Finance

1. Finance Chapter 7 Bonds and their valuation

2. Introduction to bonds • A bond is a long-term promissory note issued by a business or governmental unit. The issuer receives money in exchange for promising to make interest payments and to repay the principal on a specified future date. • U.S. Treasury bonds (government bonds) • Issued by the U.S. Government • No default risk • Prices decline when interest rates rise (risk)

3. Types of bonds • Treasury bonds • Corporate bonds • Default risk (credit risk) • Municipal bonds (“munis”) • Default risk lower than corporate bonds • Tax exempt • Foreign bonds • Default risk • Exchange rate risk

4. Characteristics of bonds • Differences in bonds, e.g.: • corporate bonds have provisions for early repayment • Underlying corporate strengths vary • Par value = the face value, the amount of money borrowed • Coupon payment = the number of dollars interest paid each period (usually 6 months) • Coupon interest rate = the stated annual interest rate on a bond

5. Coupon interest rates • Floating bond rate = interest rate tied to Treasuries or some other interest rate • Convertible – to a fixed rate • Cap – upper limit • Floor – lower limit • Zero coupon bond = pays no annual interest rate but sold at a discount (below par) • “Zeros” • Compensation is not interest but in capital appreciation • Original issue discount (OID) bond = some interest paid but not enough to issue the bond at par

6. Bond characteristics • Maturity date = a specified date on which the par value of a bond must be repaid. • Original maturity = the number of years to maturity at the time the bond is issued • Call provisions = a contract provision giving the bond issuer the right to redeem the bonds under specified conditions prior to the maturity date • Call premium • Deferred call & call protection • Protects a company when interest rates fall, but may be create a loss for the investor

7. Bond characteristics • Sinking funds = a bond provision requiring the issuer to retire a portion of the bond issue each year using the least cost method: • Company can call in bonds for redemption at par value if interest rates have fallen (no call premium paid) • Buy the bonds on the open market at a discount if interest rates have risen causing the price of bonds to fall • Cash drain on the issuer • Subject to default

8. Other bond features • Convertible bonds = a bond that can be exchanged for common stock at a fixed price • Lower coupon rates • Opportunity for capital gains if stock prices rise • See website article link • Warrants = a long term option to buy a stated number of shares of common stock at a specified price (similar to convertible bonds)

9. Other bond features • Putable bonds = bond holder may sell the bonds back to the issuer at a prearranged price prior to maturity. Cf. callable bonds • Income bond = a bond that pays interest only if the interest is earned • Protects company from bankruptcy • Riskier for the investor • Indexed (purchasing power) bond = interest payment is based on an inflation index to protect the investor

10. Junk bonds • Junk bonds are high risk, high-yield instruments issued by firms with very high debt ratios. Reasons for issuing: • About 2/3 are issued for takeovers (including LBO’s) • Revise a firm’s capital structure (proceeds used to buy back stock)

11. Bond valuation • The value of the bond is the present value of cash flows the bond is expected to produce: • Interest payments (annuity) during the life of the bond + • The amount borrowed (principal) 0 1 2 3 4 5 6 ….. N kd% Bond’s value INT INT INT INT INT INT INT kd% = bond’s market rate of interest M

12. Bond valuation • kd% = bond’s market rate of interest • Kd = the bond’s market rate of interest. This is the discount rate that is used to calculate the PV of the bond’s cash flow. • Kd equals the coupon rate only if the bond is selling at par. • Generally, most coupon rates are issued at par, thereafter, the rate will change.

13. Changes in bond value over time • New issue = a bond that has been within the past 30 days • Outstanding bond (seasoned issue) = a bond whose issue date is greater than 30 days • Discounted bond = a bond that sells below its par value; occurs whenever the going rate of interest is above the coupon rate • Premium bond = a bond that sells above its par value; occurs whenever the going rate of interest is below the coupon rate

14. Changes in bond value over time • Whenever kd is equal to the coupon rate, a fixed-rate bond will sell at its par value. • Normally, the coupon rate is set equal to the going rate when a bond is issued. • Interest rates do change over time, but the coupon rate remains the same • If interest rates rise above the coupon rate, a fixed bond’s price will fall below its par value = discount bond • If interest rates fall below the coupon rate, a fixed bond’s price will rise above its par value = premium bond

15. Changes in bond value over time • An increase in interest rates will cause the prices of outstanding bonds to fall, while a decrease in rates will cause bond prices to rise. • The market value of a bond will always approach par value as its maturity date approaches.

16. Bond yields • Bond yields change daily depending on market conditions. Yields are calculated 3 ways • Yield to maturity (YTM) = the rate of return if the bond is held to maturity; generally the same as the market rate of interest, Kd • Yield to call (YTC) = the rate of return if it is called before maturity; likely if interest rates are significantly below the coupon rate • Current yield = the annual interest payment on a bond divided by the bond’s current price

17. Assessing a bond’s riskiness • Interest rate risk = the risk of a decline in a bond’s price due (value) to an increase in interest rates. The longer the maturity of a bond, the more its price changes in response to interest rate changes. • Reinvestment rate risk = the risk that a decline in interest rates will lead to a decline in income from a bond portfolio • Callable bonds • Investment horizon = the period of time an investor plans to hold a particular investment

18. Default risk • Investors will pay less for bonds with greater risk for default. Bond type affects risk: • Mortgage bond = a bond backed by a fixed asset. First mortgage bonds are senior in priority to claims of second mortgage bonds • Indenture = a formal agreement between the issuer of bond and the bondholders spelling out the rights of the bondholder and the corporation • Places limits on the %age of total property that can be used to back a bond offering

19. Default risk • Debentures = a long-term bond not secured (unsecured) by a mortgage on a specific property • Strong companies have no need to put up property as security for their debt (Exxon Mobil) • Weak companies may use if already pledged most of their assts as collateral for mortgage loans. High risk – will bear high interest rates • Subordinated debentures = a bond having a claim on assts only after the senior debt has been pad off in the event of liquidation

20. Bond ratings • Rating agencies: • Moody’s Investor Services • Standard & Poor’s Corporation (S&P) • Fitch Investors Service • Investment-grade bonds = Bonds rated triple-B or higher • Junk bond = a high-risk, high-yield bond • Bond rating criteria: pages 288-289 • Changes in ratings effect ability to borrow long-term capital and the cost of that capital

21. Bankruptcy & Reorganization • Insolvent = insufficient cash to meet interest & principal payments • Remedies • Liquidation – dissolve the firm • Reorganization – usually with a restructuring of the debt • Decision depends on whether the value of the firm is more or less than the value of its assets sold off piecemeal