Ch 5. Bond and their Valuation

1. Ch 5. Bond and their Valuation

2. 1. Goals • To discuss the types of bonds • To understand the terms of bonds • To understand the types of risks to issuers and investors • To understand the changes of value

3. I. Bonds • A bond: a long term debt instrument under which a borrower agrees to make payments of interest and principal, on specific dates, to the holders of the bond. • Four main types of bonds, depending on issuers: • (1) Treasury bonds: bonds issued by the federal government, no default risk • (2) Corporate bonds: bonds issued by corporations, default risk

4. (3) Municipal bonds: bonds issued by state and local governments, default risk, interests earned are exempt from federal taxes and state taxes (4) Foreign bonds: bonds issued by either foreign governments or corporations 2. Characteristics of Bonds • Par value: the stated face value of the bond. Ex) $1000 or multiples of $1000 • Coupon Interest rate: coupon payment / par value. (usually coupon is paid semiannually)

5. -fixed rate bond: fixed coupon payment. • -floating rate bond: every 6 month, coupon rate changes. • -zero coupon bond: no coupon payment. • -original issue discount bond (OID) bond: price is below par value. • - payment in kind (PIK) bond: a bond paying coupon composed of additional bonds.

6. (3) Maturity date: a specific date on which the par value of the bond must be paid • (4) Call provision: A provision that gives the issuer the right to redeem the bonds prior to the maturity date. In this case, call premium (difference between call price and par value) is offered. Call premium is one year interest if it is called in a year. But it declines at a constant rate of interest / maturity. But bonds are often not callable until several years after issues – deferred call (call protection).

7. - refunding operation: a process replacing expensive old debts with cheaper new debts. • - event risk: the chance that some sudden event will occur and increase the credit risk of a company, hence lowering the firm’s bond rating and the value of its outstanding bonds. If a company has this risk, it needs to pay a high interest. TO reduce this interest rate, some bonds have a covenant called a super poison put, which enables a bondholder to turn in or “put,” a bond back to the issuer at par in the event of a takeover, or major recapitalization.

8. - make-whole call provision allowing a company to call the bond but it must pay a call price that is essentially equal to the market value of a similar non-callable bond.

9. (5) Sinking funds: A provision that requires the issuer to retire a portion of the bond issue each year. A failure to meet the sinking fund requirement constitutes a default. • (6) Convertible bonds: bonds exchangeable into shares of common stocks at a fixed price. • (7) Warrant: A long term option to buy a stated number of shares of common stock at specified price.

10. (8) Income bond: a bond that pays interest only if it is earned. • (9) Indexed (purchasing power) bond: coupon and maturity payments are based on an inflation index so as to protect the holder from inflation. E.g) Treasury Inflation – Protected Securities (TIPS). • (10) Bond market information

11. 3. Bond valuation: • It is based on the cash flows to investors. • Two types of cash flows: Coupon payment & Par value • Bond value = discounted coupon payments (PV of annuity) + discounted par value

12. Formula: Yield To Maturity (YTM): • The discount rate (kd) that will match current market bond price with the above formula. • Promised rate of return that investors/lenders will receive if all promised payments are made.(Table 7-1).

13. Yield to call: the rate of return earned on a bond when it is called before its maturity date. In order to calculate yield to call, Face (value) in the equation will be replaced by call price offered by an issuer.

14. Coupon rate and Bond price: • (1) if the coupon rate equals to discount (interest) rates, a bond price is par value • (2) if the coupon rate > discount (interest) rates, premium bond • (3) if the coupon rate < discount (interest) rates, discount bond • (4) As maturities approach, the premium/discount bonds’ prices approach to par value

15. Current Yield = annual coupon payment/ current bond price 3-1) Bond valuation with semi-annual coupon rate. 4. Riskiness of Bonds • Interest rate risk: • The risk of a decline in a bond’s price due to an increase in interest rates.

