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Chapter 5

Chapter 5. Bonds, Bond Valuation, and Interest Rates. Topics in Chapter. Read sections 1, 2, 3, 5, 6, 7, 8, 9, 10, 11, 12, 15. Key features of bonds Bond valuation Measuring yield Assessing risk. Determinants of Intrinsic Value: The Cost of Debt. Net operating profit after taxes.

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Chapter 5

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  1. Chapter 5 Bonds, Bond Valuation, and Interest Rates

  2. Topics in Chapter Read sections 1, 2, 3, 5, 6, 7, 8, 9, 10, 11, 12, 15. • Key features of bonds • Bond valuation • Measuring yield • Assessing risk

  3. Determinants of Intrinsic Value: The Cost of Debt Net operating profit after taxes Required investments in operating capital − Free cash flow (FCF) = FCF1 FCF2 FCF∞ ... Value = + + + (1 + WACC)1 (1 + WACC)2 (1 + WACC)∞ Weighted average cost of capital (WACC) Market interest rates Firm’s debt/equity mix Cost of debt Cost of equity Market risk aversion Firm’s business risk

  4. Overview The debt markets are a major source of funding for business growth: therefore every manager should have a working knowledge of: • types of bonds that companies and government agencies issue; • terms that are contained in bond contracts; • types of risks to which both bond investors and issuers are exposed; • procedures for determining the values of and rates of return on bonds.

  5. 5-1 Who Issues Bonds:Bond: long-term debt instrument.

  6. 5-2 Key Characteristics of Bonds • Par value: Face amount; paid at maturity. Usually $1,000/bond. • Coupon (interest) rate: Stated (annual) interest rate. Multiply by par value to get dollars of interest. Fixedin the contract at the time of issuance. (More…)

  7. Key Characteristics of Bonds (continued) • Issue date: Date when bond was issued. • Maturity date: Date when par value must be repaid. • Maturity: Years until maturity date. Declines over time.

  8. Call (or Redemption) Provision • Issuer can buy back the existing bonds (call price = par value + call premium) and refund (issue new bonds) if rates decline. That helps the issuer but hurts the investors (even with the call premium). • Most callable bonds have a deferred call (call protection) and a declining call premium. • Redemption Provision: the bond holder can sell back to the issuer at par value before maturity.

  9. Sinking Funds • Provision to retire a portion of the bonds each year rather than all at maturity. • Reduces risk to investor, shortens average maturity.

  10. Sinking funds are generally handled in two ways • Call x% at par (no call premium) per year for sinking fund purposes. • Call if market interest rate (rd) is below the coupon rate and bond sells at a premium. • Buy bonds on open market. • Use open market purchase if market interest rate (rd) is above coupon rate and bond sells at a discount.

  11. Other Provisions and Features Convertible bonds: holders have the option to convert the bonds into a fixed number of the issuer’s common stock. Income Bonds: required to pay interest only if earnings are high enough to cover the interest expense. They are riskier than “regular” bonds. Indexed/purchasing power bonds: the interest payments and maturity payment rise automatically when inflation rate rises, e.g. TIPS (treasury inflation-protected securities).

  12. Bond Markets Corporate bonds are traded primarily in electronic/telephone markets (OTC) rather than in organized exchanges. Most bonds are owned by and traded among a relatively small number of very large financial institutions. Bond Information: www.finra.org

  13. 5-3 Bond Valuation: Price DCF Approach to Valuation: The Value of any financial asset---a stock or a bond, or even a physical asset ---is simply the present value (PV) of the cash flows the asset is expected to produce. The discount rate should be commensurate with the riskiness of the cash flow streams; i.e. if the cash flows are riskier, a higher discount rate should be used.

  14. 0 1 2 15 Bond Valuation: ExampleMicroDrive’s Bond: priceof a 15-year, 9% coupon bond if rd = 9%(Important: the first 9% is the coupon rate fixed in the contract; the second 9% is the going market interest rate for similar risk bonds (the required rate of return on bond/ the discount rate) which may change over time.) rd=9% ... V = ? 90 90 90 + 1,000 $90 $90 $1,000 V = . . . + + + B (1 + rd)1 (1 + rd)15 (1 + rd)15 = $82.57 + . . . + $24.71 + $274.54 = $1,000.

  15. PV of annuity PV of maturity value Value of bond $ 725.46 274.54 $1,000.00 = = = INPUTS 15 9 90 1000 N I/YR PV PMT FV -1,000 OUTPUT The bond consists of a 15-year, 9% annuity (PMT) of $90/year plus a $1,000 lump sum at t = 15:

  16. INPUTS 15 1490 1000 N I/YR PV PMT FV -692.89 OUTPUT What would happen if expected inflation rose by 5%, causing rd = 14%? When rdrisesabovethe coupon rate, the bond’s value falls below par, so it sells at a discount.

