Strategic Capital Group Workshop #4: Bond Valuation

1. Strategic Capital Group Workshop #4: Bond Valuation

2. Agenda The Bond Market Types of Bonds Time-Value of Money Valuing a Bond and its Cash Flows Zero-Coupon Bonds

3. Bonds • Remember back to when we had the option of issuing debt or equity to finance our T-shirt company? • Equity was sold to investors as stocks • Debt was either issued in the form of bonds or loans (the difference is bonds are publicly-traded)

4. Remembering bonds… Each bond has a face-value, coupon rate, and maturity date. Face value is the amount of money the issuer (typically a company or government) will pay the person holding the bond at the specified maturity date. Coupon rate is essentially the interest rate specified by the bond to be paid out at regular intervals. Zero-coupon means there are no interest payments BOND $1000 to be paid at maturity Matures in 1 year on Jan 1 Pays out 2.5% of par value semiannually

5. Quick Check for Understanding If I buy a $1000 face-value bond at par-value (for $1000) that matures in exactly one year and I can expect to receive two $25 over the course of the bond’s life, what is the coupon rate? a.) 5% b.) 2.5% c.) 62.78% (2*25)/1000 = .05

6. Being a Bond Trader What are some ways traders/investors can make money off bonds? Buy bonds in large sets (typically in increments of $10,000) and hold them to maturity, picking up interest along the way. There is another way… but first we need to understand a bit more about buying bonds…

7. The Effective Interest Rate • Effective interest rate is essentially the going-market rate for bonds of similar credit-worthiness. We use the effective interest rate as a discount rate for a bond we are considering buying, NOT THE COUPON RATE! • The coupon rate is only used in computing interest payments, NOT DISCOUNTING!

8. Getting a desired Yield from a bond sale Consider an investor that demands an 8% return on his investments. This investor wants to purchase a $10, 000 bond issue from a company, but the coupon rate on the bonds are only 7%. 10,000 Bond @ 7% for 1 year = $10,700 payout In order to make 8% on the investment, the investor can pay less for the bond than its face-value, effectively increasing the return the investor will make. If we were only to pay $9,900 for the bond issue, we would still receive a total of $10,700 in payout, but we would “effectively” yield 800 dollars beyond what we paid for the investment, or 8%. This is also referred to as “pricing to yield” an effective interest rate.

9. Price, Yield, and Interest Rates When market interest rates go up, it means investors can now buy bonds with higher interest rates. Second Bond issue First Bond issue Market interest rates increase MFST Bond 6% interest rate MFST Bond 5% interest rate Since investors can now get MFST bonds that yield 6%, 5% bonds need to reduce their price to effectively yield6%.

10. Price, Yield, and Interest Rates So as interest rates increase, yields of new bond issues increase. As yields increase, bond price must decrease in order to effectively yield the new interest rates.

11. Bond Trading Traders can buy bonds during times of high interest rates when bonds are yielding a lot, then sell them for more than they paid when interest rates decrease and drive down yields.

12. Types of Bonds Less Risk Government -AKA “Treasuries” -Least risky because governments are typically the most stable institutions in the world -Debt of developing countries is significantly more risky Municipal -AKA “Muni’s” -City governments aren’t likely to go bankrupt often, but it can happen -Free from government taxation Corporate -Much more risk than government or municipal bonds, depending on the company and its financial situation. -Higher risk, but also higher returns (in the form of higher yields) More Risk

13. Credit Ratings Bonds and their issuing institutions are rated by major credit agencies like S&P, Moody’s, and Fitch to designate how likely the institution is to pay the interest and principal back. AAA and AA are considered “risk-free” investments Investment Grade Speculative

14. Buying a Zero-Coupon Bond Face-Value: $10,000 Coupon Rate: 0% Maturity: 3 years Credit Rating: AA AAA: Average 5% Interest Rate AA: Average 7% interest Rate A: Average 9% Interest Rate BBB: Average 12% Interest Rate What is the most you would be willing to pay for this investment?

15. Remember… A dollar today is worth more than a dollar in the future because we can invest the dollar today and get interest by the time the future comes around. We refer to this as the time-value of money.

16. Solving the problem Value of the Bond = PV(Face-value) + PV(Interest) What is the PV of the interest payments? What is the interest payment? There is no interest on a zero-coupon bond! We just want to calculate the PV of the face-value

17. Solving the problem Value of the Bond = PV(Face-value) + PV(Interest) 10,000 PV(Face-value) = = $8162.98 (1 + .07) ^ 3 PV(Interest Payments) = $0 $ 8162.98 You should pay no more than $8162.98 for this bond.

18. Say we are approached by a bank… Bank of America approaches you to be a potential debt-holder. They offer you ten $10,000 zero-coupon bond to be repaid in 5 years for $85,000. After doing your research you determine that you would only be willing to take this investment risk if it yielded 8%. Should you take the deal?

19. Solving the problem by calculating future value… Future Value of your investment = 85,000 * (1 + .08) ^ 5 = $124,892.89 We can invest 85,000 at 8% and make turn it into $125,000 in 5 years, so we should not take the bonds.

20. Recap • So what’s so hard about discounting? Bonds must be super easy… • Knowing how much a bond should yield can be difficult. The market can be off a lot, creating both confusion and opportunity • Bond investing is less about making it and more about not missing