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Jun 12, 2015

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Bond valuation

Measuring yield

Assessing risk

7-1

What is a bond?

which a borrower agrees to make

payments of principal and

interest, on specific dates, to the

holders of the bond.

7-2

Bond markets

(OTC) market.

Most bonds are owned by and traded

among large financial institutions.

Full information on bond trades in the

OTC market is not published, but a

representative group of bonds is listed

and traded.

7-3

is paid at maturity (assume $1,000).

Coupon interest rate stated interest rate

(generally fixed) paid by the issuer. Multiply

by par to get dollar payment of interest.

Maturity date years until the bond must be

repaid.

Issue date when the bond was issued.

Yield to maturity - rate of return earned on

a bond held until maturity (also called the

promised yield).

7-4

issue if rates decline (helps the

issuer, but hurts the investor).

Borrowers are willing to pay

more, and lenders require more,

for callable bonds.

Most bonds have a deferred call

and a declining call premium.

7-5

its life rather than all at maturity.

Similar to amortization on a term

loan.

Reduces risk to investor,

shortens average maturity.

But not good for investors if

rates decline after issuance.

7-6

executed?

fund purposes.

rate and the bond sells at a premium.

coupon rate and the bond sells at a

discount.

7-7

assets

0

k

Value

...

CF1

CF2

CFn

CF1

CF2

CFn

Value

...

1

2

n

(1 k)

(1 k)

(1 k)

7-8

bonds

common stock of the firm, at the holders

option.

Warrant long-term option to buy a stated

number of shares of common stock at a

specified price.

Putable bond allows holder to sell the

bond back to the company prior to maturity.

Income bond pays interest only when

interest is earned by the firm.

Indexed bond interest rate paid is based

upon the rate of inflation.

7-9

10% annual coupon bond, if kd =

10%?

0

k

VB = ?

...

100

100

100 + 1,000

$100

$100

$1,000

VB

...

1

10

(1.10)

(1.10)

(1.10)10

VB $90.91 ... $38.55 $385.54

VB $1,000

7-10

value a bond

= 10, and annual $100 coupon payments

beginning at t = 1 and continuing through

t = 10, the price of the bond can be found

by solving for the PV of these cash flows.

INPUTS

OUTPUT

10

10

I/YR

PV

100

1000

PMT

FV

-1000

7-11

An example:

Increasing inflation and kd

kd = 13%. When kd rises above the

coupon rate, the bonds value falls

below par, and sells at a discount.

INPUTS

OUTPUT

10

13

I/YR

PV

100

1000

PMT

FV

-837.21

7-12

An example:

Decreasing inflation and kd

kd = 7%. When kd falls below the

coupon rate, the bonds value rises

above par, and sells at a premium.

INPUTS

OUTPUT

10

I/YR

PV

100

1000

PMT

FV

-1210.71

7-13

VB

bond if its required rate of return remained

at 10%, or at 13%, or at 7% until maturity?

1,372

1,211

kd = 7%.

kd = 10%.

1,000

837

775

kd = 13%.

30

25

20

15

10

Years

to Maturity

7-14

equal its par value.

If kd remains constant:

The value of a premium bond would

decrease over time, until it reached

$1,000.

The value of a discount bond would

increase over time, until it reached

$1,000.

A value of a par bond stays at $1,000.

7-15

annual coupon, $1,000 par value

bond, selling for $887?

INT

INT

M

VB

...

1

N

N

(1 kd )

(1 kd )

(1 kd )

90

90

1,000

$887

...

1

10

10

(1 kd )

(1 kd )

(1 kd )

7-16

to find YTM

is 10.91%. This bond sells at a

discount, because YTM > coupon

rate.

INPUTS

10

N

OUTPUT

I/YR

- 887

90

1000

PV

PMT

FV

10.91

7-17

$1,134.20.

is 7.08%. This bond sells at a

premium, because YTM < coupon

rate.

INPUTS

10

N

OUTPUT

I/YR

-1134.2

90

1000

PV

PMT

FV

7.08

7-18

Definitions

Annual coupon payment

Current yi

eld(CY)

Currentprice

Changein price

Capitalgainsyield(CGY)

Beginningprice

Expected

Expected

Expectedtotalreturn YTM

CY CGY

7-19

An example:

Current and capital gains yield

gains yield for a 10-year, 9% annual

coupon bond that sells for $887, and

has a face value of $1,000.

Current yield

= $90 / $887

= 0.1015 = 10.15%

7-20

yield

YTM = Current yield + Capital gains yield

CGY = YTM CY

= 10.91% - 10.15%

= 0.76%

Could also find the expected price one year

from now and divide the change in price by the

beginning price, which gives the same answer.

7-21

risk?

kd will cause the value of a bond to fall.

% change 1 yr

kd

+4.8% $1,048

5%

$1,000 10%

$1,000

-4.4%

$956

15%

10yr

$1,386

$749

% change

+38.6%

-25.1%

interest rate changes, and hence has more

interest rate risk.

