1 / 21

Bond Valuation

Bond Valuation. Corporate Finance. Dr. A. DeMaskey. Learning Objectives. Questions to be answered: What is a bond? Who issues bonds? What are the key characteristics of bonds? How are bonds valued? What is the rate of return on a bond? What types of risk are bondholders exposed to?.

remedios-dudley
Download Presentation

Bond Valuation

An Image/Link below is provided (as is) to download presentation Download Policy: Content on the Website is provided to you AS IS for your information and personal use and may not be sold / licensed / shared on other websites without getting consent from its author. Content is provided to you AS IS for your information and personal use only. Download presentation by click this link. While downloading, if for some reason you are not able to download a presentation, the publisher may have deleted the file from their server. During download, if you can't get a presentation, the file might be deleted by the publisher.

E N D

Presentation Transcript

  1. Bond Valuation Corporate Finance Dr. A. DeMaskey

  2. Learning Objectives • Questions to be answered: • What is a bond? • Who issues bonds? • What are the key characteristics of bonds? • How are bonds valued? • What is the rate of return on a bond? • What types of risk are bondholders exposed to?

  3. Types of Bonds • Treasury Bonds • Corporate Bonds • Municipal Bonds • Foreign Bonds

  4. Basic Terminology • Bond • Par Value • Coupon Interest Payment • Coupon Interest Rate • Maturity Date • Bond’s Market Rate of Interest, kd

  5. 0 1 2 n Value CF1 CF2 CFn Financial Asset Valuation k ... CF CF CF 1 2 n + + + PV = . . . .       1 2 n 1 + k 1 + k 1 + k

  6. Required Rate of Return • The discount rate (ki) is the opportunity cost of capital, i.e., the rate that could be earned on alternative investments of equal risk. ki = k* + IP + LP + MRP + DRP

  7. Default Risk • Risk that issuer will not make interest or principal payments. • Increases required rate of return • Bond ratings provide one measure of default risk • Defaulting on bonds may result in bankruptcy and/or reorganization

  8. 0 1 2 10 Value of Bond 10% ... 100 + 1,000 V = ? 100 100 $100 $100 $1 , 000 V  . . . + + + B 1 10 10       1 k 1 k 1 k + + + d d d = $90.91 + . . . + $38.55 + $385.54 = $1,000.

  9. Annual Coupon Bonds

  10. Semiannual Coupon Bonds • Multiply years by 2 to get periods = 2n. • Divide nominal rate by 2 to get periodic rate = kd/2. • Divide annual INT by 2 to get PMT = INT/2.

  11. General Observations About Bond Values • If coupon rate < kd, bond sells at a discount. • If coupon rate > kd, bond sells at a premium. • If coupon rate = kd, bond sells at its par value. • If kd rises, price falls; if kd falls, price rises. • At maturity, the value of a bond equals par.

  12. Changes in Bond Values Over Time • At maturity, the value of any bond must equal its par value. • The value of a premium bond would decrease to $1,000. • The value of a discount bond would increase to $1,000. • A par bond stays at $1,000 if kd remains constant.

  13. Bond Value ($) kd = 7%. 1,372 1,211 kd = 10%. M 1,000 837 kd = 13%. 775 30 25 20 15 10 5 0 Years remaining to Maturity Time Path of Bond Value

  14. Bond Yields • Yield-to-Maturity (YTM) • Effective Annual Return on Bond • Yield-to-Call • Current Yield

  15. Yield-to-Maturity • YTM is the rate of return earned on a bond held to maturity, also called “promised yield.” • It is the discount rate that equates the present value of the interest and principal payments to the price of the bond. • Annualized YTM = 2 x six-month yield • Effective YTM = (1 + six-month yield)2 - 1

  16. Total Return or Yield on Bond • The effective annual return on a bond is equal to its current yield and capital gains yield. • Current yield • Capital gains yield • YTM = Current yield + Capital gains yield • Effective annual yield • (1 + semiannual return)2 -1

  17. Yield-to-Call • Call Provision • Callable bonds • Call premium • Refunding operation • YTC is the average annual return an investor will receive if the bond is held until its expected call date.

  18. Current Yield • Annual interest payment/Current value of bond • Provides information about cash income on bond. • Does not provide accurate measure of total expected return on bond.

  19. Interest Rate Risk • Rising interest rates have an adverse effect on bond values. • The longer the maturity of a bond, the greater the exposure to interest rate risk. kd 1-year Change 10-year Change 5% $1,048 $1,386 4.8% 38.6% 10% 1,000 1,000 4.4% 25.1% 15% 956 749

  20. Interest Rate Risk Value 10-year 1,500 1-year 1,000 500 kd 0 0% 5% 10% 15%

  21. Reinvestment Rate Risk • The risk that CFs will have to be reinvested in the future at lower rates, reducing income. • The shorter the maturity of the bond, the greater the risk of a decrease in interest rates.

More Related