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BOND VALUATION CONCEPTS

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BOND VALUATION CONCEPTS

FIN 3403, 3404

PROF. DIGGLE

- What is a bond?
- How do corporate bonds differ from other kinds of bonds?
- Priority of claim pyramid
- Characteristics of Corporate bonds
- What is a Municipal bond?
- Characteristics of muny bonds.

- KINDS OF RISK--RECAP
- INFLATION RISK
- BUSINESS OR DEFAULT RISK
- MARKET RISK
- LIQUIDITY RISK
- INTR. RATE RISK
- OTHER
- CURRENCY RISK
- POLITICAL RISK
- ETC.

TERMS

PAR

COUPON RATE

DOLLAR ANNUAL COUPON

CURRENT YIELD

YIELD TO MATURITY

INDENTURE

DEBENTURE DURATION

ACCRUED INTEREST

CONCEPTS

IF INTEREST RATES RISE WHAT HAPPENS TO BOND PRICES?

Current yield vs. YTM

COUPONCOUPONCOUPON

COUPON COUPON ETC ETC

All bonds we will study pay SEMI-ANNUALLY (coupon every 6 months)

An 8% bond pays two coupons of $40 each

A 30 year bond has 60 interest coupons.

PAR AT MATURITY ($1000)

A BOND IS IN TWO PARTS:

PRINCIPAL ($1000 PAR) -- LUMP SUM AT MATURITY

INTEREST coupons (SEMIANNUAL) (ANNUITY)

The value of a bond is the NPV of both elements

The price of a bond is, therefore, another TVM problem.

What is the discount rate?

The current MARKET rate of bonds of similar TYPE, QUALITY and MATURITY

U.S. GOVERNMENT

U.S. TREASURY

Treasury series EE

U.S. AGENCY

MUNICIPAL

CORPORATE

Mortgage

Debenture

FOREIGN GOVT.

TAX CONSIDERATIONS

The Tax Equivalent yield

ZERO COUPON BONDS

STRIPS

INFLATION ADJUSTED BONDS

ALL new corporate bond issues are subject to SEC review

The Indenture

Role of the Bond Trustee

How is a bond sold

The “Shelf registration”

What terms are in the Indenture?

Collateral and priority of claim

Coupon in percent and dollars

Maturity

Call provisions

sinking fund

redemption

Trustee

MOODY’S AND STANDARD AND POOR

RATING FROM AAA (best) to BA (lowest “investment” grade), to below B (“junk bonds.”

The bond rating is a measure of business risk or risk of default only.

Corporations and municipalities must pay a fee to have bonds rated. Therefore many bonds are NR.

- GO or General Obligation (supported usually by real estate taxes)
- REVENUE AND IDR
- HOW DOES A CORPORATION DO AN IDR?

- SINGLE, DOUBLE AND TRIPLE TAX FREE MUNYS
- WHY ARE MUNY’S FREE OF FEDERAL INCOME TAX?

YTM is the “Total Return” on a bond. This consists of:

CURRENT YIELD

CAPITAL GAINS “YIELD”

If a bond is selling at a PREMIUM (above par), bondholder will have a capital loss to maturity.

If a bond is selling at a DISCOUNT, you have a guaranteed capital gain to maturity.

PREMIUM: CURRENT YIELD > THAN YTM WHY?

DISCOUNT

CURRENT YIELD < YTM. WHY?

You buy a corporate bond on 12-1-98

The coupon is 7.5%

The bond matures on May 15, 2015 (Millennium problem does not affect calculator)

The market yield is 6%. Compute PRICE

THIS IS SDT

$75 PER YEAR or $37.50 per coupon

Matures at par. Par is expressed in % in your calculator. Therefore $1000 par is entered as 100 or 100%

YLD = 6

SDT enter 12.0198

CPNenter 7.5

RDT enter 5.1515

RV = 100% OF PAR OR $1000

ACT (for corporates) and 360 for Treasuries

2/Y (semiannual pay)

