • Answer: The value of any financial asset is determined by discounting all future cash flows to the present (i.e. find the PV @ t = 0) and adding them up

  19. Bonds - Valuation • rd changes all the time due to factors we’ve preciously discussed • Since rd changes all the time, a bond’s Fair Market Value changes all the time Why? • Answer: rd is the rate at which we will discount all future cash flows to find PV. If the discount rate changes, PV must change.

  20. Bonds - Valuation • Things that will not change during the life of a bond: • FV (the face value) • the Coupon Rate (promised interest rate) • the Coupon Payment (promised interest payment)

  21. Bonds - Valuation • Pricing a Bond • We want to know how to determine the appropriate current market value/theoretical value of bonds so we know how much to pay for or charge for that bond • Basic Approach: Find Present Value of an Annuity • Basic Valuation Equation: PV = CPN/(1 + rd)1 + CPN/(1 + rd)2…+ CPN/(1 + rd)n + FV/(1 + rd)n • Note: There’s an additional term to account for the principle • When the bond is issued, the Cpn Rate is generally equal to the market interest rate (rd) at that time in order to sell the bond at par value

  22. Bonds Example 1: Two years ago Jamaica Jim’s Cruise Lines (BB bond rating) issued $100m worth of $1,000 bonds with an original maturity of 4 years and annual coupon payments. The bonds have a CPN Rate of 6% since that was the cost of debt (market interest rate, rd) for a 4-year loan for all BB rated firms at the time. The current market interest rate (rd) for BB bonds with 2 year maturity is 5%. (i.e. the current cost of a 2-year loan for all BB rated firms is 5%). What is the current fair market value of these bonds?

  23. Bonds • Why do we discount the cash flows using rd? • Why is the current fair market value greater than the face value?

  24. Bonds - Valuation Example 2: Multiple compounding periods per year: What is the current fair market value of a 3-year, $10,000 Face Value bond that has a coupon rate of 6% and has semiannual coupon payments? The current market interest rate (rd) for this bond is 7%.

  25. Bonds - Valuation • What Happens When rd = Cpn Rate? • When the market interest rate (rd) equals the coupon interest rate (rcpn) the market value of a bond equals its face value • When the fair market value of a bond equals its face value, the bond is said to be “trading at par” (recall: face value = par value) • When the bond is first issued, the Cpn Rate is generally = to rd in order to sell the bond at or very close to par value • Example: What is the current fair market value of a 2-year, $1,000 Face Value bond that has a coupon rate of 6% APR and has annual coupon payments? The current market interest rate for this bond is 6%. Answer:

  26. Bonds - Valuation • Relationship Between rd and PV: • When rd goes down (over time), PV goes up [rd↓, PV↑] • When rd goes up (over time), PV goes down [rd↑, PV↓]

  27. Bonds - Valuation • Example: A $1,000 bond issued by Home Depot paying a semi-annual coupon rate of 6.2500% APR with 2 years left to maturity has a current rd of 7.7200%. • What is the PV of this bond? • What is the PV of this bond if rd fell to 4.5000%? • What is the PV of this bond if rd rose to 8.5000%?

  28. Bonds Cpn Rate = 6.25% @ rd = 6.25%, this bond trades at par (VB = $1,000) Value @ rd > 6.25%, VB < $1,000 @ rd < 6.25%, VB > $1,000 rd (YTM)

  29. Bonds - More Bond Terms and Concepts • Premium Bond: a bond whose current market value is greater than its par value (rd < Cpn Rate) • Discount Bond: a bond whose current market value is less than its par value (rd > Cpn Rate) • When a bond is first issued it is referred to as a new issue • Once a bond has been on the market a while, it’s referred to as a seasoned issue or an outstanding bond

