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Bonds and Their Valuation

Chapter 7. Bonds and Their Valuation. Key Features of Bonds Bond Valuation Measuring Yield Assessing Risk. What is a bond?. A long-term debt instrument in which a borrower (bond issuer) agrees to make payments of principal and interest, on specific dates, to the lender (bondholders)

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Bonds and Their Valuation

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  1. Chapter 7 Bonds and Their Valuation Key Features of Bonds Bond Valuation Measuring Yield Assessing Risk

  2. What is a bond? • A long-term debt instrument in which a borrower (bond issuer) agrees to make payments of principal and interest, on specific dates, to the lender (bondholders) • They are issued by government agencies and corporations that are looking for long-term debt capital. • A bond that has just been issued new issue • A bond that has been issued  outstanding bond or seasonal issue.

  3. Key Features of a Bond • Par value: face amount of the bond, which is paid at maturity (assume $1,000). • Coupon interest rate: stated interest rate paid by the issuer. • Multiply it by par value to get dollar payment of interest. • Coupon payments can be fixed rates or floating rates • Some bond pay no coupons at all (called zero coupon bonds). However, they are offered at a discount (below the par value)  they offer capital gain not interest income • Maturity date: years until the bond must be repaid. • Effective maturity date declines each year passes after the issue date • Issue date (settlement date): when the bond was issued.

  4. Key Features of a Bond • Call Provision • Allows issuer to refund (Call) the bond issue if rates decline. • Helps the issuer (lower interest expenses), but hurts the investor (reinvestment risk). • Borrowers (bond issuers) are willing to pay more than par value if want to call bond (call premium). • Cost of borrowing at the lower rate < Cost they will pay to retire high-interest rate bonds • Investor (lender) require more return on callable bonds than on non-callable with same risk • To compensate them for the reinvestment risk

  5. Key Features of a Bond • Convertible bonds • Bonds that are exchangeable into shares of common stock at fixed price at the option of the holder. • It offer lenders (B/H) the chance to benefit from the increase in the stock price. • Buy stock with less than what it is worth in the market. • Because of this feature, borrows (firms) are willing to pay less interest (coupon rate) than on a non-convertible bond with similar risks.

  6. How to determine the bond’s value

  7. 0 1 2 N Value INT1 INT2 INTN + M The Value Bonds • INT: interest payments (par value x coupon rates). • M: The par value (bond face value) • N: Is the time until the bonds matures. rd% ...

  8. 0 1 2 N Value INT1 INT2 INTN + M The Value Bonds • rd: Market interest rates on the bond or discount rate (the cost a borrower must pay for borrowing funds) or (required rate of return that B/H requires) • It is the minimum acceptable return that B/H require to hold that bond. rd% ...

  9. Note on rd (the market interest rate) • If the minimum acceptable return (rd) is equal to the return B/H expected to get from holding the bond until maturity, then rd is called Yield to Maturity YTM • The compounding rate of return earned on a bond if it was held to maturity. It accounts for both: • Interest payment represented in (Current Yield CY) • CY = Interest/current price • Capital gains/loss: appreciation or depreciation of the bond price • CG = % change in the bond price • YTM = CY + CG • If the bond is callable, then rd is equal to minimum acceptable return B/H expected to get from holding the bond until it is called. It is called Yield to Call YTC • When the bond is called, investors have no choice of holding the bond to maturity.  YTM could not be earned.

  10. Important Bond Theorems • Coupon rate = yield to maturity  VB = M  • Bond is selling at par • Coupon rate > yield to maturity  VB > M  • Bond is selling at premium • Coupon rate < yield to maturity  VB < M  • Bond is selling at discount M is the par value at maturity

  11. Default Risk • If an issuer defaults, investors receive less than the promised return. • Therefore, the required rate of return (rd) that B/H require on corporate bonds is higher than that on T-bond that have the same maturity (MRP) and marketability (LP) (probability of default is higher than that in T-bonds). • DR is influenced by the issuer’s financial strength and the terms of the bond contract. And many agencies use such info to rate these issuers based on the default probability

  12. Bond ratings are designed to reflect the probability of a bond issue going into default. AAA bonds provide lower return (rd) than Aa, A, BBB…etc because they are considered more safer (less default risk) There is an inverse relationship between rating and required rate of return (rd). Evaluating Default Risk:Bond Ratings

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