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Bonds (Debt) Characteristics and Valuation

Bonds (Debt) Characteristics and Valuation. What is debt? What are bond ratings? How are bond prices determined? How are bond yields determined? What is the relationship between bond prices and interest rates?. Debt Characteristics.

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Bonds (Debt) Characteristics and Valuation

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  1. Bonds (Debt)Characteristics and Valuation • What is debt? • What are bond ratings? • How are bond prices determined? • How are bond yields determined? • What is the relationship between bond prices and interest rates?

  2. Debt Characteristics • Principal value, face value, maturity value, and par value • Interest payments—coupon rate of interest • Maturity date • Priority to assets and earnings • Control of the firm

  3. Types of Debt—Short-Term • Treasury bills—U.S. government securities • Repurchase agreement—repo • Federal funds—loans from one bank to another • Banker’s acceptance—a “postdated check”

  4. Types of Debt—Short-Term • Commercial Paper (CP)—promissory note • Certificate of Deposit (CD)—time deposit • Eurodollar deposit—dollar-denominated deposits • Money market mutual funds—short-term investments

  5. Types of Debt—Long-Term • Term loans • Bank or insurance company • Amortized—payment includes principal and interest • Bonds • Borrower agrees to make payments of interest and principal on specific dates to the bondholder (investor)

  6. Common Bonds • Government bonds • Treasury—notes and bonds • State and local governments (municipals) • Revenue bonds • General obligation bonds • Corporate bonds • Mortgage bonds—backed by fixed assets • Debenture—unsecured bond • Subordinated debenture—low priority

  7. Other Types of Bonds • Income bond—pays interest when the firm’s income is sufficient • Putable bond—can be redeemed at the bondholder’s option • Indexed (purchasing power) bond—interest payments are based on an inflation index • Floating-rate bond—bond’s interest is based on market interest rates • Zero (or very low) coupon bond—little or no interest is paid (discounted) • Junk bond—high-risk, high-yield bond (low rating)

  8. Bond Contract Features • Indenture—bond contract • Maturity, coupon, etc. are set in the contract • Coupon rate of interest—set at prevailing rate when the bond is issued • Trustee—represents bondholders’ interests • Restrictive covenant—restricts borrower’s a actions • Sinking fund—a required annual payment • Call provision—issuer can redeem the bonds prior to maturity • Refunding—retire (repay) existing debt with proceeds of new debt—that is, refinancing debt • Convertible feature—conversion in to stock

  9. High quality Substandard Speculative Investment grade Ba BB B B Caa CCC C D Junk Bonds Bond Ratings Moody’sS&P Aaa AAA Aa AA A A Baa BBB Ba BB B B Caa CCC C D

  10. Importance of Bond Ratings • Indication of default risk • Institutional investors are restricted to investment-grade securities • Ratings changes—affect a firm’s ability to borrow and the cost of borrowing

  11. Foreign Debt Instruments • Foreign debt—sold by a foreign borrower; denominated in the currency of the country in which it is sold • Eurodebt • Debt sold in a country other than the one in whose currency the debt is denominated • LIBOR: London InterBank Offer Rate

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

  13. Basic Valuation r = required rate of return

  14. 1 N 0 2 3 … Bond Value = Vd Valuation of Bonds rd INT INT INT INT PV of INT M PV of M INT = $ interest paid each period M = maturity, or face, value rd = investors’ required rate of return

  15. Valuation of Bonds

  16. 50 50 1,000 1,000 (1+rd)8 (1.06)8 (1+rd)8 (1.06)8 Bond Valuation—Example Bond Characteristics: Face (maturity) value, M $1,000 Coupon rate of interest, C 5% Annual interest payment, INT $50 = $1,000 x 0.05 Years to maturity, N 8 Market rate, rd 6% Bond Characteristics: Face (maturity) value, M $1,000 Coupon rate of interest, C 5% Annual interest payment, INT $50 = $1,000 x 0.05 Years to maturity, N 8 Market rate, rd 6% Bond Characteristics: Face (maturity) value, M $1,000 Coupon rate of interest, C 5% Annual interest payment, INT $50 = $1,000 x 0.05 Years to maturity, N 8 Market rate, rd 6% Bond Characteristics: Face (maturity) value, M $1,000 Coupon rate of interest, C 5% Annual interest payment, INT $50 = $1,000 x 0.05 Years to maturity, N 8 Market rate, rd 6% Bond Characteristics: Face (maturity) value, M $1,000 Coupon rate of interest, C 5% Annual interest payment, INT $50 = $1,000 x 0.05 Years to maturity, N 8 Market rate, rd 6% Bond Characteristics: Face (maturity) value, M $1,000 Coupon rate of interest, C 5% Annual interest payment, INT $50 = $1,000 x 0.05 Years to maturity, N 8 Market rate, rd6% 50 50 1,000 1,000 (1+rd)8 (1.06)8 (1+rd)8 (1.06)8 = 50(6.20979) + 1,000(0.62741) = 937.90

