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1st Session - Chapter 5 - Bonds, Bond Valuation, And Interest Rates

1st Session - Chapter 5 - Bonds, Bond Valuation, And Interest Rates

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Chapter 5

Bonds, Bond Valuation, and Interest Rates

1

Topics in Chapter
  

Key features of bonds Bond valuation Measuring yield Assessing risk

2

Determinants of Intrinsic Value: The Cost of Debt

Net operating profit after taxes

Required investments in operating capital =

Free cash flow (FCF)

Value =

FCF1 FCF2 FCF∞ ... + + + (1 + WACC)1 (1 + WACC)2 (1 + WACC)∞

Weighted average cost of capital (WACC)

Market interest rates
Market risk aversion

Cost of debt
Cost of equity

Firm’s debt/equity mix
Firm’s business risk
3

Key Features of a Bond

Par value: Face amount; paid at maturity. Assume $1,000. Coupon interest rate: Stated interest rate. Multiply by par value to get dollars of interest. Generally fixed.

(More…)
4

Maturity: Years until bond must be repaid. Declines. Issue date: Date when bond was issued. Default risk: Risk that issuer will not make interest or principal payments.

5

Most bonds have a deferred call and a declining call premium. borrowers are willing to pay more.Call Provision    Issuer can refund if rates decline. 6 . That helps the issuer but hurts the investor. Therefore. and lenders require more. on callable bonds.

shortens average maturity.What’s a sinking fund?     Provision to pay off a loan over its life rather than all at maturity. Similar to amortization on a term loan. But not good for investors if rates decline after issuance. Reduces risk to investor. 7 .

Sinking funds are generally handled in 2 ways  Call x% at par per year for sinking fund purposes.  Call if rd is below the coupon rate and bond sells at a premium. Use open market purchase if rd is above coupon rate and bond sells at a discount.  8 .  Buy bonds on open market.

.000 VB = $100 (1 + rd) . ..54 9 . . 100 + 1. + $38.000. + + 1 $100 (1 + rd)N + $1.55 + $385. . .000 (1 + rd)N = $90.Value of a 10-year. 10% coupon bond if rd = 10% 0 10% V=? 100 100 1 2 10 .91 + = $1. .

10% annuity of $100/year plus a $1.000.46 = 385.54 = $1.00 10 N 10 I/YR OUTPUT PV -1.000 lump sum at t = 10: PV annuity PV maturity value Value of bond INPUTS = $ 614.000 100 PMT 1000 FV 10 .The bond consists of a 10-year.

causing r = 13%? INPUTS OUTPUT 10 N 13 I/YR PV -837. the bond’s value falls below par. 11 . so it sells at a discount.What would happen if expected inflation rose by 3%. above the coupon rate.21 100 PMT 1000 FV When rd rises.

and bond sells at a premium.71 If coupon rate > rd.What would happen if inflation fell. and rd declined to 7%? INPUTS 10 N 7 I/YR 100 PMT 1000 FV OUTPUT PV -1. 12 .210. price rises above par.

or at 13%.  Suppose the bond was issued 20 years ago and now has 10 years to maturity. or at 7%? See next slide. 13 . What would happen to its value over time if the required rate of return remained at 10%.

M 837 775 30 25 20 15 10 5 rd = 13%.Bond Value ($) vs Years remaining to Maturity 1.211 1.372 rd = 7%. 1.000 rd = 10%. 14 0 .

The value of a discount bond would increase to $1. the value of any bond must equal its par value.    At maturity. A par bond stays at $1. 15 .000 if rd remains constant. The value of a premium bond would decrease to $1.000.000.

Also called “promised yield.What’s “yield to maturity”?   YTM is the rate of return earned on a bond held to maturity. 16 .” It assumes the bond will not default.

PV10 PVM 887 Find rd that “works”! 17 .YTM on a 10-year. $1. 9% annual coupon.000 par value bond selling for $887 0 1 9 10 90 1..000 rd=? . . .. 90 90 PV1 .

