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Bonds, Bond Valuation, and Interest Rates

This chapter discusses bonds, bond valuation, and interest rates. It covers key bond features such as par value, coupon rate, maturity date, and call provisions. It also discusses how the value of a bond is determined based on required rate of return and cash flows. Bond valuation methods such as yield to maturity and current yield are explained. The determinants of bond risk premia and ratings are also reviewed.

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Ali Jumani
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206 views52 pages

Bonds, Bond Valuation, and Interest Rates

This chapter discusses bonds, bond valuation, and interest rates. It covers key bond features such as par value, coupon rate, maturity date, and call provisions. It also discusses how the value of a bond is determined based on required rate of return and cash flows. Bond valuation methods such as yield to maturity and current yield are explained. The determinants of bond risk premia and ratings are also reviewed.

Uploaded by

Ali Jumani
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPT, PDF, TXT or read online on Scribd
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Chapter 5

Bonds, Bond Valuation, and


Interest Rates

Topics in Chapter

Key features of bonds


Bond valuation
Measuring yield
Assessing risk

Determinants of Intrinsic Value: The Cost of


Debt
Net operating
profit after taxes

Required investments
in operating capital

Free cash flow


=
(FCF)

Value =

FCF1
(1 + WACC)1

FCF2
+
(1 + WACC)2

... + FCF
+
(1 +
WACC)

Weighted average
cost of capital
(WACC)
Market interest rates
Market risk aversion

Cost
Costof
ofdebt
debt
Cost of equity
Cost of equity

Firms debt/equity mix


Firms 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

Call Provision

Issuer can refund if rates decline.


That helps the issuer but hurts the
investor.
Therefore, borrowers are willing to
pay more, and lenders require
more, on callable bonds.
Most bonds have a deferred call and
a declining call premium.
6

Whats 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

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.

Buy bonds on open market.

Use open market purchase if rd is


above coupon rate and bond sells at a
discount.
8

Value of a 10-year, 10%


coupon bond if rd = 10%
0

10%
V=?

10

...
100

100

100 + 1,000

$100
$100
$1,000
VB =
+... +
+
1
N
(1 + rd)
(1 + rd) (1 + rd)N
= $90.91 +
= $1,000.

. . . + $38.55 + $385.54
9

The bond consists of a 10-year, 10%


annuity of $100/year plus a $1,000
lump sum at t = 10:
PV annuity
=$ 614.46
PV maturity value = 385.54
Value of bond
=$1,000.00
INPUTS
OUTPUT

10
N

10
I/YR

PV
-1,000

100
PMT

1000
FV

10

What would happen if expected


inflation rose by 3%, causing r =
13%?

INPUTS
OUTPUT

10
N

13
I/YR

PV
-837.21

100
PMT

1000
FV

When rd rises, above the coupon


rate, the bonds value falls below
par, so it sells at a discount.
11

What would happen if


inflation fell, and rd
declined to 7%?
INPUTS
OUTPUT

10
N

7
I/YR

PV
-1,210.71

100
PMT

1000
FV

If coupon rate > rd, price rises above


par, and bond sells at a premium.
12

Suppose the bond was issued 20


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

Bond Value ($) vs Years


remaining to Maturity
rd = 7%.

1,372
1,211

rd = 10%.

1,000

837

rd = 13%.

775
30

25

20

15

10

14

At maturity, the value of any bond


must equal its par value.
The value of a premium bond
would decrease to $1,000.
The value of a discount bond would
increase to $1,000.
A par bond stays at $1,000 if rd
remains constant.
15

Whats yield to
maturity?

YTM is the rate of return earned on


a bond held to maturity. Also
called promised yield.
It assumes the bond will not
default.

16

YTM on a 10-year, 9% annual


coupon, $1,000 par value bond
selling for $887
0

rd=?

1
90

PV1
.
.
.
PV10
PVM

887

...

9
90

10
90
1,000

Find rd that works!


17

Find rd
INT

INT
M
... +
VB =
+
+
N
1
(1 + r d)
(1 + r d) (1 + r d)N
1,000
90
90
...
887 =
+
+
+
1
N
(1 + rd)
(1 + rd) (1 + rd)N
INPUTS
OUTPUT

10
N

I/YR
10.91

-887
PV

90
PMT

1000
FV
18

If coupon rate < rd, bond sells at a


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

Find YTM if price were


$1,134.20.
INPUTS 10
N
OUTPUT

I/YR
7.08

-1134.2 90
PV
PMT

1000
FV

Sells at a premium.
Because coupon = 9% > rd
= 7.08%, bonds value >
par.
20

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

9% coupon, 10-year bond, P


= $887, and YTM = 10.91%

$90
Current yield =
$887
= 0.1015 = 10.15%.

22

YTM = Current yield +


Capital gains yield.
Cap gains yield = YTM - Current
yield
= 10.91% - 10.15%
= 0.76%.
Could also find values in Years 1 and
2,
get difference, and divide by value in
Year 1. Same answer.
23

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

I/YR

PV

PMT

FV
24

Value of 10-year, 10%


coupon, semiannual bond if
rd = 13%.