LEAVE YOUR TI BA2 AT ACT AND 2/Y

YLD = market yield on bonds of similar type, quality and maturity = 6

SOLVE FOR PRI (price -- push CPT)

MAY ALSO SOLVE FOR YTM where price is given

AI = accrued interest

- THE PRICE OF A BOND IS THE NET PRESENT VALUE OF:
- THE LUMP SUM OF $1000 PAR RECEIVED AT MATURITY
- THE ANNUITY OF COUPON INTEREST RECEIVED SEMIANNUALLY OVER REMAINING LIFE OF BOND (P/Y = 2)

- HOW WOULD YOU COMPUTE THE PRICE OF A ZERO COUPON BOND?

Why would a company or municipality call a bond?

Why do investors dislike callable bonds?

If a bond is not callable for 5 years this is called call protection.

REDEMPTION CALL

SINKING FUND CALL

CALCULATING YIELD TO CALL ON YOUR CALCULATOR

ACCRUED INTEREST

A. YOU BUY A BOND TODAY MATURING IN 30 YEARS.

YOU PAY 1030 (103% of par)

THE COUPON IS 7.33%

WHAT IS THE YIELD TO MATURITY?

B. YOU BUY A BOND TODAY MATURING IN 25 YEARS THAT IS CALLABLE IN 15 YEARS AT 105

ALL FACTS ON LEFT SIDE ARE THE SAME.

COMPUTE YIELD TO CALL.

SEE TEXT

MATURITY IS A FIXED DATE IN TIME

DURATION IS A MEASURE OF BOND CASH FLOW COMBINING MATURITY AND COUPON INCOME

A HIGH COUPON BOND WILL HAVE A SHORTER DURATION THAN A LOWER COUPON ISSUE THAT IS IDENTICAL IN ALL OTHER RESPECTS

You buy a bond on March 10. Coupons are paid on Jan 1 and June 30.

What is the accrued income? Who pays it and why?

Accrued income is added to the amount received by the SELLER

Who will receive the June 30 coupon? THE BUYER.

The buyer must pay the seller accrued interest for the time he owned the bond since the last coupon. This is done on settlement date.

Corporate securities settle in 3 business days after trade date.

You buy a bond on Friday. Monday is a Holiday. When is corporate settlement? This is when good funds must be available to pay for bond or stock.

Government (TREASURY) bonds are next day settlement (next business day).

SDT on your financial calculator is settlement date.

RDT (redemption date) is maturity or call date.

A convert is a bond with additional contractual provisions in the indenture providing for conversion of the bond into common stock.

A convert is “Quasi Equity.” It behaves like common stock.

TERMINOLOGY

CONVERSION PRICE

CONVERSION RATIO

THEORETICAL VALUE

PREMIUM OVER THEORETICAL VALUE

Why would a company include convertibility as a “sweetener” in the indenture?

What happens if a convertible bond is called by the company?

2 situations

Are converts a good investment? Why or why not?

Should you buy a callable convert selling above call price? Why or why not?

A convert is convertible into 20 shares of common. This is the conversion ratio.

This means the conversion price is $50 ($1000 par / 20)

When a convert is issued, the conversion price is usually 15% or so below common price. Why?

Assume the common price is $40 when the bond is floated.

Assume now it is 3 years later and the common is selling for $65 per share.

What is the theoretical value of the convert?

Conv ratio = number of common shares per bond X stock price

TV = 20 x $65 = $1300

Assume the call price set in the indenture is 103 ($1030). What happens if this bond is called?

Why do most converts sell at a PREMIUM over conversion or theoretical value?

Priority of claim

Current yield on bond vs dividend yield on stock

Say the bond we are looking at carried a coupon of 8%. The burrent yield at a price of $1300 = 6.15%. Assume the common dividend is $2.00. The dividend yield is 2/65 or 3.1%. Which would you rather own?

Bond in which coupons have been stripped off.

Price is simply the NPV of the par value ($1000) at maturity.

What reasons can you think of for investors to own zero coupon treasuries?

Compute the price of a Treasury maturing in 30 years when the yield on coupon conds of similar type and quality is 6.4%