Find rd VB = . 887 = + + + 1 N (1 + rd) (1 + rd) (1 + rd)N INPUTS OUTPUT 10 N I/YR 10.... + + + N 1 (1 + rd) (1 + rd) (1 + rd)N INT INT M 1..91 -887 PV 90 PMT 1000 FV 18 .000 90 90 .

bond sells at its par value. bond sells at a premium. bond sells at a discount. Price = par at maturity. 19 . If rd rises. If coupon rate > rd. If coupon rate = rd. price falls.     If coupon rate < rd.

134.08 Sells at a premium. 20 . bond’s value > par. INPUTS 10 N OUTPUT -1134.Find YTM if price were $1.08%.20.2 90 PV PMT 1000 FV I/YR 7. Because coupon = 9% > rd = 7.

Definitions Current yield = Annual coupon pmt Current price Change in price Beginning price Capital gains yield = Exp total return Exp Exp cap = YTM = + Curr yld gains yld 21 .

P = $887.91% Current yield $90 = $887 = 0.1015 = 10.9% coupon. and YTM = 10. 10-year bond.15%. 22 .

Same answer.91% . and divide by value in Year 1.76%. 23 .Current yield = 10.YTM = Current yield + Capital gains yield. Cap gains yield = YTM . Could also find values in Years 1 and 2.10. get difference.15% = 0.

Multiply years by 2 to get periods = 2N. Divide nominal rate by 2 to get periodic rate = rd/2. Divide annual INT by 2 to get PMT = INT/2. INPUTS OUTPUT 24 2N N rd/2 I/YR OK PV INT/2 PMT OK FV . 2. 3.Semiannual Bonds 1.

2(10) INPUTS 20 N OUTPUT 13/2 6.72 100/2 50 PMT 1000 FV 25 .5 I/YR PV -834. semiannual bond if rd = 13%. 10% coupon.Value of 10-year.

xls for details.Spreadsheet Functions for Bond Valuation  See Ch05 Mini Case.   PRICE YIELD 26 .

135. $1. It can be called after 5 years at $1. 10% semiannual coupon.050.90 with an 8% yield to maturity.000 par value bond is selling for $1. 27 .Callable Bonds and Yield to Call  A 10-year.

765 x 2 = 7.9 50 I/YR PV PMT 3.Nominal Yield to Call (YTC) INPUTS 10 N OUTPUT -1135.53% 1050 FV 28 .

not YTM = 8%.If you bought bonds. hence YTC = 7. YTC = rd = 7.53%.53%.30/year. Could raise money by selling new bonds which pay 7.5%. Investors should expect a call. Could thus replace bonds which pay $100/year with bonds that pay only $75. would you be more likely to earn YTM or YTC?    Coupon rate = 10% vs. 29 .

if a bond sells at a premium. expect to earn:   YTC on premium bonds. 30 . YTM on par & discount bonds.  In general. so a call is likely. then coupon > rd. So.

Default risk premium. 31 . Liquidity premium. Maturity risk premium. Inflation premium. Here: rd r* IP DRP LP MRP = Required rate of return on a debt security.rd = r* + IP + DRP + LP + MRP. = = = = = Real risk-free rate.

(Because r*xIP is small) rRF = Rate on Treasury securities.What is the nominal risk-free rate?  rRF = (1+r*)(1+IP)-1 = r*+ IP + (r*xIP) ≈ r*+ IP.  32 .

Estimating IP   Treasury Inflation-Protected Securities (TIPS) are indexed to inflation. 33 . 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.

Bond’s of small companies often have LPs as high as 2%. the DRP. Therefore:  Spread = DRP + LP.  Bond’s of large. strong companies often have very small LPs. and the LP  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. 34 .Bond Spreads.

2 36.6 Investment grade bonds: AAA AA A Aaa Aa A BBB Baa Ba B Caa 0.1 5 yrs.3 1.0 0.9 8. 0.9 35 Junk bonds: BB B CCC Source: Fitch Ratings .8 22.0 0.2 9.Bond Ratings S&P and Fitch Moody’s % defaulting within: 1 yr.0 0.3 2.4 1. 0.1 0.

