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Valuation and Characteristics of Bonds

Chapter 7. Valuation and Characteristics of Bonds. General Valuation: The following comments are valid for all kind of assets. Book Value Stated value from the firm’s Balance Sheet Market Value

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Valuation and Characteristics of Bonds

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  1. Chapter 7 Valuation and Characteristics of Bonds

  2. General Valuation: The following comments are valid for all kind of assets. • Book Value • Stated value from the firm’s Balance Sheet • Market Value • The price for the asset at any given time--determined by supply and demand in the marketplace. Asset can be bought or sold at this price. • Intrinsic Value • Present value of the asset’s expected cash flow • Investor estimates cash flows • Investor determines required rate based on risk of asset and market conditions.

  3. In a perfect market where all investors have the same expectations & risk aversion:Market Value = Intrinsic Value

  4. Bonds • Debt Instruments • Bondholders are lending to the corporation (or, governments) money for some stated period of time. • Liquid Asset • Corporate Bonds can be traded in the secondary market. • Price at which a given bond trades is determined by market conditions and terms of the bond.

  5. Bond Terminology • Par Value • Usually $1,000. Also called the Face Value • Coupon Interest Rate • Borrowers (firms) typically make periodic payments to the bondholders. Coupon rate is the percent of face value paid every year. • Maturity • Time at which the maturity value (Par Value) is paid to the bondholder. • Indenture • Document which details the legal obligation of the corporation to the bondholders. The indenture lists all the terms and conditions of the bond.

  6. Types of Bonds • Debentures • Subordinated Debenture • Mortgage Bond • Eurobond • Convertible Bond • Zero Coupon Bonds • Junk Bond

  7. Bond Ratings • Moody’s and Standard & Poors regularly monitor issuers’ financial conditions and assign a rating to the debt. Bond rating shows the relative probability of default. • similar to a personal credit report AAA Top Quality AA A BBB BB B CCC CC Low Quality C No interest being paid D Currently in Default Investment Grade Junk

  8. Bond Ratings • Bond Ratings can change due to many factors. • Caterpillar Corp debt was recently upgraded due to fact that it appears that current 10 month strike has not affected prospects of firm in any significant manner. Corporate Bond Ratings Citicorp A- GMAC BBB+ Bell South AAA DuPont AA- Phillip Morris A Kroger BB+ Unisys BB- Bethlehem Steel B+ Grand Union D

  9. Bond Quotes Cur Net Bonds Yld Vol Close Chg AMR 6¼24 cv 6 91¼ -1½ ATT 8.35s25 8.3 110 102¾ +¼ IBM 63/8 00 6.6 228 965/8 -1/8 Kroger 9s99 8.8 74 1017/8 -¼ Source: Wall Street Journal Company Issuing the Bond

  10. Bond Quotes Cur Net Bonds Yld Vol Close Chg AMR 6¼24 cv 6 91¼ -1½ ATT 8.35s25 8.3 110 102¾ +¼ IBM 63/8 00 6.6 228 965/8 -1/8 Kroger 9s99 8.8 74 1017/8 -¼ Source: Wall Street Journal Coupon Interest Rate

  11. Bond Quotes Cur Net Bonds Yld Vol Close Chg AMR 6¼24 cv 6 91¼ -1½ ATT 8.35s25 8.3 110 102¾ +¼ IBM 63/8 00 6.6 228 965/8 -1/8 Kroger 9s99 8.8 74 1017/8 -¼ Source: Wall Street Journal Coupon Interest Rate Determines the Investor’s Periodic Cash Flow

  12. Bond Quotes Cur Net Bonds Yld Vol Close Chg AMR 6¼24 cv 6 91¼ -1½ ATT 8.35s25 8.3 110 102¾ +¼ IBM 63/8 00 6.6 228 965/8 -1/8 Kroger 9s99 8.8 74 1017/8 -¼ Source: Wall Street Journal Coupon Interest Rate Determines the Investor’s Periodic Cash Flow Cash Flow = Interest Payment = Coupon Rate x Par = .06375 x 1000 = $63.75/Year