  30. Bonds • Bond Mkt Price vs. Fair Mkt Value/Theoretical Value • A bond’s theoretical value is almost always equal to or very close to its bond market price (the price paid by bond traders) • This is because there is very little uncertainty about bond valuation parameters • the amount of each future cash flow is known (the coupon rate never changes) • the cash flow termination date is known (we know exactly how many payments will be received) • all of the above are contractually guaranteed • everyone in the bond market knows how to determine fair market/theoretical value of a bond • Since bond traders know how to determine bond FMVs, they won’t pay more or sell for less than FMV (not including transaction costs) • Market forces (supply & demand) will sometimes cause minor discrepancies between Market Price and Fair market Value • You & I will have to pay a fee to buy bonds from bond brokers; for us, price ≠ fair market value

  31. Bonds - Yield to Maturity • Definition: The average rate of return earned on a particular bond if it is held to maturity. • Approach: Given all the normal bond parameters (i.e. face value, coupon rate and maturity) and the current price of the bond, find YTM (this is like solving for r of an annuity)

  32. Bonds - Yield to Maturity Example: (finding YTM): The current price of a 4-year, $10,000 AA bond issued by GM paying an annual coupon rate of 5% p.a. is $9,913.89. What is the yield to maturity (YTM) of this bond?

  33. Bonds • If you buy this bond today it will earn 5.2442% until it matures. • The price is based on the current market interest rate (rd) so….. • YTM should be equal to the current market interest rate (rd)

  34. Bonds Example: (finding YTM w/ other-than-annual cpn payments): The current FMV of a $1,000 BB bond issued by Home Depot paying a semi-annual coupon rate of 6.2500% APR with 2 years left to maturity is $973.23. What is the yield to maturity of this bond?

  35. Bonds • Why would we want to know a bond’s YTM? Answer: to determine if the bond is selling at FMV • Each bond issue/series from a particular firm has a particular YTM • All BB bonds of the same maturity will have the same market interest rate and thus the prices of all these bonds should be equal or very close to each other (Law of One Price) • Thus the YTMs for all BB rated bonds of similar maturity will be equal to the market interest rate (rd) • However, the price of a particular firm’s bonds is a result of market perception of that firm’s financial health • If a bond’s reported YTM is higher than that of other bonds in the same bond market it means the bond is selling for less than FMV

  36. Bonds • How Bond Values are Reported: • YTM • Bond prices are also reported as a percent of par value • Example: $1,000 face value 5 year BB bonds are currently selling for $1,025.15. Their price is reported as 102.515

  37. Bonds • What happens to the Price (Value) of a bond over time? • Example: A $1,000 face value bond with an annual coupon rate of 5.0000% p.a., paying annual coupon payments and a maturity of 5 years is issued at t = 0. What is its value at t = 1 if it’s trading at par?

  38. Bonds • PV = $1,000 (rd = Cpn Rate, it’s trading at par) • What is the bond’s value if one coupon payment has been made, (4 years remain until maturity) if market interest rates have dropped to 2.8000%? • PV = • What is the value of the bond with only (3 years remaining until maturity), if the market rate is 2.8000%? • PV = • What is the value of the bond with only (1 year remaining until maturity), if the market rate is 2.8000% ? • PV = • As a bond approaches maturity, value fluctuation due to changes in rd decreases • the value of a premium bond would decrease towards $1,000. • the value of a discount bond would increase towards $1,000. • At maturity, the value of any bond must equal its par value

  39. Increasing rd Decreasing rd 30 25 20 15 10 5 0 Bonds Value Fluctuation Due to Changes in rd rd < Coupon Rate Value M Price Range rd > Coupon Rate Years to Maturity

  40. Bonds • As time goes on, the fair market value of a bond approaches (converges) to its par value (FV) • The price range of a 30-year bond is much greater than that of shorter maturity bonds • The prices of bonds with longer remaining maturity are much more influenced by a change in rd than the price of bonds with shorter remaining maturity Why? • Price volatility of long maturity bonds is greater than that of short maturity bonds • Longer term bonds are more sensitive to change in rd than shorter term bonds • Long maturity bonds are riskier than shorter maturity bonds; this is reflected by the higher rd

