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Comprehensive Overview of Bond Valuation Principles by Dr. Menahem Rosenberg

This resource offers a thorough exploration of bond valuation components as covered in BUS 512 by Dr. Menahem Rosenberg. Learn key features of bonds, including par value, coupon interest rate, maturity, and unique features like call and conversion options. Understand different types of bonds, such as pure discount and coupon bonds, alongside the determinants of rates of return and yield to maturity (YTM). This guide effectively breaks down complex financial concepts into accessible information for students and professionals interested in bond valuation methodologies.

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Comprehensive Overview of Bond Valuation Principles by Dr. Menahem Rosenberg

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  1. Valuation of Bonds Bus 512- Bond Valuation | Dr. Menahem Rosenberg

  2. Bond Key Features • Bond - a term promissory note - loan agreement - a contract- specifying loan amount, methods of payment and interest if any. Most common Bond features: • Par value: Face amount; paid at maturity. Assume $1,000. • Coupon interest rate: Stated interest rate. Multiply by par to get $ of interest. Generally fixed. • Maturity: Years until bond is repaid. Bus 512- Bond Valuation | Dr. Menahem Rosenberg

  3. Special Features • Call feature: • Issuer can refund if rates decline (will pay a call premium). That helps the issuer but hurts the investor. • Most bonds have a deferred call and a declining call premium. • Conversion feature: • Lender (bond holder) can exchange the bond with a pre-specified number of stocks. • Since it provide an equity option, the interest rate on such a bond might be lower, reducing the Cash Flow drain. Bus 512- Bond Valuation | Dr. Menahem Rosenberg

  4. Asset Valuation • Asset Value as Present Value of the Cash Flows it will produce: Bus 512- Bond Valuation | Dr. Menahem Rosenberg

  5. Pure Discount Bonds • A pure discount bond (also called Zero Coupon or Zeroes) is a security that promises to pay a specified single cash payment (face value or par value) at a specified date called its maturity date • Note • There is no cash flow associated with interest • Pure discount bonds are purchased at a discount from their face or par value Bus 512- Bond Valuation | Dr. Menahem Rosenberg

  6. Pure Discount Bond • The pure discount bond is an example of the present value of a lump sum equation we analyzed previously. • Let i be the appropriate discount rate,n number of periods to maturity. • When we observe a price, we can compute the discount rate used to set that price: • The yield-to-maturity is the discount rate that makes the present value of the cash flows from the bond equal to the current price of the bond. Bus 512- Bond Valuation | Dr. Menahem Rosenberg

  7. Determinants of Rates of Return • “Real” vs “Nominal” rates • r* - real risk free rate, T-bill rate when there is no inflation • rf - risk free rate, free of any risk including inflation risks • r - Nominal rate, as rate required by assets holders • IP – Inflation premium • Short Term T-Bill rate of return (3) r = rf = r* + IP Bus 512- Bond Valuation | Dr. Menahem Rosenberg

  8. Determinants of Rates of Return • For other assets (long term government, foreign government, municipal, corporate) add all or some of the following: • DRP - Default Risk Premium • LP - Liquidity Premium • MRP – Maturity Risk Premium • So that: (4) r = r* + IP +DRP + LP + MRP Bus 512- Bond Valuation | Dr. Menahem Rosenberg

  9. Yield Curve • Term Structure: the relationship between interest rates (or yields) and maturities. • A graph of the term structure is called the Yield Curve. • We use pure discount bonds yield to maturity as the different period rates, called also pure discount rate. Bus 512- Bond Valuation | Dr. Menahem Rosenberg

  10. Yield Curve • October 10 2002 data. Bus 512- Bond Valuation | Dr. Menahem Rosenberg

  11. Coupon Bonds • A coupon bond obligates the issuer to • make periodic payments of interest (called coupon payments) to the bond holder until the bond matures • at maturity the face value of the bond is also paid to the bond holder • and the contract is satisfied • The coupon rate is the interest rate applied to the face value to compute the coupon payment • A bond with a face value of $1,000 and a coupon rate of 10% pays an annual coupon of $100 • At maturity, the payment is $1,000+$100 Bus 512- Bond Valuation | Dr. Menahem Rosenberg

  12. Coupon Bond Price • We can always analyze any fixed income contract into a sum of pure discount bonds • Let i0,tbe the t years pure discount rate. • Such that i0,1is a one year pure rate and i0,10is the 10 years pure discount rate • A bond with F par value and that pays $C coupon every period and is maturing in T periods. Bus 512- Bond Valuation | Dr. Menahem Rosenberg

  13. The YTM of a Coupon Bond • We have the price of the coupon bond, and the timing and magnitude of its future cash flows, so we can determine its YTM • The yield-to-maturity is the (one equal) discount rate that makes the present value of the cash flows from the bond equal to the current price of the bond. • i that solves for the price is the YTM • If we are provided a bond YTM, we can use it to price the bond. Bus 512- Bond Valuation | Dr. Menahem Rosenberg

  14. Par, premium, and Discount Bonds • A coupon bond with its current price equal to its par value is a par bond • If it is trading below par it is a discount bond • If it is trading above par it is a premium bond • At maturity, the value of any bond must equal its par value. • If a bond is currently valued at a premium (discount), as it approached maturity its value will decline (appreciate) towards par value. Bus 512- Bond Valuation | Dr. Menahem Rosenberg

  15. Bond Yields • YTM is the rate of return earned on a bond held to maturity. Also called “promised yield.” Bus 512- Bond Valuation | Dr. Menahem Rosenberg

  16. Bond Risks • Reinvestment Risk: The risk that Cash Flows will have to be reinvested in the future at lower rates, reducing income. • Interest rate risk: Rising discount rates cause bond’s price to fall. • Long-term bonds: High interest rate risk, low reinvestment rate risk. • Short-term bonds: Low interest rate risk, high reinvestment rate risk. Bus 512- Bond Valuation | Dr. Menahem Rosenberg

  17. Bond Default Risk • If issuer defaults, investors receive less than the promised return. • Bond Ratings Services Provide One Measure of Default Risk Bus 512- Bond Valuation | Dr. Menahem Rosenberg

  18. Bond Default Risk • Financial performance • Debt ratio • TIE ratio • Current ratios • Provisions in the bond contract • Secured vs. unsecured debt • Senior vs. subordinated debt • Guarantee provisions • Sinking fund provisions • Debt maturity • Other factors • Earnings stability • Regulatory environment • Potential product liability • Accounting policies Bus 512- Bond Valuation | Dr. Menahem Rosenberg

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