16. The longer the maturity of the bond, the higher the interest rate risk. 2) Reinvestment Rate Risk: • The risk that a decline in interest rates will lead to a decline in income from a bond portfolio. • The shorter maturity, the higher the reinvestment rate risk. 3) Summary • Long term bond: more interest rate risk and less reinvestment risk • Short term bond: more reinvestment risk and less interest rate risk

17. 5. Default Risk: Risk of not paying promised amounts. Whether collateral has been pledged will produce different types of bonds. • Mortgage bonds: a bond backed by fixed assets. First mortgage bonds are senior in priority to claims of second mortgage bonds. All mortgage bond is subject to an indenture which is a legal document that spells out in detail the rights of the bondholders and the corporation. • Debenture: a long term bond that is not secured by a mortgage on specific property. • Subordinated debenture: a bond paying a claim on assets only after the senior debt has been paid off in the event of liquidation.

18. (1) Bond ratings reflect agency's opinion about an issue's potential default, not its relative investment merits. Agencies: Moody’s and S&P. Many institutional investors are not internally allowed to purchase bonds below BBB. (Table 7-3). (2) Junk bonds: high-risk, high-yield bonds. BB or lower. It relates to LBO market in 1980s. (3) Yield spreads for bonds of equal maturity Changes in yield spread mainly attributed to changes in default risk. During recessions yield spread increase because: 1) investors become more risk-averse and 2) the probability of default increases.

19. 6. Pre-tax cost of debt YTM is a pre-tax cost of debt. Why different bonds have different YTM? 1) r=r*+IP+DRP+LP+MRP • r: quoted or nominal rate of interest • r*: real risk free rate (short term) on a riskless security if zero inflation were expected • rrf: r*+IP = rT-Bill The yield on a TIPS with 1 year until maturity is a good estimate of the real risk-free rate.

20. IP: inflation premium, average expected inflation rate over the life of the security. Non indexed T-bond yield – TIPS yield = inflation premium. • DRP: default risk premium reflecting the possibility that the issuer will not pay interest or principal at the stated time and in the stated amounts. • Indenture: a legal document spelling out the rights of both bond holders and the issuing corporations. It include restrictive covenants. • Mortgage bonds: senior or junior. • Debentures and subordinated debentures: unsecured debts.

21. Development or pollution bonds issued by state or local governments’ agencies. The procedure resulting from selling these bonds will be used for corporations. These corporation will guarantee these bonds. • Municipal bond insurance: an insurance company guarantees to pay the coupon and principal payments if an issuer defaults. • Bond rating: rating agencies – Moody’s, S&P, and Fitch. Investment –grade bonds. • Bond spread.

22. LP: liquidity premium. This is a premium charged by lenders to reflect the fact that some securities cannot be converted to cash on short notice at a “reasonable” price. • MRP: maturity risk premium. Long term bonds are exposed to interest rate risks, compared to short term bonds.

23. - interest rate risk and reinvestment rate risk • 2) Term structure of interest rates (Yield Curve) • Describe the relationship between interest rates and maturity. • - normal (upward sloping curve) • - inverted (downward sloping curve) • - humped (mid term rate is higher than either short or long term rate)

24. 7. Junk bond financing • In 1980s, leverage buyouts (LBO) were financed by junk bonds. This occurred because historical data showed that the yield of junk bonds compensated the risk of holding those bonds. • Recently private equity firms used junk bond financing to do their business.

25. 8. Bankruptcy and Reorganization • When a business becomes insolvent, a firm have to make a decision whether it will restructure (Ch11) or liquidate itself (Ch7). • In restructuring, a key issue is to reduce the financial charges to a level that the firm’s cash flow can support. • In liquidation, assets are sold off and the cash obtained is distributed as specified in Ch 7 of bankruptcy act.

26. Priority of claims. - Past due property tax - Secured debts - Trustee’s costs - Expenses incurred after bankruptcy filing - Wages (limit: $2000) - Claims on the employee benefits - Unsecured customer deposit - Federal, state and local taxes - Unfunded pension plan liabilities - Unsecured creditors - Preferred stockholders - Common stockholders

27. 8. Bond market • Corporate bonds are traded primarily in the over the counter (OTC) market. Most bonds are owned and traded by large financial institutions.