Bonds and Their Valuation - Chapter 7

1. Bonds and Their Valuation Chapter 7

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3. Bond Characteristics 3 Par (or Face) Value (M) = stated face value that is the amount the issuer must repay, usually $1,000 Coupon Interest Rate Coupon (INT) = Coupon Rate x Face Value Maturity Date = when the face value is repaid. A legal contract called the bond indenture specifies these values. This makes a bond’s cash flows look like this:

4. Bond Valuation Discount the bond’s cash flows at the investor’s required rate of return. the coupon payment (INT) stream (an annuity). the par (M) value payment (a lump sum). V = INT (PVA r, n) + M /(1+r)n 4

5. Bond Valuation Example #1 5 Duff’s Beer has $1,000 par value bonds outstanding that make annual coupon payments. These bonds have a 7.5% annual coupon rate and 15 years left to maturity. Bonds with similar risk have a required return of 9%, and Moe Szyslak thinks this required return is reasonable. What’s the most that Moe is willing to pay for a Duff’s Beer bond?

7. Let’s Play with Example #1 7 Homer Simpson is interested in buying a Duff Beer bond but demands an 7.5 percent required return. What is the most Homer would pay for this bond?

8. r = 7.5%

9. Let’s Play with Example #1 some more. 9 Barney (belch!) Gumble is interested in buying a Duff Beer bond and demands on a 6 percent required return. What is the most Barney (belch!) would pay for this bond?

10. r = 6%

11. Lesson from Example 1: Bond Prices and Interest Rates have an inverse relationship! 11

12. Another Example 1 Lesson: Bond Premiums and Discounts 12 What happens to bond values if required return is not equal to the coupon rate? When r is greater than the coupon interest rate, P0 will be less than par value, and the bond will sell at a discount For Sun, if r >5%, P0 will be less than $1,000 For practice: Value Sun Company, 10-year, 5% coupon rate bond if required return, r =6% and again if r = 4%. Premiums & discounts change systematically as r changes.When r is greater than the coupon interest rate, P0 will be less than par value, and the bond will sell at a discount For Sun, if r >5%, P0 will be less than $1,000 For practice: Value Sun Company, 10-year, 5% coupon rate bond if required return, r =6% and again if r = 4%. Premiums & discounts change systematically as r changes.

13. Bonds with Semiannual Coupons 13 Double the number of years, and divide required return and annual coupon by 2.

14. Semiannual Example 14 Kwickee-Mart has an $1000 par value bond with an annual coupon rate of 6% that pays coupons semiannually with 20 years left to maturity. What is the most you would be willing to pay for this bond if your required return is 7% APR? Semiannual coupon = 6%/2($1000) = $30 20x2 = 40 remaining coupons

16. Bond Yields 16 Current Yield - Annual coupon payments divided by bond price. Yield To Maturity - Interest rate for which the present value of the bond’s payments equal the price. Also known as the market’s required rate of return. Yield To Maturity = total expected return = current yield + expected capital gains yield (change in price)

17. Yield Definitions 17

18. Bond Yields 18 Calculating Yield to Maturity (YTM=r) If you are given the price of a bond (PV) and the coupon rate, the yield to maturity can be found by solving for r.

19. Yield to Maturity Example 19 Burns Power $1000 face value bond with a 5% coupon rate paid annually with 10 years left to maturity sells for $890. What is this bond’s yield to maturity?

21. U.S. Treasury Bond Quotations 21 -Yield to Maturity (YTM) is the rate of return investors earn if they buy the bond at P0 and hold it until maturity. The YTM on a bond selling at par (P0 = Par) will always equal the coupon interest rate. When P0 ? Par, the YTM will differ from the coupon rate. YTM is the discount rate that equates the PV of a bond’s cash flows with its price. If P0, CFs, n known, can find YTM Use T-Bond with n=2 years, 2n=4, C/2=$20, P0=$992.43 -Yield to Maturity (YTM) is the rate of return investors earn if they buy the bond at P0 and hold it until maturity. The YTM on a bond selling at par (P0 = Par) will always equal the coupon interest rate. When P0 ? Par, the YTM will differ from the coupon rate. YTM is the discount rate that equates the PV of a bond’s cash flows with its price. If P0, CFs, n known, can find YTM Use T-Bond with n=2 years, 2n=4, C/2=$20, P0=$992.43

22. Verifying the T-bond’s YTM (Ask Yld) 22 Par Value = $1000, semi-annual coupons Ask Price = 136.969%($1000) = $1,369.69 INT/2 = 8.5%($1000)/2 = $42.50 N = 2020-2007 = 13, 2N = 26

23. Causes of Bond Price Changes 23 Since a bond’s cash flows are fixed: Changes in interest rates, and Passage of time. cause changes in a bond’s price.

24. Bond Value Changes Over Time 24 Returning to the Duff’s Beer original example #1, where r = 9%, N = 15, C (PMT) = $75, par (FV) = $1000, & PV = $879.09. What is bond value one year later when N = 14 and r is still = 9%?

25. Bond values over time 25 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.

26. Changes in Bond Value over Time What would happen to the value of these three bonds is bond if its required rate of return remained at 10%: 26

27. What about this? 27 What if Barney buys Duff Bond at $1145.68 with n =15 and sells at r = 7% with n = 14. What is his return?

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29. Interest Rate Risk 29 Measures Bond Price Sensitivity to changes in interest rates. In general, long-term bonds have more interest rate risk than short-term bonds. Also, for bonds with same time to maturity, lower coupon bonds have more interest rate risk than higher coupon bonds.

30. Interest Rate Risk Example 30 Recall from our earlier example (#1), the 15-year, 7.5% annual coupon bond has the following values at kd = 6%, 7.5%, & 9%. Let’s compare with a 2-yr, 7.5% annual coupon bond. 15-year bond 2-year bond r=6%: PV = $1,145.68 PV = $1,027.50 r=7.5%: PV = $1,000 PV = $1,000 r=9%: PV = $879.09 PV = $973.61

31. Interest Rate Risk: Bond Price Sensitivity Graph 31

32. Reinvestment rate risk 32 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.

33. Reinvestment rate risk example 33 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.

34. Conclusions about interest rate and reinvestment rate risk CONCLUSION: Nothing is riskless! 34

35. Default Risk 35 Credit risk Default premium Investment grade Speculative grade (Junk bonds)

36. Default Risk 36

37. Callable Bonds & the effect of a call provision 37 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.

38. A 10-year, 10% semiannual coupon bond selling for $1,135.90 can be called in 4 years for $1,050, what is its yield to call (YTC)? 38 The bond’s yield to maturity can be 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.

39. Yield to call 39 3.568% represents the periodic semiannual yield to call. YTCNOM = rNOM = 3.568% x 2 = 7.137% is the rate that a broker would quote. The effective yield to call can be calculated YTCEFF = (1.03568)2 – 1 = 7.26%

40. If you bought these callable bonds, would you be more likely to earn the YTM or YTC? 40 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 of 8%.

41. When is a call more likely to occur? 41 In general, if a bond sells at a premium, then (1) coupon rate > rd, so (2) a call is more likely. So, expect to earn: YTC on premium bonds. YTM on par & discount bonds.

42. Sinking Fund 42 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.

43. How are sinking funds executed? 43 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.

44. Other types (features) of bonds 44 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.