  13. Bond Quotes Cur Net Bonds Yld Vol Close Chg AMR 6¼24 cv 6 91¼ -1½ ATT 8.35s25 8.3 110 102¾ +¼ IBM 63/8 00 6.6 228 965/8 -1/8 Kroger 9s99 8.8 74 1017/8 -¼ Source: Wall Street Journal Year of Maturity

  14. Bond Quotes Cur Net Bonds Yld Vol Close Chg AMR 6¼24 cv 6 91¼ -1½ ATT 8.35s25 8.3 110 102¾ +¼ IBM 63/8 00 6.6 228 965/8 -1/8 Kroger 9s99 8.8 74 1017/8 -¼ Source: Wall Street Journal Year of Maturity Determines the Time frame for the Investment 00 = year 2000, therefore in 1995 this is a 5 year investment

  15. Bond Quotes Cur Net Bonds Yld Vol Close Chg AMR 6¼24 cv 6 91¼ -1½ ATT 8.35s25 8.3 110 102¾ +¼ IBM 63/8 00 6.6 228 965/8 -1/8 Kroger 9s99 8.8 74 1017/8 -¼ Source: Wall Street Journal Current Yield (%)

  16. Bond Quotes Cur Net Bonds Yld Vol Close Chg AMR 6¼24 cv 6 91¼ -1½ ATT 8.35s25 8.3 110 102¾ +¼ IBM 63/8 00 6.6 228 965/8 -1/8 Kroger 9s99 8.8 74 1017/8 -¼ Source: Wall Street Journal Current Yield (%) Anuual $ Coupon Market Price 63.75 966.25 = = .066 = 6.6% Current Yield =

  17. Bond Quotes Cur Net Bonds Yld Vol Close Chg AMR 6¼24 cv 6 91¼ -1½ ATT 8.35s25 8.3 110 102¾ +¼ IBM 63/8 00 6.6 228 965/8 -1/8 Kroger 9s99 8.8 74 1017/8 -¼ Source: Wall Street Journal Daily Trading Volume

  18. Bond Quotes Cur Net Bonds Yld Vol Close Chg AMR 6¼24 cv 6 91¼ -1½ ATT 8.35s25 8.3 110 102¾ +¼ IBM 63/8 00 6.6 228 965/8 -1/8 Kroger 9s99 8.8 74 1017/8 -¼ Source: Wall Street Journal Daily Closing Market Price

  19. Bond Quotes Cur Net Bonds Yld Vol Close Chg AMR 6¼24 cv 6 91¼ -1½ ATT 8.35s25 8.3 110 102¾ +¼ IBM 63/8 00 6.6 228 965/8 -1/8 Kroger 9s99 8.8 74 1017/8 -¼ Source: Wall Street Journal Daily Closing Market Price Expressed as a % of Par

  20. Bond Quotes Cur Net Bonds Yld Vol Close Chg AMR 6¼24 cv 6 91¼ -1½ ATT 8.35s25 8.3 110 102¾ +¼ IBM 63/8 00 6.6 228 965/8 -1/8 Kroger 9s99 8.8 74 1017/8 -¼ Source: Wall Street Journal Daily Closing Market Price Expressed as a % of Par $Price = 965/8 x 10 = $966.25

  21. Bond Quotes Cur Net Bonds Yld Vol Close Chg AMR 6¼24 cv 6 91¼ -1½ ATT 8.35s25 8.3 110 102¾ +¼ IBM 63/8 00 6.6 228 965/8 -1/8 Kroger 9s99 8.8 74 1017/8 -¼ Source: Wall Street Journal Change from Previous Day’s Closing Price

  22. Bond Valuation Model • Bond Valuation is an application of Present Value. • The Value of the bond is the present value of all the cash flows the investor receives as a result of holding the bond. • 3 Cash Flows • Amount that is paid to purchase the bond (PV) • Periodic Interest Payments made to the bondholders (PMT) • Payment of maturity value at end of Bond’s life. • Other Terminology • Time frame for cash flows (N) = Bond’s Maturity • Interest Rate for Time Value is the rate at which future cash flows are being discounted to present.