  17. INPUTS 15490 1000 N I/YR PV PMT FV -1,552.92 OUTPUT What would happen if inflation fell, and rd declined to 4%? If rd < coupon rate, bond price rises above par, and bond sells at a premium.

  18. Excel Function for Bond Price: = PV(I, N, PMT, FV, 0) I: the discount rate; N: number of periods; PMT: the periodic coupon payment; FV: the face value/par value of the bond.

  19. 5-5 Bonds with Semiannual Coupons Although some bonds pay interest annually, the vast majority pay interest semiannually. To evaluate semiannual payment bonds, we must modify the valuation models as follows: Divide annual coupon payment (coupon rate * par value) by 2 to get PMTevery six months. Multiply years by 2 to get number of periods =2*number of years. Divide the nominal/quoted (annual) interest rate by 2 to get periodic rate (semiannual rate)= rd/2.

  20. 2*15 4/2 9%*1000/2 =30 =2=45 1000 N I/YR PV PMT FV -1559.91 INPUTS OUTPUT MicroDrive: Value of 15-year, 9% coupon, semiannual bond if rd = 4%.

  21. 5-6 Bond Valuation: Yields What’s the yield to maturity (YTM)? • YTM is the rate of return earned on a bond held to maturity. Also called “promised yield.” • It assumes the bond will not default.

  22. 0 1 13 14 rd=? ... 90 90 90 1,000 PV1 . . . PV14 PVM Find rd that “works”! 1528.16 5-6a Yield to MaturityMicroDrive: one year has passed since the issuance of its 15-year bond. What’s the YTM on this 14-year remaining maturity, 9% annual coupon, $1,000 par value bond selling for $1,528.16 on the market?

  23. Find rd INT INT M ... V = + + + B (1 + rd)N (1 + rd)1 (1 + rd)N 1,000 90 90 ... 1528.16 = + + + (1 + rd)1 (1 + rd)14 (1 + rd)14 INPUTS 14-1528.16 90 1000 N I/YR PV PMT FV 4 OUTPUT

  24. Calculate Yield in Excel = RATE(N, PMT, PV, FV, 0) • N: number of periods; • PMT: the periodic coupon payment; • PV: the current price (cash outflow:”-”); • FV: the face value/par value.

  25. 5-6c Current Yieldcoupon component of YTM annual coupon PMT purchaseprice Current Yield = Capital Gains Yield = = YTM = + change in price purchaseprice Exp. Total Return Exp. Curr. Yld. Exp. Cap. Gains Yld.

  26. $90 $1528.16 Current Yield= = 0.0589 = 5.89%. For MicroDrive’s 9% coupon, 14-year remaining maturity bondwith P = $1,528.16

  27. YTM = Current yield + Capital gains yield Cap. gains yield = YTM - Current yield = 4% - 5.89% = -1.89%. For capital gains/loss yield: Could also find bond prices at time 1 and 0, get the difference, and divide by price at time0. Same answer.

  28. INPUTS 9 -1528.16 90 1100 N I/YR PV PMT FV 3.15 OUTPUT 5-6b Yield to Call (YTC) for Callable BondsExample: Find YTC if the bond in the previous example is callable in 9 years at a call price of $1,100 (par value + $100 call premium) The impact of call provision in bond contract/indenture: The bond is selling at a premium because coupon = 9% > YTM (rd)= 4% (previous example). But since it has a call provision, the bond is likely to be called back exactly because the issuer can refund the bond at the lower going interest rate 4%. As a result, the bondholders would probably earn the YTC (3.15%) rather than YTM (4%).

  29. If you bought callable bonds, would you be more likely to earn YTM or YTC? • In general, if a bond sells at a premium, then coupon > rd, so a call is likely. • So, expect to earn: • YTC on premium bonds. • YTM on par & discount bonds.

  30. 5-6d The Cost of Debt and a Firm’s Intrinsic Value The “Intrinsic Value Box” at the beginning of this chapter highlights the cost of debt, which affects the weighted average cost of capital (WACC), which in turn affects the company’s intrinsic value. The pre-tax cost of debt from the company’s perspective is the required return from the debtholder’s perspective. Therefore, the pre-tax cost of debt is the yield to maturity (or the yield to call if a call is likely).

  31. Determinants of Intrinsic Value: The Cost of Debt Net operating profit after taxes Required investments in operating capital − Free cash flow (FCF) = FCF1 FCF2 FCF∞ ... Value = + + + (1 + WACC)1 (1 + WACC)2 (1 + WACC)∞ Weighted average cost of capital (WACC) Market interest rates Firm’s debt/equity mix Cost of debt Cost of equity Market risk aversion Firm’s business risk

  32. Here: rd = Quoted market rate: required rate of return on a debt security r* = Real risk-free rate IP = Inflation premium rRF = Nominal/Quoted risk-free rate = r*+IP MRP = Maturity risk premium DRP = Default risk premium LP = Liquidity premium 5-7 The Pre-Tax Cost of Debt to a Firm:Why do different bonds have different yields to maturity?Determinants of Market Interest Rates:rd = r* + IP + MRP + DRP + LP = rRF + MRP + DRP + LP

  33. 5-8 The Risk-Free Interest Rate:Nominal (rRF) and Real (r*) The Real Risk-Free Rate: • r*: the rate that would exist on a riskless security if zero inflation were expected. • The yield on a TIPS with 1-year until maturity is a good estimate of the real risk-free rate. The Nominal/Quoted Risk-Free Rate: • rRF = r* + Inflation Premium • In general, we use the T-bill rate to approximate the short-term risk-free rate and use the T-bond rate to approximate the long-term risk-free rate.

