BOND VALUATION CONCEPTS . FIN 3403, 3404 PROF. DIGGLE. BOND CONCEPTS. 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. RISK VS RETURN.
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BOND VALUATION CONCEPTS
FIN 3403, 3404
DOLLAR ANNUAL COUPON
YIELD TO MATURITY
IF INTEREST RATES RISE WHAT HAPPENS TO BOND PRICES?
Current yield vs. YTM
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
Treasury series EE
The Tax Equivalent yield
ZERO COUPON BONDS
INFLATION ADJUSTED BONDS
ALL new corporate bond issues are subject to SEC review
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
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.
YTM is the “Total Return” on a bond. This consists of:
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?
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
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
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.
SINKING FUND CALL
CALCULATING YIELD TO CALL ON YOUR CALCULATOR
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.
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.
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?
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%