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Finance. Chapter 7 Bonds and their valuation. Introduction to bonds. A bond is a long-term promissory note issued by a business or governmental unit. The issuer receives money in exchange for promising to make interest payments and to repay the principal on a specified future date.

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Finance

Finance

Chapter 7

Bonds and their valuation


Introduction to bonds

Introduction to bonds

  • A bond is a long-term promissory note issued by a business or governmental unit. The issuer receives money in exchange for promising to make interest payments and to repay the principal on a specified future date.

  • U.S. Treasury bonds (government bonds)

    • Issued by the U.S. Government

    • No default risk

    • Prices decline when interest rates rise (risk)


Types of bonds

Types of bonds

  • Treasury bonds

  • Corporate bonds

    • Default risk (credit risk)

  • Municipal bonds (“munis”)

    • Default risk lower than corporate bonds

    • Tax exempt

  • Foreign bonds

    • Default risk

    • Exchange rate risk


Characteristics of bonds

Characteristics of bonds

  • Differences in bonds, e.g.:

    • corporate bonds have provisions for early repayment

    • Underlying corporate strengths vary

  • Par value = the face value, the amount of money borrowed

  • Coupon payment = the number of dollars interest paid each period (usually 6 months)

  • Coupon interest rate = the stated annual interest rate on a bond


Coupon interest rates

Coupon interest rates

  • Floating bond rate = interest rate tied to Treasuries or some other interest rate

    • Convertible – to a fixed rate

    • Cap – upper limit

    • Floor – lower limit

  • Zero coupon bond = pays no annual interest rate but sold at a discount (below par)

    • “Zeros”

    • Compensation is not interest but in capital appreciation

  • Original issue discount (OID) bond = some interest paid but not enough to issue the bond at par


Bond characteristics

Bond characteristics

  • Maturity date = a specified date on which the par value of a bond must be repaid.

  • Original maturity = the number of years to maturity at the time the bond is issued

  • Call provisions = a contract provision giving the bond issuer the right to redeem the bonds under specified conditions prior to the maturity date

    • Call premium

    • Deferred call & call protection

    • Protects a company when interest rates fall, but may be create a loss for the investor


Bond characteristics1

Bond characteristics

  • Sinking funds = a bond provision requiring the issuer to retire a portion of the bond issue each year using the least cost method:

    • Company can call in bonds for redemption at par value if interest rates have fallen (no call premium paid)

    • Buy the bonds on the open market at a discount if interest rates have risen causing the price of bonds to fall

    • Cash drain on the issuer

    • Subject to default


Other bond features

Other bond features

  • Convertible bonds = a bond that can be exchanged for common stock at a fixed price

    • Lower coupon rates

    • Opportunity for capital gains if stock prices rise

    • See website article link

  • Warrants = a long term option to buy a stated number of shares of common stock at a specified price (similar to convertible bonds)


Other bond features1

Other bond features

  • Putable bonds = bond holder may sell the bonds back to the issuer at a prearranged price prior to maturity. Cf. callable bonds

  • Income bond = a bond that pays interest only if the interest is earned

    • Protects company from bankruptcy

    • Riskier for the investor

  • Indexed (purchasing power) bond = interest payment is based on an inflation index to protect the investor


Junk bonds

Junk bonds

  • Junk bonds are high risk, high-yield instruments issued by firms with very high debt ratios. Reasons for issuing:

  • About 2/3 are issued for takeovers (including LBO’s)

  • Revise a firm’s capital structure (proceeds used to buy back stock)


Bond valuation

Bond valuation

  • The value of the bond is the present value of cash flows the bond is expected to produce:

    • Interest payments (annuity) during the life of the bond +

    • The amount borrowed (principal)

0 1 2 3 4 5 6 ….. N

kd%

Bond’s value INT INT INT INT INT INT INT kd% = bond’s market rate of interest M


Bond valuation1

Bond valuation

  • kd% = bond’s market rate of interest

  • Kd = the bond’s market rate of interest. This is the discount rate that is used to calculate the PV of the bond’s cash flow.

    • Kd equals the coupon rate only if the bond is selling at par.

    • Generally, most coupon rates are issued at par, thereafter, the rate will change.


Changes in bond value over time

Changes in bond value over time

  • New issue = a bond that has been within the past 30 days

  • Outstanding bond (seasoned issue) = a bond whose issue date is greater than 30 days

  • Discounted bond = a bond that sells below its par value; occurs whenever the going rate of interest is above the coupon rate

  • Premium bond = a bond that sells above its par value; occurs whenever the going rate of interest is below the coupon rate


Changes in bond value over time1

Changes in bond value over time

  • Whenever kd is equal to the coupon rate, a fixed-rate bond will sell at its par value.

    • Normally, the coupon rate is set equal to the going rate when a bond is issued.

  • Interest rates do change over time, but the coupon rate remains the same

    • If interest rates rise above the coupon rate, a fixed bond’s price will fall below its par value = discount bond

    • If interest rates fall below the coupon rate, a fixed bond’s price will rise above its par value = premium bond


Changes in bond value over time2

Changes in bond value over time

  • An increase in interest rates will cause the prices of outstanding bonds to fall, while a decrease in rates will cause bond prices to rise.

  • The market value of a bond will always approach par value as its maturity date approaches.


Bond yields

Bond yields

  • Bond yields change daily depending on market conditions. Yields are calculated 3 ways

  • Yield to maturity (YTM) = the rate of return if the bond is held to maturity; generally the same as the market rate of interest, Kd

  • Yield to call (YTC) = the rate of return if it is called before maturity; likely if interest rates are significantly below the coupon rate

  • Current yield = the annual interest payment on a bond divided by the bond’s current price


Assessing a bond s riskiness

Assessing a bond’s riskiness

  • Interest rate risk = the risk of a decline in a bond’s price due (value) to an increase in interest rates. The longer the maturity of a bond, the more its price changes in response to interest rate changes.

  • Reinvestment rate risk = the risk that a decline in interest rates will lead to a decline in income from a bond portfolio

    • Callable bonds

  • Investment horizon = the period of time an investor plans to hold a particular investment


Default risk

Default risk

  • Investors will pay less for bonds with greater risk for default. Bond type affects risk:

  • Mortgage bond = a bond backed by a fixed asset. First mortgage bonds are senior in priority to claims of second mortgage bonds

  • Indenture = a formal agreement between the issuer of bond and the bondholders spelling out the rights of the bondholder and the corporation

    • Places limits on the %age of total property that can be used to back a bond offering


Default risk1

Default risk

  • Debentures = a long-term bond not secured (unsecured) by a mortgage on a specific property

    • Strong companies have no need to put up property as security for their debt (Exxon Mobil)

    • Weak companies may use if already pledged most of their assts as collateral for mortgage loans. High risk – will bear high interest rates

  • Subordinated debentures = a bond having a claim on assts only after the senior debt has been pad off in the event of liquidation


Bond ratings

Bond ratings

  • Rating agencies:

    • Moody’s Investor Services

    • Standard & Poor’s Corporation (S&P)

    • Fitch Investors Service

  • Investment-grade bonds = Bonds rated triple-B or higher

  • Junk bond = a high-risk, high-yield bond

  • Bond rating criteria: pages 288-289

  • Changes in ratings effect ability to borrow long-term capital and the cost of that capital


Bankruptcy reorganization

Bankruptcy & Reorganization

  • Insolvent = insufficient cash to meet interest & principal payments

  • Remedies

    • Liquidation – dissolve the firm

    • Reorganization – usually with a restructuring of the debt

  • Decision depends on whether the value of the firm is more or less than the value of its assets sold off piecemeal


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