March 2009) Long-term Bonds 10-Year T-bond AAA AA A BBB BB B CCC Yield (%) Spread (%) 2.82 2.62 5.53 11.11 4.30 2.70 26.94 11.79 7.68 5.62 36 .02 23.50 5.Bond Ratings and Bond Spreads (YahooFinance.94 3.62 13.85 8.

What factors affect default risk and bond ratings?  Financial ratios     Debt ratio Coverage ratios. such as interest coverage ratio or EBITDA coverage ratio Profitability ratios Current ratios (More…) 37 .

6% 27.2 0.5 1.7% 75.5% 38 .Bond Ratings Median Ratios (S&P) AAA AA A BBB BB B CCC Interest coverage 23.9% 113.5% 53.5% 13.4% 28.5% 42.7% 3.7 2.8 19.4% 11.0 4.5 8.3% 8.3% 37.2% Debt to capital 12.4 Return on capital 27.0% 17.

Other Factors that Affect Bond Ratings  Provisions in the bond contract      Secured versus unsecured debt Senior versus subordinated debt Guarantee provisions Sinking fund provisions Debt maturity (More…) 39 .

 Other factors     Earnings stability Regulatory environment Potential product liability Accounting policies 40 .

1% 41 .000 956 4.000 749 38.Interest rate (or price) risk for 1year and 10-year 10% bonds Interest rate risk: Rising rd causes bond’s price to fall.386 1.6% 25.048 10% 15% 1.8% 4. rd 1-year Change 10-year Change 5% $1.4% $1.

000 500 0 0% 5% 10% 15% rd 42 .Value 1.500 10-year 1-year 1.

You’ll invest the money and live off the interest. 43 .What is reinvestment rate risk?   The risk that CFs will have to be reinvested in the future at lower rates. You buy a 1-year bond with a YTM of 10%. reducing income.000 playing the lottery. Illustration: Suppose you just won $500.

44 .  Year 1 income = $50.000.000 to reinvest. At year-end get back $500.000. income would have remained constant. If rates fall to 3%.000 to $15. Had you bought 30-year bonds. income will drop from $50.

Nothing is riskless! Yields on longer term bonds usually are greater than on shorter term bonds.The Maturity Risk Premium     Long-term bonds: High interest rate risk. 45 . so the MRP is more affected by interest rate risk than by reinvestment rate risk. low reinvestment rate risk. high reinvestment rate risk. Short-term bonds: Low interest rate risk.

46 .Term Structure Yield Curve   Term structure of interest rates: the relationship between interest rates (or yields) and maturities. A graph of the term structure is called the yield curve.

Hypothetical Treasury Yield Curve 14% 12% Interest Rate 10% 8% 6% 4% 2% 0% MRP IP r* 11 13 15 17 Years to Maturity 47 19 1 3 5 7 9 .

company wants Chapter 11. creditors may prefer Chapter 7. 48 .Bankruptcy  Two main chapters of Federal Bankruptcy Act:   Chapter 11. Liquidation  Typically. Reorganization Chapter 7.

Management usually stays in control.   Court appoints a “trustee” to supervise reorganization. Company has 120 days to file a reorganization plan. taking assets.  If company can’t meet its obligations. it files under Chapter 11. and shutting down the business. That stops creditors from foreclosing. 49 .

  Company must demonstrate in its reorganization plan that it is “worth more alive than dead. 50 .” Otherwise. judge will order liquidation under Chapter 7.

If the company is liquidated. here’s the payment priority:            Past due property taxes Secured creditors from sales of secured assets. Trustee’s costs Expenses incurred after bankruptcy filing Wages and unpaid benefit contributions. subject to limits Unsecured customer deposits. subject to limits Taxes Unfunded pension liabilities Unsecured creditors Preferred stock Common stock 51 .

  In a liquidation. and a chance for success. 52 . Various groups of creditors vote on the reorganization plan. If both the majority of the creditors and the judge approve. This makes them more willing to participate in reorganization even though their claims are greatly scaled back. unsecured creditors generally get zero. company “emerges” from bankruptcy with lower debts. reduced interest charges.

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