  34. 5-9 The Inflation Premium(IP) The annual inflation premium is equal to the average expected inflation rate over the life of the security.

  35. Estimating IP • Treasury Inflation-Protected Securities (TIPS) are indexed to inflation. • The IP for a particular length maturity can be approximated as the difference between the yield on a non-indexed Treasury security of that maturity minus the yield on a TIPS of that maturity.

  36. 5-10 The Maturity Risk Premium(MRP) All bonds, even Treasury bonds, are exposed to two additional sources of risk: interest rate risk and reinvestment risk. The net effect of these two sources of risk upon a bond’s yield is called the maturity risk premium, MRP.

  37. 5-10a Interest Rate RiskCompare prices of 1-year and 25-year 10% bonds under different interest rates:Ceteris paribus, the longer the maturity of the bond, the more its price changes in response to a given change in interest rates.

  38. 1,500 25-year bond 1-year bond 1,000 500 rd 0 0% 5% 10% 15% Value

  39. 5-10b Reinvestment Rate Risk • The risk that CFs will have to be reinvested in the future at lower rates, reducing income. • Illustration: Suppose you just won $500,000 playing the lottery. You’ll invest the money and live off the interest. You buy a 1-year bond with a YTM of 10%.

  40. What is reinvestment rate risk? (continued) • Year 1 income = $50,000. At year-end get back $500,000 to reinvest. • If rates fall to 3%, income will drop from $50,000 to $15,000. Had you bought 30-year bonds, income would have remained constant.

  41. 5-10c The Maturity Risk Premium: Combining Interest Rate Risk and Reinvestment Risk • Long-term bonds: high interest rate risk, low reinvestment rate risk. • Short-term bonds: low interest rate risk, high reinvestment rate risk. • Nothing is totally riskless! • Yields on longer term bonds usually are greater than on shorter term bonds, so the MRP is more affected by interest rate risk than by reinvestment rate risk.

  42. 5-11 The Default Risk Premium(DRP) The default risk on Treasury securities is virtually zero, but default risk can be substantial for corporate and municipal bonds. The default risk is measured by bond ratings.

  43. 5-11a Bond Contract Provisions That Influence Default Risk Some Terminologies: • Bond Indenture: the contract which include covenants. • Secured Debt: pledge a particular asset as collateral. • Mortgage Bond: secured by property. • Debenture: unsecured bond. • Subordinated Debenture: subordinated to other senior debt. • Development Bond: tax-exempt bond for specific uses deemed to be in the public interest. • Revenue Bond: municipal bond that is secured by the revenues derived from a specific project. • Municipal Bond Insurance: bring the bond’s rating to the insurance company’s rating.

  44. Source: Fitch Ratings

  45. 5-11c Bond Rating Criteria, Upgrades, and Downgrades Bond ratings are based on both quantitative and qualitative factors: • Financial ratios: • Debt/Leverage ratios • Coverage ratios, such as interest coverage ratio or EBITDA coverage ratio • Profitability ratios • Liquidity ratios (More…)

  46. Example: Bond Ratings Median Ratios (S&P)

  47. Bond Rating Criteria (Continued) • Bond Contract Terms: • Secured versus unsecured debt • Senior versus subordinated debt • Sinking fund provisions • Guarantee provisions • Restrictive covenants (More…)

  48. Bond Rating Criteria (Continued) • Other Qualitative Factors: • Earnings stability • Regulatory environment • International Exposure • Etc. Upgrades and Downgrades: rating agencies review outstanding bonds on a periodic basis and re-rate if necessary.

  49. 5-11d Bonds Ratings and the Default Risk Premium: Impact of Bond Rating The rating has a direct, measurable influence on the bond’s interest rate and the firm’s cost of capital. Many institutional investors are restricted to investment grade securities only.

  50. 5-12 The Liquidity Premium(LP) • LP: charged by investors to reflect the fact that some securities can’t be converted to cash on short notice at a “reasonable” price. • A “bond spread” is often calculated as the difference between a corporate bond’s yield and a Treasury security’s yield of the same maturity. Therefore: • Bond Spread = DRP + LP • Bond’s of large, strong companies often have very small LPs. Bond’s of small companies often have LPs as high as 2%.

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