7-22

risk?

that kd will fall, and future CFs will

have to be reinvested at lower rates,

hence reducing income.

EXAMPLE: Suppose you just won

$500,000 playing the lottery. You

intend to invest the money and

live off the interest.

7-23

example

a series of ten 1-year bonds. Both 10-year

and 1-year bonds currently yield 10%.

If you choose the 1-year bond strategy:

After Year 1, you receive $50,000 in

income and have $500,000 to reinvest.

But, if 1-year rates fall to 3%, your

annual income would fall to $15,000.

If you choose the 10-year bond strategy:

You can lock in a 10% interest rate, and

$50,000 annual income.

7-24

and reinvestment rate risk

Short-term

Long-term

Interest

rate risk

Low

High

Reinvestme

nt rate risk

High

Low

7-25

Semiannual bonds

2.

Divide nominal rate by 2 : periodic rate (I/YR) =

kd / 2.

3.

1.

INPUTS

2n

kd / 2

OK

cpn / 2

OK

I/YR

PV

PMT

FV

OUTPUT

7-26

semiannual coupon bond, if kd =

13%?

1.

2.

3.

Divide nominal rate by 2 : I/YR = 13 / 2 = 6.5.

Divide annual coupon by 2 : PMT = 100 / 2 =

50.

INPUTS

OUTPUT

20

6.5

I/YR

PV

50

1000

PMT

FV

- 834.72

7-27

10% annual coupon bond or a 10year, 10% semiannual coupon bond,

all else equal?

is:

m

2

iNom

0.10

EFF% 1

1 1

1 10.25%

m

2

effective rate), so you would prefer the

semiannual bond.

7-28

bond is $1,000, what would be the

proper price for the annual coupon

bond?

The semiannual coupon bond has an

effective rate of 10.25%, and the annual

coupon bond should earn the same EAR.

At these prices, the annual and semiannual

coupon bonds are in equilibrium, as they

earn the same effective return.

INPUTS

OUTPUT

10

10.25

I/YR

PV

100

1000

PMT

FV

- 984.80

7-29

bond selling for $1,135.90 can be called

in 4 years for $1,050, what is its yield to

call (YTC)?

determined to be 8%. Solving for the YTC

is identical to solving for YTM, except the

time to call is used for N and the call

premium is FV.

INPUTS

8

N

OUTPUT

I/YR

- 1135.90

50

1050

PV

PMT

FV

3.568

7-30

Yield to call

semiannual yield to call.

YTCNOM = kNOM = 3.568% x 2 =

7.137% is the rate that a broker

would quote.

The effective yield to call can be

calculated

7-31

would you be more likely to earn the

YTM or YTC?

YTC = 7.137%. The firm could raise

money by selling new bonds which

pay 7.137%.

Could replace bonds paying $100 per

year with bonds paying only $71.37

per year.

Investors should expect a call, and to

earn the YTC of 7.137%, rather than

the YTM of 8%.

7-32

occur?

premium, then (1) coupon > kd, so

(2) a call is more likely.

So, expect to earn:

YTM on par & discount bonds.

7-33

Default risk

receive less than the promised

return. Therefore, the expected

return on corporate and municipal

bonds is less than the promised

return.

Influenced by the issuers financial

strength and the terms of the bond

contract.

7-34

Types of bonds

Mortgage bonds

Debentures

Subordinated debentures

Investment-grade bonds

Junk bonds

7-35

Bond ratings

Investment Grade

Junk Bonds

Moody

s

Aaa Aa A Baa

Ba B Caa C

S&P

AAA AA A BBB

BB B CCC

D

the probability of a bond issue going

into default.

7-36

bond ratings

Financial performance

Debt ratio

TIE ratio

Current ratio

Senior vs. subordinated debt

Guarantee and sinking fund provisions

Debt maturity

7-37

risk

Earnings stability

Regulatory environment

Potential antitrust or product

liabilities

Pension liabilities

Potential labor problems

Accounting policies

7-38

Bankruptcy

reorganization plan that it is worth

more alive than dead.

7-39

Priority of claims in

liquidation

1.

2.

3.

4.

5.

6.

7.

8.

secured assets.

Trustees costs

Wages, subject to limits

Taxes

Unfunded pension liabilities

Unsecured creditors

Preferred stock

Common stock

7-40

Reorganization

generally get zero. This makes them

more willing to participate in

reorganization even though their claims

are greatly scaled back.

Various groups of creditors vote on the

reorganization plan. If both the majority

of the creditors and the judge approve,

company emerges from bankruptcy

with lower debts, reduced interest

charges, and a chance for success.

7-41

debt capital?

opportunity cost of capital, and is

the rate that could be earned on

alternative investments of equal

risk.

ki = k* + IP + MRP + DRP + LP

7-42

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