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Chapter 7

Chapter 7. Valuation and Characteristics of Bonds. Characteristics of Bonds. Bonds pay fixed coupon (interest) payments at fixed intervals (usually every 6 months) and pay the par value at maturity. $I $I $I $I $I $I+$M.

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Chapter 7

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  1. Chapter 7

  2. Valuation and Characteristics of Bonds

  3. Characteristics of Bonds • Bonds pay fixed coupon (interest) payments at fixed intervals (usually every 6 months) and pay the par value at maturity.

  4. $I $I $I $I $I $I+$M 0 1 2 . . . n Characteristics of Bonds • Bonds pay fixed coupon (interest) payments at fixed intervals (usually every 6 months) and pay the par value at maturity.

  5. example: AT&T 8 24 • par value= $1000 • coupon= 8% of par value per year. = $80 per year ($40 every 6 months). • maturity= 24 years (matures in 2024). • issued by AT&T.

  6. $40 $40 $40 $40 $40 $40+$1000 0 1 2 … 48 example: AT&T 8 24 • par value= $1000 • coupon= 8% of par value per year. = $80 per year ($40 every 6 months). • maturity= 24 years (matures in 2024). • issued by AT&T. (Assume year is 2000)

  7. Types of Bonds • Debentures- unsecured bonds. • Subordinated debentures- unsecured “junior” debt. • Mortgage bonds- secured bonds. • Zeros- bonds that pay only par value at maturity; no coupons. (example: Series EE government savings bonds.)

  8. Types of Bonds • Eurobonds- bonds denominated in one currency and sold in another country. (Borrowing overseas). • example- suppose Disney decides to sell $1,000 bonds in France. These are U.S. denominated bonds trading in a foreign country. Why do this? • If borrowing rates are lower in France, • To avoid SEC regulations.

  9. The Bond Indenture • The bond contract between the firm and the trustee representing the bondholders. • Lists all of the bond’s features: coupon, par value, maturity, etc. • Listsrestrictive provisionswhich are designed to protect bondholders. • Describes repayment provisions.

  10. Value • Book Value: value of an asset as shown on a firm’s balance sheet; historical cost. • Liquidation value: amount that could be received if an asset were sold individually. • Market value: observed value of an asset in the marketplace; determined by supply and demand. • Intrinsic value: economic or fair value of an asset; the present value of the asset’s expected future cash flows.

  11. Bond Ratings • 1. Moodys • 2. Standard & Poor’s • 3. Fitch Investor Service • Affected by: • Greater reliance on equity for financing firm • Profitable Operations • Low Variability in Earnings • Large Firm

  12. Security Valuation • In general, the intrinsic value of an asset = the present value of the stream of expected cash flows discounted at an appropriate required rate of return. • Can the intrinsic value of an asset differ from its market value?

  13. n $Ct (1 + k)t S V = t = 1 Valuation • Ct= cash flow to be received at time t. • k= the investor’s required rate of return. • V= the intrinsic value of the asset.

  14. Bond Valuation • Discount the bond’s cash flows at the investor’s required rate of return. • the coupon payment stream(an annuity). • the par value payment(a single sum).

  15. n t = 1 S $It $M (1 + kb)t (1 + kb)n Vb = + Bond Valuation Vb = $It (PVIFA kb, n) + $M (PVIF kb, n)

  16. Bond Example • Suppose our firm decides to issue 20-year bonds with a par value of $1,000 and annual coupon payments. The return on other corporate bonds of similar risk is currently 12%, so we decide to offer a 12% coupon interest rate. • What would be a fair price for these bonds?

  17. 1000 120 120 120 . . . 120 0 1 2 3 . . . 20 Note: If the coupon rate = discount rate, the bond will sell for par value. P/YR = 1 N = 20 I%YR = 12 FV = 1,000 PMT = 120 Solve PV = -$1,000

  18. Suppose interest rates fall immediately after we issue the bonds. The required return on bonds of similar risk drops to 10%. • What would happen to the bond’s intrinsic value?

  19. P/YR = 1 Mode = end N = 20 I%YR = 10 PMT = 120 FV = 1000 Solve PV = -$1,170.27

  20. P/YR = 1 Mode = end N = 20 I%YR = 10 PMT = 120 FV = 1000 Solve PV = -$1,170.27 Note: If the coupon rate > discount rate, the bond will sell for a premium.

  21. Suppose interest rates rise immediately after we issue the bonds. The required return on bonds of similar risk rises to 14%. • What would happen to the bond’s intrinsic value?

  22. P/YR = 1 Mode = end N = 20 I%YR = 14 PMT = 120 FV = 1000 Solve PV = -$867.54

  23. P/YR = 1 Mode = end N = 20 I%YR = 14 PMT = 120 FV = 1000 Solve PV = -$867.54 Note: If the coupon rate < discount rate, the bond will sell for a discount.

  24. Suppose coupons are semi-annual P/YR = 2 Mode = end N = 40 I%YR = 14 PMT = 60 FV = 1000 Solve PV = -$866.68

  25. n t = 1 S $It $M (1 + kb)t (1 + kb)n P0 = + Yield To Maturity • The expected rate of return on a bond. • The rate of return investors earn on a bond if they hold it to maturity.

  26. YTM Example • Suppose we paid $898.90 for a $1,000 par 10% coupon bond with 8 years to maturity and semi-annual coupon payments. • What is our yield to maturity?

  27. YTM Example P/YR = 2 Mode = end N = 16 PV = -898.90 PMT = 50 FV = 1000 Solve I%YR = 12%

  28. Current Yield • Current yield: the ratio of the interest payment to the bond’s current market price. • Calculated by dividing the annual interest payment by the market price of the bond • A $1,000 bond with 10% coupon rate and market price of $700 Current yield = $100 / $700 = 14.286 %

  29. Zero Coupon Bonds • No coupon interest payments. • The bond holder’s return is determined entirely by the price discount.

  30. -$508 $1000 0 10 Zero Example • Suppose you pay $508 for a zero coupon bond that has 10 years left to maturity. • What is your yield to maturity?

  31. Zero Example P/YR = 1 Mode = End N = 10 PV = -508 FV = 1000 Solve: I%YR = 7%

  32. The Financial Pages: Corporate Bonds Cur Net Yld Vol Close Chg Polaroid 11 1/206 11.2 52 103 ... • What is the yield to maturity for this bond? P/YR = 2, N = 12, FV = 1000, PV = $-1,030, (assume it is year 2000) PMT = 57.50 • Solve: I/YR = 10.81%

  33. The Financial Pages: Corporate Bonds Cur Net Yld Vol Close Chg Honywll zr 09 ... 10 46 5/8 -1 • What is the yield to maturity for this bond? P/YR = 1, N = 9, FV = 1000, PV = $-466.25, PMT = 0 (assume it is year 2000) • Solve: I/YR = 8.85%

  34. The Financial Pages: Treasury Bonds Rate Mo/Yr Bid Asked Chg Yld 9 Nov 18 127:16 127:22 +11 6.39 • What is the yield to maturity for this Treasury bond? (assume it is year 2000) P/YR = 2, N = 36, FV = 1000, PMT = 45, PV = - 1,276.875 (127.6875% of par) • Solve: I/YR = 6.39%

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