  23. Bond Valuation Model IBM Bond Timeline: Cur Net Bonds Yld Vol Close Chg AMR 6¼24 cv 6 91¼ -1½ ATT 8.35s25 8.3 110 102¾ +¼ IBM 63/8 00 6.6 228 965/8 -1/8 Kroger 9s99 8.8 74 1017/8 -¼ Source: Wall Street Journal Investor that purchases bond today (1995) for $966.25 will receive 5 annual interest payments of $63.75 and a $1,000 payment in 5 years.

  24. 1995 1996 1997 1998 1999 2000 0 1 2 3 4 5 Bond Valuation Model IBM Bond Timeline: Cur Net Bonds Yld Vol Close Chg AMR 6¼24 cv 6 91¼ -1½ ATT 8.35s25 8.3 110 102¾ +¼ IBM 63/8 00 6.6 228 965/8 -1/8 Kroger 9s99 8.8 74 1017/8 -¼ Source: Wall Street Journal Investor that purchases bond today (1995) for $966.25 will receive 5 annual interest payments of $63.75 and a $1,000 payment in 5 years. 63.75 63.75 63.75 63.75 63.75 1000.00

  25. 1995 1996 1997 1998 1999 2000 0 1 2 3 4 5 Bond Valuation Model Compute Bond’s Intrinsic Value 63.75 63.75 63.75 63.75 63.75 1000.00 Compute the Intrinsic Value for the IBM Bond given that you require a 8% return on your investment.

  26. 1995 1996 1997 1998 1999 2000 0 1 2 3 4 5 Bond Valuation Model Compute Bond’s Intrinsic Value 63.75 63.75 63.75 63.75 63.75 1000.00 $59.03 $63.75 (1.08) Compute the Intrinsic Value for the IBM Bond given that you require a 8% return on your investment.

  27. 1995 1996 1997 1998 1999 2000 0 1 2 3 4 5 Bond Valuation Model Compute Bond’s Intrinsic Value 63.75 63.75 63.75 63.75 63.75 1000.00 $63.75 (1.08)2 $59.03 $54.66 Compute the Intrinsic Value for the IBM Bond given that you require a 8% return on your investment.

  28. 1995 1996 1997 1998 1999 2000 0 1 2 3 4 5 Bond Valuation Model Compute Bond’s Intrinsic Value 63.75 63.75 63.75 63.75 63.75 1000.00 $59.03 $63.75 (1.08)3 $54.66 $50.61 Compute the Intrinsic Value for the IBM Bond given that you require a 8% return on your investment.

  29. 1995 1996 1997 1998 1999 2000 0 1 2 3 4 5 Bond Valuation Model Compute Bond’s Intrinsic Value 63.75 63.75 63.75 63.75 63.75 1000.00 $59.03 $54.66 $63.75 (1.08)4 $50.61 $46.86 Compute the Intrinsic Value for the IBM Bond given that you require a 8% return on your investment.

  30. 1995 1996 1997 1998 1999 2000 0 1 2 3 4 5 Bond Valuation Model Compute Bond’s Intrinsic Value 63.75 63.75 63.75 63.75 63.75 1000.00 $59.03 $54.66 $50.61 $63.75 (1.08) 5 $46.86 $43.39 Compute the Intrinsic Value for the IBM Bond given that you require a 8% return on your investment.

