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Chapter 11 Bond Valuation

The document discusses key concepts related to bonds and their valuation. It defines what a bond is and describes their key features such as par value, coupon rate, and maturity date. It also discusses how bond values can change over time depending on interest rates and factors that affect the risk and rates of return on bonds such as call provisions, sinking funds, bond ratings, and interest rate risk. The document provides examples of how to calculate current and capital gains yields as well as the yield to maturity of a bond.

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2K views24 pages

Chapter 11 Bond Valuation

The document discusses key concepts related to bonds and their valuation. It defines what a bond is and describes their key features such as par value, coupon rate, and maturity date. It also discusses how bond values can change over time depending on interest rates and factors that affect the risk and rates of return on bonds such as call provisions, sinking funds, bond ratings, and interest rate risk. The document provides examples of how to calculate current and capital gains yields as well as the yield to maturity of a bond.

Uploaded by

fiq8809
Copyright
© Attribution Non-Commercial (BY-NC)
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PPT, PDF, TXT or read online on Scribd
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CHAPTER 10

Bonds and Their Valuation

 Key features of bonds


 Bond valuation
 Measuring yield
 Assessing risk
7-1
What is a bond?
 A long-term debt instrument in
which a borrower agrees to make
payments of principal and
interest, on specific dates, to the
holders of the bond.

7-2
Bond markets
 Primarily traded in the over-the-counter
(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 on the bond division of the
NYSE.
7-3
Key Features of a Bond
 Par value – face amount of the bond, which
is paid at maturity (assume $1,000).
 Coupon interest rate – stated interest rate
(generally fixed) paid by the issuer. Multiply
by par value 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
Effect of a call provision
 Allows issuer to refund the bond
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
What is a sinking fund?
 Provision to pay off a loan over
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
How are sinking funds
executed?
 Call x% of the issue at par, for
sinking fund purposes.
 Likely to be used if rd is below the
coupon rate and the bond sells at a
premium.
 Buy bonds in the open market.
 Likely to be used if rd is above the
coupon rate and the bond sells at a
discount.
7-7
Other types (features) of
bonds
 Convertible bond – may be exchanged for
common stock of the firm, at the holder’s
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. 7-8
What is the opportunity cost of
debt capital?
 The discount rate (ri ) is the
opportunity cost of capital, and is
the rate that could be earned on
alternative investments of equal
risk.

ri = r* + IP + MRP + DRP + LP

7-9
Changes in Bond Value over
Time
 What would happen to the value of these
three bonds is bond if its required rate of
VB
return remained at 10%:

1,184 13% coupon rate

10% coupon rate.


1,000

816 7% coupon rate


Years
to Maturity
10 5 0 7-10
Bond values over time
 At maturity, the value of any bond
must equal its par value.
 If rd 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. 7-11
What is the YTM on a 10-year, 9%
annual coupon, $1,000 par value
bond, selling for $887?
 Must find the rd that solves this model.

INT INT M
VB = + ... + +
(1 + rd )1
(1 + rd ) N
(1 + rd )N
90 90 1,000
$887= + ... + +
(1 + rd )1
(1 + rd )10
(1 + rd )10

7-12
Definitions
Annual coupon payment
eld(CY) =
Current yi
Currentprice

Changein price
Capitalgainsyield(CGY)=
Beginningprice

 Expected
  Expected

Expectedtotalreturn= YTM =   +  
 CY   CGY 
7-13
An example:
Current and capital gains yield
 Find the current yield and the
capital 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 =
7-14
Calculating capital gains
yield
YTM = Coupon + (Par Value – Market Price)/n
2(Market Price) + Par Value/3

Or 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.

7-15
What is interest rate (or price) risk?

Does a 1-year or 10-year bond


have more interest rate risk?
 Interest rate risk is the concern that rising
rd will cause the value of a bond to fall.

rd 1-year Change 10-year Change


5% $1,048 + 4.8% $1,386 +38.6%
10% 1,000 1,000
15% 956 – 4.4% 749 –25.1%

The 10-year bond is more sensitive to


interest rate changes, and hence has
more interest rate risk. 7-16
Illustrating interest rate
risk
1,600
1,400
1,200
Value ($)

1,000
800
600
400
200
0
0 5 10 15 20
YTM (% )

7-17
What is reinvestment rate
risk?
 Reinvestment rate risk is the concern
that rd 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.
7-18
Reinvestment rate risk
example
 You may invest in either a 10-year bond
or 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. 7-19
Conclusions about interest rate
and reinvestment rate risk
Short-term Long-term
AND/OR High AND/OR Low
Interest coupon bonds coupon bonds
Low High
rate risk
Reinvestme
High Low
nt rate risk

 CONCLUSION: Nothing is riskless!

7-20
Would you prefer to buy a 10-year,
10% annual coupon bond or a 10-
year, 10% semiannual coupon bond,
all else equal?

The semiannual bond’s effective rate


is: m 2
 iNom   0.10
EFF% = 1 +  − 1 = 1 +  − 1 = 10.25%
 m  2 

10.25% > 10% (the annual bond’s


effective rate), so you would prefer
the semiannual bond.
7-21
Types of bonds
 Mortgage bonds
 Debentures
 Subordinated debentures
 Investment-grade bonds
 Junk bonds

7-22
Evaluating default risk:
Bond ratings
Investment Grade Junk Bonds

Moody’ Aaa Aa A Baa Ba B Caa C


s
S&P AAA AA A BBB BB B CCC
D
 Bond ratings are designed to reflect
the probability of a bond issue
going into default.

7-23
Factors affecting default risk and
bond ratings
 Financial performance
 Debt ratio
 TIE ratio
 Current ratio
 Bond contract provisions
 Secured vs. Unsecured debt
 Senior vs. subordinated debt
 Guarantee and sinking fund provisions
 Debt maturity
7-24

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