CHAPTER 4 Bonds and Their Valuation

1. CHAPTER 4Bonds and Their Valuation Key features of bonds Bond valuation Measuring yield Assessing risk

2. Definition of a Bond • A bond is a security that obligates the issuer to make specified interest and principal payments to the holder on specified dates. • Coupon rate • Face value (or par) • Maturity (or term) • Bonds are sometimes called fixedincome securities.

3. Valuation of Financial Assets: Bonds - long term debt instruments • Principal Amount, Face Value, Maturity Value, Par Value: The amount of money the firm borrows and promises to repay at some future date, often at maturity. • Coupon Payment: The specified number of dollars of interest paid each period, generally each six months, on a bond. Key Terms

4. Key Terms • Coupon Interest Rate: The stated annual rate of interest paid on a bond. • Maturity Date: A specified date on which the par value of a bond must be repaid.

5. Types of Bonds • Pure Discount or Zero-Coupon Bonds • Pay no coupons prior to maturity. • Pay the bond’s face value at maturity. • Coupon Bonds • Pay a stated coupon at periodic intervals prior to maturity. • Pay the bond’s face value at maturity. • Perpetual Bonds (Consols) • No maturity date. • Pay a stated coupon at periodic intervals.

6. Bond Issuers • Federal Government • Local Municipalities • Corporations

7. U.S. Government Bonds • Treasury Bills • No coupons (zero coupon security) • Face value paid at maturity • Maturities up to one year • Treasury Notes • Coupons paid semiannually • Face value paid at maturity • Maturities from 2-10 years

8. U.S. Government Bonds • Treasury Bonds • Coupons paid semiannually • Face value paid at maturity • Maturities over 10 years • The 30-year bond is called the long bond. • Treasury Strips • Zero-coupon bond • Created by “stripping” the coupons and principal from Treasury bonds and notes.

9. Yield Curve

10. Municipal Bonds • Maturities from one month to 40 years. • Exempt from federal, state, and local taxes. • Generally two types: • Revenue bonds • General Obligation bonds • Riskier than U.S. Government bonds.

11. Corporate Bonds • Secured Bonds (Asset-Backed) • Secured by real property • Ownership of the property reverts to the bondholders upon default. • Debentures • General creditors • Have priority over stockholders, but are subordinate to secured debt.

12. Basic Valuation From “The Time Value of Money” we realize that the value of anything is based on the present value of the cash flows the asset is expected to produce in the future.

13. ^ ^ ^ Asset value ^ CFt = the cash flow expected to be generated by the asset in period t ^ Basic Valuation • k = the return investors consider appropriate for holding such an asset--usually referred to as the required return-- based on riskiness and economic conditions.

14. The Basic Bond Valuation Model • kd = required rate of return on a debt instrument • N = number of years before the bond matures • INT = dollars of interest paid each year (Coupon rate x Par value) • M = par or face, value of the bond to be paid off at maturity

15. Bond Value

16. Value of a Bond What is the value of a 10-year, 10% semiannual coupon bond, if kd = 10%? =PV(0.05,20,100,1000,0) = ? 20 5 50 1000 INPUTS N I/YR PV PMT FV OUTPUT ?

17. Value of a Bond What is the value of a 10-year, 10% semiannual coupon bond, if kd = 12%? =PV INPUTS N I/YR PV PMT FV OUTPUT ?

18. Value of a Bond What is the value of a 10-year, 10% semiannual coupon bond, if kd = 8%? =PV INPUTS N I/YR PV PMT FV OUTPUT ?

19. Changes in Bond Values Over Time • Par Bond ($1,000): • A bond that sells at par value, which occurs whenever the going rate of interest is equal to the coupon rate. • Discount Bond (< $1,000): • A bond that sells below its par value, which occurs whenever the going rate of interest rises above the coupon rate. • Premium Bond (>$1,000): • A bond that sells above its par value, which occurs whenever the going rate of interest falls below the coupon rate.

20. Yield-to-maturity (YTM) • What is the YTM of a 10-year, 10% semiannual coupon bond, if the current price is $1,000? =RATE(20,50,-1000,1000,0) = ? 20 - 1,000 50 1000 INPUTS N I/YR PV PMT FV OUTPUT ?

21. Yield-to-maturity (YTM) • What is the YTM of a 10-year, 10% semiannual coupon bond, if the current price is $1,100? =RATE INPUTS N I/YR PV PMT FV OUTPUT ?

22. Yield-to-maturity (YTM) • What is the YTM of a 10-year, 10% semiannual coupon bond, if the current price is $900? =RATE INPUTS N I/YR PV PMT FV OUTPUT ?

23. Changes in Bond Values Over Time • An increase in interest rates will cause the price of an outstanding bond to fall. • A decrease in interest rates will cause the price to rise. • The market value of a bond will always approach its par value as its maturity date approaches, provided the firm does not go bankrupt.

24. Time path of value of a 15% Coupon, $1000 par value bond when interest rates are 10%, 15%, and 20%

25. Bond Value kd < Coupon Rate kd = Coupon Rate kd > Coupon Rate Years Changes in Bond Values Over Time • Time path of value of a 15% Coupon, $1000 par value bond when interest rates are 10%, 15%, and 20%

26. YTM = CY + CGY • YTM = Total return • Current Yield (CY) = Return from Interest • Capital Gains Yield (CGY) = Return from the difference in purchase price and face value • CY = Annual Int ($) / Price ($) • CGY = YTM - CY

27. An example: Current and capital gains yield • Find the current yield and the capital gains yield for a 10-year, 9% semiannual coupon bond that sells for $887, and has a face value of $1,000. YTM = 10.88% Current yield = $90 / $887 = 0.1015 = 10.15% CGY= YTM – CY = 10.88% - 10.15% = 0.73%

28. Call provision (YTC) A bond that sells for $950, has five years to maturity, 10 percent semi-annual coupon, and is callable in 2 years at a $50 call premium. What is the yield-to-call? • YTC = RATE(4,50,-950,1050) = ?

29. Call provision (YTC) A bond that sells for $1075, has 14 years to maturity, 8 percent semi-annual coupon, and is callable in 5 years at a $50 call premium. What is the yield-to-call? • YTC = ?

30. Interest rate risk

31. Interest rate risk

32. Interest rate risk

33. Interest rate risk

34. 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.

35. Bond Ratings

36. 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