  31. 1995 1996 1997 1998 1999 2000 0 1 2 3 4 5 Bond Valuation Model Compute Bond’s Intrinsic Value 63.75 63.75 63.75 63.75 63.75 1000.00 $59.03 $54.66 $50.61 $46.86 $43.39 $1000 (1.08) 5 $680.58 $935.12 Compute the Intrinsic Value for the IBM Bond given that you require a 8% return on your investment.

  32. 1995 1996 1997 1998 1999 2000 0 1 2 3 4 5 Bond Valuation Model Compute Bond’s Intrinsic Value 63.75 63.75 63.75 63.75 63.75 1000.00 $63.75 Annuity for 5 years

  33. 1995 1996 1997 1998 1999 2000 0 1 2 3 4 5 Bond Valuation Model Compute Bond’s Intrinsic Value 63.75 63.75 63.75 63.75 63.75 1000.00 $63.75 Annuity for 5 years $1000 Lump Sum in 5 years

  34. 1995 1996 1997 1998 1999 2000 0 1 2 3 4 5 Bond Valuation Model Compute Bond’s Intrinsic Value 63.75 63.75 63.75 63.75 63.75 1000.00 $63.75 Annuity for 5 years $1000 Lump Sum in 5 years Vb = I(PV of Annuity) + PV of Par

  35. 1995 1996 1997 1998 1999 2000 0 1 2 3 4 5 Bond Valuation Model Compute Bond’s Intrinsic Value 63.75 63.75 63.75 63.75 63.75 1000.00 $63.75 Annuity for 5 years $1000 Lump Sum in 5 years Vb = I(PV of Annuity) + PV of Par 1 .08 1 .08(1+.08)5 1000 (1+.08)5 = 63.75( ) +

  36. 1995 1996 1997 1998 1999 2000 0 1 2 3 4 5 Bond Valuation Model Compute Bond’s Intrinsic Value 63.75 63.75 63.75 63.75 63.75 1000.00 $63.75 Annuity for 5 years $1000 Lump Sum in 5 years Vb = I(PV of Annuity) + PV of Par 1 .08 1 .08(1+.08)5 1000 (1+.08)5 = 63.75( ) + = 63.75(3.9927) + 680.58

  37. 1995 1996 1997 1998 1999 2000 0 1 2 3 4 5 Bond Valuation Model Compute Bond’s Intrinsic Value 63.75 63.75 63.75 63.75 63.75 1000.00 $63.75 Annuity for 5 years $1000 Lump Sum in 5 years Vb = I(PV of Annuity) + PV of Par 1 .08 1 .08(1+.08)5 1000 (1+.08)5 = 63.75( ) + = 63.75(3.9927) + 680.58 = 254.54 + 680.58 = 935.12

  38. 1995 1996 1997 1998 1999 2000 0 1 2 3 4 5 Bond Valuation Model Some Bonds Pay Interest Semi-Annually: Cur Net Bonds Yld Vol Close Chg AMR 6¼24 cv 6 91¼ -1½ ATT 8.35s25 8.3 110 102¾ +¼ IBM 63/8 00 6.6 228 965/8 -1/8 Kroger 9s99 8.8 74 1017/8 -¼ Source: Wall Street Journal 45 45 45 45 45 45 45 45.00 1000.00

  39. 1995 1996 1997 1998 1999 2000 0 1 2 3 4 5 Bond Valuation Model Some Bonds Pay Interest Semi-Annually: Cur Net Bonds Yld Vol Close Chg AMR 6¼24 cv 6 91¼ -1½ ATT 8.35s25 8.3 110 102¾ +¼ IBM 63/8 00 6.6 228 965/8 -1/8 Kroger 9s99 8.8 74 1017/8 -¼ Source: Wall Street Journal 45 45 45 45 45 45 45 45.00 1000.00 Rather than receiving 4 annual payments of $90, the bondholder will receive 4x2 = 8 semiannual payments of 90÷2=$45.