2(10)
INPUTS
20
N
OUTPUT

13/2
6.5
I/YR

PV
-834.72

100/2
50
PMT

1000
FV

25

Spreadsheet Functions
for Bond Valuation

See Ch05 Mini Case.xls for details.

PRICE
YIELD

26

Callable Bonds and Yield


to Call

A 10-year, 10% semiannual


coupon,
$1,000 par value bond is selling for
$1,135.90 with an 8% yield to
maturity.
It can be called after 5 years at
$1,050.
27

Nominal Yield to Call (YTC)

INPUTS 10
N
OUTPUT

-1135.9 50
I/YR
PV
PMT
3.765 x 2 = 7.53%

1050
FV

28

If you bought bonds, would you


be more likely to earn YTM or
YTC?

Coupon rate = 10% vs. YTC = rd =


7.53%. Could raise money by
selling new bonds which pay 7.53%.
Could thus replace bonds which pay
$100/year with bonds that pay only
$75.30/year.
Investors should expect a call,
hence YTC = 7.5%, not YTM = 8%.
29

In general, if a bond sells at a


premium, then coupon > rd, so a
call is likely.
So, expect to earn:

YTC on premium bonds.


YTM on par & discount bonds.

30

rd = r* + IP + DRP + LP +
MRP.
Here:
rd
r*
IP
DRP
LP
MRP

=Required rate of return on a


debt security.
=
Real risk-free rate.
=
Inflation premium.
=
Default risk premium.
=
Liquidity premium.
=
Maturity risk premium.
31

What is the nominal riskfree rate?

rRF = (1+r*)(1+IP)-1
= r*+ IP + (r*xIP)
r*+ IP. (Because r*xIP is
small)
rRF = Rate on Treasury securities.

32

Estimating IP

Treasury Inflation-Protected Securities


(TIPS) are indexed to inflation.
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.
33

Bond Spreads, the DRP,


and the LP

A bond spread is often calculated as


the difference between a corporate
bonds yield and a Treasury securitys
yield of the same maturity. Therefore:

Spread = DRP + LP.

Bonds of large, strong companies often


have very small LPs. Bonds of small
companies often have LPs as high as
2%.
34

Bond Ratings

% defaulting within:

S&P and
Moody
1 yr.
Fitch
s
Investment grade bonds:
AAA
Aaa
0.0
AA
Aa
0.0
A
A
0.1
BBB
Baa
0.3
Junk bonds:
BB
Ba
1.4
B
B
1.8
CCC
Caa
22.3
Source: Fitch Ratings

5 yrs.

0.0
0.1
0.6
2.9
8.2
9.2
36.9
35

Bond Ratings and Bond


Spreads (YahooFinance, March 2009)
Long-term Bonds
10-Year T-bond
AAA
AA
A
BBB
BB
B
CCC

Yield (%)

Spread (%)

2.68
5.50
5.62
5.79
7.53
11.62
13.70
26.30

2.82
2.94
3.11
4.85
8.94
11.02
23.62

36

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

Bond Ratings Median


Ratios (S&P)

AAA
AA
A
BBB
BB
B

Interest
coverag
e

Return on
capital

Debt to
capital

23.8
19.5
8.0
4.7
2.5
1.2

27.6%
27.0%
17.5%
13.4%
11.3%
8.7%

12.4%
28.3%
37.5%
42.5%
53.7%
75.9%

38

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

Interest rate (or price) risk for


1-year and 10-year 10%
bonds
Interest rate risk: Rising rd
causes bonds price to fall.
rd
1-year Change 10-yearChange
5% $1,048
10%

1,000

15%

956

4.8%
4.4%

$1,386
1,000
749

38.6%
25.1%
41

Value
1,500

10-year
1-year

1,000

500

rd

0
0%

5%

10%

15%

42

What is reinvestment rate


risk?

The risk that CFs will have to be


reinvested in the future at lower
rates, reducing income.
Illustration: Suppose you just won
$500,000 playing the lottery. Youll
invest the money and live off the
interest. You buy a 1-year bond
with a YTM of 10%.
43

Year 1 income = $50,000. At yearend get back $500,000 to reinvest.


If rates fall to 3%, income will drop
from $50,000 to $15,000. Had you
bought 30-year bonds, income
would have remained constant.

44

The Maturity Risk Premium

Long-term bonds: High interest rate


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

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.

46

Hypothetical Treasury Yield


Curve

47

Bankruptcy

Two main chapters of Federal


Bankruptcy Act:

Chapter 11, Reorganization


Chapter 7, Liquidation

Typically, company wants Chapter


11, creditors may prefer Chapter 7.

48

If company cant meet its obligations, it


files under Chapter 11. That stops
creditors from foreclosing, taking
assets, and shutting down the business.
Company has 120 days to file a
reorganization plan.

Court appoints a trustee to supervise


reorganization.
Management usually stays in control.
49

Company must demonstrate in its


reorganization plan that it is
worth more alive than dead.
Otherwise, judge will order
liquidation under Chapter 7.

50

If the company is
liquidated, heres the
payment
priority:
Past due property taxes

Secured creditors from sales of secured assets.


Trustees 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, unsecured creditors


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.
52

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