  17. N I/Y PV PMT FV Bond Characteristics: Face (maturity) value, M $1,000 Coupon rate of interest, C 5% Annual interest payment, INT $50 Years to maturity, N 8 Market rate, rd 6% Bond Characteristics: Face (maturity) value, M $1,000 Coupon rate of interest, C 5% Annual interest payment, INT $50 Years to maturity, N 8 Market rate, rd 6% Bond Characteristics: Face (maturity) value, M $1,000 Coupon rate of interest, C 5% Annual interest payment, INT $50 Years to maturity, N 8 Market rate, rd 6% Bond Characteristics: Face (maturity) value, M $1,000 Coupon rate of interest, C 5% Annual interest payment, INT $50 Years to maturity, N 8 Market rate, rd 6% Bond Characteristics: Face (maturity) value, M $1,000 Coupon rate of interest, C 5% Annual interest payment, INT $50 Years to maturity, N 8 Market rate, rd6% 8 8 8 6 6 ? 50 50 50 50 1,000 1,000 1,000 1,000 1,000 Bond ValuationFinancial Calculator Solution Bond Characteristics: Face (maturity) value, M $1,000 Coupon rate of interest, C 5% Annual interest payment, INT $50 Years to maturity, N 8 Market rate, rd 6% -937.90

  18. Bond Valuation—Yield to Maturity, rd Bond Characteristics: Face (maturity) value, M $1,000 Coupon rate of interest, C 10% Annual interest payment, INT $100 = $1,000 x 0.10 Years to maturity, N 5 Market price, Vd $1,123 Bond Characteristics: Face (maturity) value, M $1,000 Coupon rate of interest, C 10% Annual interest payment, INT $100 = $1,000 x 0.10 Years to maturity, N 5 Market price, Vd $1,123 Bond Characteristics: Face (maturity) value, M $1,000 Coupon rate of interest, C 10% Annual interest payment, INT $100 = $1,000 x 0.10 Years to maturity, N 5 Market price, Vd $1,123 Bond Characteristics: Face (maturity) value, M $1,000 Coupon rate of interest, C 10% Annual interest payment, INT $100 = $1,000 x 0.10 Years to maturity, N 5 Market price, Vd $1,123 Bond Characteristics: Face (maturity) value, M $1,000 Coupon rate of interest, C 10% Annual interest payment, INT $100 = $1,000 x 0.10 Years to maturity, N 5 Market price, Vd $1,123 Bond Characteristics: Face (maturity) value, M $1,000 Coupon rate of interest, C 10% Annual interest payment, INT $100 = $1,000 x 0.10 Years to maturity, N 5 Market price, Vd$1,123 Bond Characteristics: Face (maturity) value, M $1,000 Coupon rate of interest, C 10% Annual interest payment, INT $100 = $1,000 x 0.10 Years to maturity, N 5 Market price, Vd $1,123 5 100 1,000 1,123 5 rd = Yield to maturity, YTM

  19. Adj interest Avg investment = Bond Valuation—Yield to Maturity, rd , Approximation Example: M = $1,000, INT = $100, N = 5, Vd= $1,123

  20. N I/Y PV PMT FV Bond Characteristics: Face (maturity) value, M $1,000 Coupon rate of interest, C 10% Annual interest payment, INT $100 Years to maturity, N 5 Market price, Vd $1,123 Bond Characteristics: Face (maturity) value, M $1,000 Coupon rate of interest, C 10% Annual interest payment, INT $100 Years to maturity, N 5 Market price, Vd $1,123 Bond Characteristics: Face (maturity) value, M $1,000 Coupon rate of interest, C 10% Annual interest payment, INT $100 Years to maturity, N 5 Market price, Vd $1,123 Bond Characteristics: Face (maturity) value, M $1,000 Coupon rate of interest, C 10% Annual interest payment, INT $100 Years to maturity, N 5 Market price, Vd $1,123 Bond Characteristics: Face (maturity) value, M $1,000 Coupon rate of interest, C 10% Annual interest payment, INT $100 Years to maturity, N 5 Market price, Vd $1,123 5 5 5 -1,123 -1,123 100 100 100 100 1,000 1,000 1,000 1,000 1,000 Bond Valuation—YTMFinancial Calculator Solution Bond Characteristics: Face (maturity) value, M $1,000 Coupon rate of interest, C 10% Annual interest payment, INT $100 Years to maturity, N 5 Market price, Vd $1,123 ? 7.0