  40. 1995 1996 1997 1998 1999 2000 0 1 2 3 4 5 Bond Valuation Model Some Bonds Pay Interest Semi-Annually: 45 45 45 45 45 45 45 45.00 1000.00 Compute the Intrinsic Value for the Kroger Bond given that you require a 10% return on your investment.

  41. 1995 1996 1997 1998 1999 2000 0 1 2 3 4 5 Bond Valuation Model Some Bonds Pay Interest Semi-Annually: 45 45 45 45 45 45 45 45.00 1000.00 Compute the Intrinsic Value for the Kroger Bond given that you require a 10% return on your investment. Since interest is received every 6 months, need to use semi-annual compounding

  42. 1995 1996 1997 1998 1999 2000 0 1 2 3 4 5 Bond Valuation Model Some Bonds Pay Interest Semi-Annually: 45 45 45 45 45 45 45 45.00 1000.00 Compute the Intrinsic Value for the Kroger Bond given that you require a 10% return on your investment. Since interest is received every 6 months, need to use semi-annual compounding 1 .05 1 .05(1+.05)8 1000 (1+.05)8 Vb = 45( ) + 10% 2 Semi-Annual Compounding

  43. 1995 1996 1997 1998 1999 2000 0 1 2 3 4 5 Bond Valuation Model Some Bonds Pay Interest Semi-Annually: 45 45 45 45 45 45 45 45.00 1000.00 Compute the Intrinsic Value for the Kroger Bond given that you require a 10% return on your investment. Since interest is received every 6 months, need to use semi-annual compounding 1 .05 1 .05(1+.05)8 1000 (1+.05)8 Vb = 45( ) + =45(6.4632) + 676.84

  44. 1995 1996 1997 1998 1999 2000 0 1 2 3 4 5 Bond Valuation Model Some Bonds Pay Interest Semi-Annually: 45 45 45 45 45 45 45 45.00 1000.00 Compute the Intrinsic Value for the Kroger Bond given that you require a 10% return on your investment. Since interest is received every 6 months, need to use semi-annual compounding 1 .05 1 .05(1+.05)8 1000 (1+.05)8 Vb = 45( ) + =45(6.4632) + 676.84 = 290.85 + 676.84 = 967.68

  45. Yield to Maturity • Bondholder’s Expected Rate of Return. • If an investor purchases bond at today’s price and hold it until maturity, what is the annual rate of return that is earned?

  46. Yield to Maturity • Bondholder’s Expected Rate of Return. • If an investor purchases bond at today’s price and hold it until maturity, what is the annual rate of return that is earned? Substitute the Market Price (P0) for Vb and solve for kb where kb = Annual YTM

  47. Yield to Maturity • Bondholder’s Expected Rate of Return. • If an investor purchases bond at today’s price and hold it until maturity, what is the annual rate of return that is earned? Substitute the Market Price (P0) for Vb and solve for kb where kb = Annual YTM Cannot Solve Directly

  48. 1995 1996 1997 1998 1999 2000 0 1 2 3 4 5 Yield to Maturity • Bondholder’s Expected Rate of Return. • If an investor purchases bond at today’s price and hold it until maturity, what is the annual rate of return that is earned? IBM Corporate Bond: -966.25 63.75 63.75 63.75 63.75 63.75 1000.00

  49. 1995 1996 1997 1998 1999 2000 0 1 2 3 4 5 Yield to Maturity • Bondholder’s Expected Rate of Return. • If an investor purchases bond at today’s price and hold it until maturity, what is the annual rate of return that is earned? IBM Corporate Bond: -966.25 63.75 63.75 63.75 63.75 63.75 1000.00 ?? + ?? 966.25

  50. 1995 1996 1997 1998 1999 2000 0 1 2 3 4 5 Yield to Maturity • Bondholder’s Expected Rate of Return. • If an investor purchases bond at today’s price and hold it until maturity, what is the annual rate of return that is earned? IBM Corporate Bond: -966.25 63.75 63.75 63.75 63.75 63.75 1000.00 ?? + ?? 966.25

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