what are bonds and how to evaluate them in financial management?

8/9/2019 What are bonds and how to evaluate them in financial management?

1/43

7-1

Key features of bonds Bond valuation Measuring yield Assessing risk


2/43

7-2

A long-term debt instrument in which aborrower agrees to make payments ofprincipal and interest, on specificdates, to the holders of the bond.


3/43

7-3

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 representativegroup of bonds is listed and traded on the bond

division of the NYSE.


4/43

7-4

Par value face amount of the bond, whichis paid at maturity (assume $1,000).

Coupon interest rate stated interest rate

(generally fixed) paid by the issuer. Multiply bypar to get dollar payment of interest.

Maturity date years until the bond must berepaid.

Issue date when the bond was issued. Yield to maturity - rate of return earned on

a bond held until maturity (also called thepromised yield).


5/43

7-5

Allows issuer to refund the bond issueif rates decline (helps the issuer, but

hurts the investor).Borrowers are willing to pay more, and

lenders require more, for callablebonds.

Most bonds have a deferred call and adeclining call premium.


6/43

7-6

Provision to pay off a loan over its liferather 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.


7/43

7-7

Call x% of the issue at par, for sinking fundpurposes.

Likely to be used if kd is below the coupon rateand the bond sells at a premium.

Buy bonds in the open market. Likely to be used if kd is above the coupon rate

and the bond sells at a discount.


8/43

7-8

n

n

2

2

1

1

k)(1CF...

k)(1CF

k)(1CFValue

!

0 1 2 nk

CF1 CFnCF2Value

...


9/43

7-9

Convertible bond may be exchanged forcommon stock of the firm, at the holders option.

Warrant long-term option to buy a statednumber of shares of common stock at aspecified price.

Putable bond allows holder to sell the bondback to the company prior to maturity.

Income bond pays interest only when interestis earned by the firm.

Indexed bond interest rate paid is based uponthe rate of inflation.


10/43

7-10

The discount rate (ki ) is theopportunity cost of capital, and is therate that could be earned onalternative investments of equal risk.

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


11/43

7-11

$1,000V$385.54$38.55...$90.91V

(1.10)

$1,000

(1.10)

$100...

(1.10)

$100V

B

B

10101B

!

!

!

0 1 2 nk

100 100 + 1,000100VB = ?

...


12/43

7-12

This bond has a $1,000 lump sum due at t = 10,and annual $100 coupon payments beginning at

t = 1 and continuing through t = 10, the price ofthe bond can be found by solving for the PV ofthese cash flows.

INPUTS

OUTPUT

N I/YR PMTPV FV

-


13/43

7-13

Suppose inflation rises by 3%, causing kd =13%. When kd rises above the coupon rate,

the bonds value falls below par, and sells at adiscount.

INPUTS

OUTPUT

N I/YR PMTPV FV

3

-837.


14/43

7-14

Suppose inflation falls by 3%, causing kd =7%. When kd falls below the coupon rate,

the bonds value rises above par, and sellsat a premium.

INPUTS

OUTPUT

N I/YR PMTPV FV

7

- .7


15/43

7-15

What would happen to the value of this bond ifits required rate of return remained at 10%, or at

13%, or at 7% until maturity?

Years

to Maturity

1, 2

1,211

1,000

5

0 25 20 15 10 5 0

kd = %.

kd = 1 %.

kd = 10%.

VB


16/43

7-16

At maturity, the value of any bond mustequal its par value.

If kd remains constant: The value of a premium bond would decreaseover time, until it reached $1,000.

The value of a discount bond would increaseover time, until it reached $1,000.

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


17/43

7-17

Must find the kd that solves this model.

10d

10d

1d

Nd

Nd

1d

B

)k(1

1,000)k(1

90...)k(1

90$887

)k(1

M

)k(1

INT...

)k(1

INTV

!

!


18/43

7-18

Solving for I/YR, the YTM of this bond is10.91%. This bond sells at a discount,

because YTM > coupon rate.

INPUTS

OUTPUT

N I/YR PMTPV FV

.9

9- 887


19/43

7-19

Solving for I/YR, the YTM of this bond is7.08%. This bond sells at a premium,

because YTM < coupon rate.

INPUTS

OUTPUT

N I/YR PMTPV FV

7. 8

9- 34.


20/43

7-20

!!

!

!

CGY

Expected

CY

ExpectedYTMreturntotalExpected

priceBeginning

priceinChange(CGY)yieldgainsCapital

priceCurrent

paymentcouponAnnual(CY)eldCurrent yi


21/43

7-21

Find the current yield and the capitalgains yield for a 10-year, 9% annual

coupon bond that sells for $887, andhas a face value of $1,000.

Current yield = $90 / $887

= 0.1015 = 10.15%


22/43

7-22

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 thebeginning price, which gives the same answer.


23/43

7-23

Interest rate risk is the concern that rising kd willcause the value of a bond to fall.

