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Bond Values

Bond Values. Objectives. Define the term value. Distinguish between different kinds of bonds. Describe the basic process for valuing assets. Explain the key features of bonds. Estimate the value of a bond. Compute a bondholder’s expected rate of return.

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Bond Values

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  1. Bond Values Richard MacMinn

  2. Objectives • Define the term value. • Distinguish between different kinds of bonds. • Describe the basic process for valuing assets. • Explain the key features of bonds. • Estimate the value of a bond. • Compute a bondholder’s expected rate of return. • Explain important relationships that exist in bond valuation • Study the concept of duration. Richard MacMinn

  3. Bond Types • Debentures • A certificate issued by a corporation that states the amount of a loan, the interest to be paid and the time for repayment. It is backed only by the corporation's reputation and good word, but not by collateral. • Subordinated Debenture • A debt security that will be paid off after the issuer first pays off debt to senior creditors in the event of insolvency. • Mortgage Bonds • Debt issues secured by a mortgage on the issuer's property, such as buildings or equipment. Richard MacMinn

  4. Bond Types • Zero Coupon Bonds • A bond sold at a deep discount. It does not pay periodic interest payments to investors; instead, investors receive their return on investment at maturity. The return is equal to the difference between the bond's price at issuance and its face value. • Junk Bonds • These are high-yield bonds that credit-rating agencies consider speculative. The bonds typically offer higher yields and carry higher risk than bonds with investment-grade ratings. See Standard & Poor’s or Moody’s for rating information. • Eurobonds • Bonds issued by a borrower outside its own country. The bonds are denominated in a currency foreign to the borrower or the purchaser or both. Richard MacMinn

  5. Bond Types • Inflation Indexed Bonds • These are bonds designed to provide a stream of payments with a constant purchasing power. • Calculator • 100 Year Bonds • Convexity and risk • Much Ado About Nothing? Richard MacMinn

  6. Examples • Equity Analytics, Ltd. has an excellent primer on corporate bonds. Also see the bond directory. • Briefing.com provides intraday trading information on bonds. Richard MacMinn

  7. Basic Valuation Model • where ct = cash flow at date tp = the price of the asset r = the investor’s required rate of return Richard MacMinn

  8. What is a Bond? • A bond is a long-term promissory note that commits the firm to pay the bondholder a fixed amount of interest each year until maturity and the principal at maturity. Richard MacMinn

  9. Bond Terminology • A bond's Par Value is the amount that will be repaid by the firm when the bond matures. • The bond has a Maturity Date, at which time the borrowing firm is committed to repay the loan principal. • The bond’s contractual agreement specifies a Coupon Rate that is expressed either as a percent of the par value or as a flat amount of interest which the borrowing firm promises to pay the bondholder each year. Richard MacMinn

  10. Bond Valuation • The value of a bond with semi-annual interest payments is the present value of the interest payment stream plus the present value of the face value. Letting It = rc FV be the interest payment per period, T be the maturity, FV be the face value (par value) and rb be the rate of interest, the bond value B may be expressed as • Examples • Century Bonds • Problems Richard MacMinn

  11. Relationships in Bond Valuation • A decrease in interest rates 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. • 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. Richard MacMinn

  12. Relationships in Bond Valuation • Regardless of whether a bond is selling below or above par value, the value of the bond will gradually approach par value as the bond matures. • A bondholder owning a long-term bond is exposed to greater interest rate risk than when owning a short-term bond. • In understanding a bond's sensitivity to interest rate changes, we must consider not only the time to maturity, but also the time pattern of interim cash flows, or its duration. Richard MacMinn

  13. Interest Rate Risk • Consider the value of a coupon bearing bond at various dates tas the interest rate changes from 5% to 15%. Suppose the coupon rate is 10% and the maturity initially is 30 years. Richard MacMinn

  14. Interest Rate Risk • Consider the value of a zero coupon bond with an initial maturity of 30 years as the interest rate changes from 1% to 15% Richard MacMinn

  15. Duration • The duration of an asset or liability is simply a measure of the responsiveness of its price to a change in interest rateswhere V is the present value of the asset or liability. • Macaulay Duration Richard MacMinn

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