  41. Bonds FV = $1,000 rcoupon = 7.50% Annual Coupon 20-yr Bond rd = rcoupon thus VB = FV 1-yr Bond

  42. Bonds • Implications of Bond Sensitivity to a change in rd • When market interest rates are falling, it’s good to have an inventory of long-term bonds to sell: • when rd decreases, bond values rise • since long-term bond prices are more sensitive (react more) to changes in rd, the profits from selling them will be greater than for short term bonds • When market interest rates bottom out and start to rise, it’s better to deal in (buy, hold, sell) short-term bonds: • when rd increases, bond prices fall • shorter-term bonds are less sensitive to changes in rd and will have lower int. rate (price) and reinvestment risk

  43. Bonds • Other Risks Associated With Bonds • Interest Rate Risk (Bond Price Risk): This is the uncertainty concerning the future value of a bond due to changes in rd • Reinvestment Risk: • The risk that income from a bond portfolio will vary because cash flows have to be reinvested at current market rates • When a bond matures, the owner may not be able to reinvest the face value of that bond at a rate at least a favorable as the one currently paid by that bond. • These two types of risk are what is really being compensated by the Maturity Risk Premium (MRP) • Point: Shorter term bonds have less exposure to these types of risk than longer term bonds. • That’s why MRP is smaller for short-term bonds than for long-term bonds • A possible decision criteria for selecting bond maturities

  44. Bonds • Capital Gains Yield • This is how much you earn if/when you sell a bond • It is capital gain(loss) due to changes in rd • It’s a percentage • It’s like computing Rate of Return (ROR) • Example: At the beginning of the year, a $1,000 bond paying 8.25% APR semiannually bought for $1,048 . At the end of the year, this bond was sold for $1,059 . What is the capital gains yield on this bond? Capital Gains Yield = (End Value - Begin. Value)/ Begin. Value = ($1,059 - $1,048)/$1,048 = 0.010496 = 1.0496%

  45. Bonds • Total Yield • This is the total return from interest and capital gains • Usually computed over a 1 Year period • Total Return = EAR of Cpn Rate + Cap. Gains Yield • (Important Assumption: interest payments are reinvested at the coupon rate. This is not always the case but it’s easier to learn total return if we make this assumption.) • Example: What is the total return on the bond in the above example? • 1) Find EAR Cpn Rate = 8.4202% APR • 2) Find Cap. Gains Yield: 1.0496% (from above example) • 3) Find Total Yield: 8.4202% + 1.0496% = 9.4698%

  46. Bonds - Types of Bonds • Mortgage Bonds: A bond with some fixed asset presented as collateral • higher claim priority than unsecured bonds • usually have lower interest rates • Debentures: A long-term bond that is not secured by a mortgage on a specific property • higher interest rates than secured bonds Why? • Subordinated Debentures: A bond that is specifically designated to be of lower claim priority than other bonds

  47. Bond Provisions • Convertible bonds: A bond that can be converted to a fixed number of stock shares specified at time of issue (it’s like a stock option) • have a lower coupon rate than non-convertible bonds. • offers the holder a chance at capital gains through stock • Warrants: • Similar to a convertible bond but the price of the stock is specified at time of issue, not the number of shares • offer a chance at capital gains if stock price at time of conversion is higher than the specified stock price • Income Bond: pays interest only if the issuing firm has sufficient income to pay the interest • A real safe deal from the issuer’s stand point; this type of bond can’t bankrupt a firm • These type bonds pay high relative interest (otherwise, who would buy them?) • Putable Bonds: a bond that can be redeemed for cash at the bond holder’s option • pay lower interest rates • Callable Bond: a bond that has a “call provision” which allows the issuer to redeem the bond for cash at the issuer’s option prior to the stated maturity date • pay higher interest rates. • Call premium: Compensation paid to the holder by the issuer if/when the bond is “called”

More Related