% change 1 yr kd 10yr % change+4.8% $1,048 5% $1,386 +38.6%

$1,000 10% $1,000-4.4% $956 15% $749 -25.1%

The 10-year bond is more sensitive to interestrate changes, and hence has more interest raterisk.


24/43

7-24

Reinvestment rate risk is the concern that kdwill fall, and future CFs will have to be

reinvested at lower rates, hence reducingincome.

EXAMPLE: Suppose you just won

$500,000playing the lottery. You

intend to invest the money and

live off the interest.


25/43

7-25

You may invest in either a 10-year bond or aseries of ten 1-year bonds. Both 10-year and1-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-yearrates fall to 3%, your annual income wouldfall to $15,000.

If you choose the 10-year bond strategy: You can lock in a 10% interest rate, and

$50,000 annual income.


26/43

7-26

Short-term AND/ORHi h coupon bonds

Long-term AND/ORLow coupon bonds

Interestrate risk

Low High

Reinvestmentrate risk

High Low

CONCLUSION: Nothing is riskless!


27/43

7-27

1. Multiply years by 2 : number of periods = 2n.2. Divide nominal rate by 2 : periodic rate (I/YR) = kd

/ 2.3. Divide annual coupon by 2 : PMT = ann cpn / 2.

INPUTS

OUTPUT

N I/YR PMTPV FV

/ cp / OKOK


28/43

7-28

1. Multiply years by 2 : N = 2 * 10 = 20.2. Divide nominal rate by 2 : I/YR = 13 / 2 = 6.5.

3. Divide annual coupon by 2 : PMT = 100 / 2 = 50.

INPUTS

OUTPUT

N I/YR PMTPV FV

6.

- .


29/43

7-29

10.25%12

0.1011

m

i1EFF%

2mNom !

!

!

The semiannual bonds effective rate is:

10.25% > 10% (the annual bonds

effective rate), so you would prefer thesemiannual bond.


30/43

7-30

The semiannual coupon bond has an effectiverate of 10.25%, and the annual coupon bondshould earn the same EAR. At these prices,the annual and semiannual coupon bonds arein equilibrium, as they earn the same effectivereturn.

INPUTS

OUTPUT

N I/YR PMTPV FV

.

- .


31/43

7-31

The bonds yield to maturity can be determinedto be 8%. Solving for the YTC is identical to

solving for YTM, except the time to call is usedfor N and the call premium is FV.

INPUTS

OUTPUT

N I/YR PMTPV FV

8

3. 68

- 3 .


32/43

7-32

3.568% represents the periodicsemiannual yield to call.

YTCNOM = kNOM = 3.568% x 2 = 7.137% isthe rate that a broker would quote.The effective yield to call can be calculated

YTCEFF = (1.03568)2 1 = 7.26%


33/43

7-33

The coupon rate = 10% compared to 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 of8%.


34/43

7-34

In general, if a bond sells at a premium,then (1) coupon > kd, so (2) a call is more

likely.So, expect to earn: YTC on premium bonds.

YTM on par & discount bonds.


35/43

7-35

If an issuer defaults, investors receiveless than the promised return.

Therefore, the expected return oncorporate and municipal bonds is lessthan the promised return.

Influenced by the issuers financialstrength and the terms of the bondcontract.


36/43

7-36

Mortgage bondsDebentures

Subordinated debentures Investment-grade bondsJunk bonds


37/43

7-37

Investment Grade Junk Bonds

Moodys

Aaa Aa A Baa Ba B Caa CS & P AAA AA A BBB BB B CCC D

Bond ratings are designed to reflect theprobability of a bond issue going intodefault.


38/43

7-38

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


39/43

7-39

Earnings stabilityRegulatory environmentPotential antitrust or product liabilitiesPension liabilitiesPotential labor problemsAccounting policies


40/43

7-40

Two main chapters of the FederalBankruptcy Act: Chapter 11, Reorganization

Chapter 7, Liquidation

Typically, a company wants Chapter 11,while creditors may prefer Chapter 7.


41/43

7-41

If company cant meet its obligations It files under Chapter 11 to stop creditors from

foreclosing, taking assets, and closing the business.

Has 120 days to file a reorganization plan. Court appoints a trustee to supervise reorganization. Management usually stays in control.

Company must demonstrate in itsreorganization plan that it is worth

more alive than dead. If not, judge will order liquidation under Chapter 7.


42/43

7-42

1. Secured creditors from sales ofsecured assets.

2. Trustees costs3. Wages, subject to limits4. Taxes5. Unfunded pension liabilities

6. Unsecured creditors7. Preferred stock8. Common stock


43/43

7-43

In a liquidation, unsecured creditorsgenerally get zero. This makes themmore willing to participate inreorganization even though their claimsare greatly scaled back.

Various groups of creditors vote on thereorganization plan. If both the majorityof the creditors and the judge approve,company emerges from bankruptcy withlower debts, reduced interest charges,and a chance for success.

what are bonds and how to evaluate them in financial management?

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