  21. N I/Y PV PMT FV Bond Valuation—Yield to Call Bond Characteristics: Face (maturity) value, M $1,000 Call price $1,060 Coupon rate of interest, C 10% Annual interest payment, INT $100 Years to maturity, N 5 Date to first call 3 Market price, Vd $1,123 3?-1,123 100 1,060 7.44

  22. N I/Y PV PMT FV 16 16 16 16 3.0 3.0 3.0 3.0 25 25 25 1,000 1,000 ? Bond ValuationSemiannual Payment of Interest • Most bonds pay interest semiannually • Adjustments to computations • N = # years x m; m = # of interest payments per year • r = rd/m • INT = interest payment per period = Annual INT/m Example: M = $1,000, C = 5%, Yrs to maturity = 8, rd = 6% 16 -931.23

  23. Changes in Bond Values Over Time • Whenever the going rate of interest, rd, equals the coupon rate, a bond will sell at its par value • An increase (decrease) in interest rates will cause the price of an outstanding bond to fall (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. Bond ValuationRelationship of YTM, Coupon, and Price

  25. Interest-Rate Risk • When market rates change, bondholders are affected in two ways: • bond prices change in an opposite direction—price risk • the rates investors earn change—reinvestment risk • When market rates change, bondholders are affected in two ways: • bond prices change in an opposite direction—price risk • the rates investors earn change—reinvestment risk • When market rates change, bondholders are affected in two ways: • bond prices change in an opposite direction—price risk • the rates investors earn change—reinvestment risk Bond Characteristics: M = $1,000.00 INT = $60.00 N= 5 yrs Annual Interest

  26. Vd1 – Vd0 Vd0 INT Vd0 Bond Return Return on investment Capital gains yield Income yield = + rd = + Rate of return Capital gains yield Current yield = +

  27. Bond Valuation—Change in Value Over Time Bond Characteristics: M = $1,000.00, INT = $60.00, rd = 8% 920.15 920.15 933.76 933.76 933.76 1.48% 1.48% 6.52% 6.52% 8.00% 8.00% 948.46 1.57 6.43 8.00% 964.33 1.67 6.33 8.00% 981.48 1.78 6.22 8.00% 1,000.00 1.89 6.11 8.00% 27

  28. Market Value ($), Vd 1,100.00 1,050.00 1,000.00 950.00 900.00 850.00 Years to Maturity 800.00 5 4 3 2 1 0 Bond Valuation—Change in Value Over Time INT = $60 (C = 6%) N = 5 yrs 1,089.04 if rd = 4% < C = 6% Premium bond, Vd > M Par bond, Vd = M; rd = C = 6% M = 1,000 Discount bond, Vd < M 920.15 if rd = 8% > C = 6%

  29. Long-Term versus Short-Term Bonds Value of Coupon = 10% Current market 1-year 15-year Interest rate rd bond bond 6% 8 10 12 14 16 $1,037.74 1,018.52 1,000.00 982.14 964.91 948.28 $1,388.49 1,171.19 1,000.00 863.78 754.31 665.47

  30. 15-Year Bond Long-Term versus Short-Term Bonds

  31. Bonds (Debt)Characteristics and Valuation • What is debt? • Debt represents a loan • What are bond ratings? • Ratings give an indication of the default risk associated with a bond • How are bond prices determined? • Value = PV of the cash flows the bond is expected to pay during its life

  32. Bonds (Debt)Characteristics and Valuation • How are bond yields determined? • YTM is the average annual rate of return that an investor will earn if he or she buys the bond at the current market price and holds it until it matures • YTC is the average annual rate of return that an investor will earn if he or she buys the bond at the current market price and holds it until the first date the bond can be called • What is the relationship between bond prices and interest rates? • When interest rates increase, bond prices decrease, and vice versa

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