Bonds Debt Characteristics and Valuation What is debt

Bonds (Debt) Characteristics and Valuation What is debt? What are bond ratings? How are bond prices determined? How are bond yields determined? What is the relationship between bond prices and interest rates? 1

Debt Characteristics Principal value, face value, maturity value, and par value Interest payments—coupon rate of interest Maturity date Priority to assets and earnings Control of the firm 2

Types of Debt—Short-Term Treasury bills—U. S. government securities Repurchase agreement—repo Federal funds—loans from one bank to another Banker’s acceptance—a “postdated check” 3

Types of Debt—Short-Term Commercial Paper (CP)—promissory note Certificate of Deposit (CD)—time deposit Eurodollar deposit—dollar-denominated deposits Money market mutual funds—short-term investments 4

Types of Debt—Long-Term loans Bank or insurance company Amortized—payment includes principal and interest Bonds Borrower agrees to make payments of interest and principal on specific dates to the bondholder (investor) 5

Common Bonds Government bonds Treasury—notes and bonds State and local governments (municipals) • Revenue bonds • General obligation bonds Corporate bonds Mortgage bonds—backed by fixed assets Debenture—unsecured bond Subordinated debenture—low priority 6

Other Types of Bonds Income bond—pays interest when the firm’s income is sufficient Putable bond—can be redeemed at the bondholder’s option Indexed (purchasing power) bond—interest payments are based on an inflation index Floating-rate bond—bond’s interest is based on market interest rates Zero (or very low) coupon bond—little or no interest is paid (discounted) Junk bond—high-risk, high-yield bond (low rating) 7

Bond Contract Features Indenture—bond contract Maturity, coupon, etc. are set in the contract Coupon rate of interest—set at prevailing rate when the bond is issued Trustee—represents bondholders’ interests Restrictive covenant—restricts borrower’s a actions Sinking fund—a required annual payment Call provision—issuer can redeem the bonds prior to maturity Refunding—retire (repay) existing debt with proceeds of new debt—that is, refinancing debt Convertible feature—conversion in to stock 8

Bond Ratings High quality Investment grade Substandard Junk Bonds Speculative Moody’s Aaa Aa A Baa Ba B Caa C S&P AAA AA A BBB BB B CCC D 9

Importance of Bond Ratings Indication of default risk Institutional investors are restricted to investment-grade securities Ratings changes—affect a firm’s ability to borrow and the cost of borrowing 10

Foreign Debt Instruments Foreign debt—sold by a foreign borrower; denominated in the currency of the country in which it is sold Eurodebt Debt sold in a country other than the one in whose currency the debt is denominated LIBOR: London Inter. Bank Offer Rate 11

Basic Valuation From “The Time Value of Money” we know that the value of an asset is based on the present value of the cash flows the asset is expected to produce in the future. 12

Basic Valuation r = required rate of return 13

Valuation of Bonds 0 rd 1 2 3 INT INT PV of M … N INT M Bond Value = Vd INT = $ interest paid each period M = maturity, or face, value rd = investors’ required rate of return 14

Valuation of Bonds 15

Bond Valuation—Example Bond Characteristics: Face (maturity) value, M $1, 000 Coupon rate of interest, C 5% Annual interest payment, INT $50 = $1, 000 x 0. 05 Years to maturity, N 8 Market rate, rd 6% 50 (1(1. 06) + rd)88 1, 000 8 (1+r (1. 06) d) = 50(6. 20979) + 1, 000(0. 62741) = 937. 90 16

Bond Valuation Financial Calculator Solution Bond Characteristics: Face (maturity) value, M $1, 000 Coupon rate of interest, C 5% Annual interest payment, INT $50 Years to maturity, N 8 Market rate, rd 6% 8 6 ? 50 N I/Y PV PMT 1, 000 FV -937. 90 17

Bond Valuation—Yield to Maturity, rd Bond Characteristics: Face (maturity) value, M Coupon rate of interest, C Annual interest payment, INT Years to maturity, N Market price, Vd 1, 123 100 5 $1, 000 10% $100 = $1, 000 x 0. 10 5 $1, 123 1, 000 5 rd = Yield to maturity, YTM 18

Bond Valuation—Yield to Maturity, rd , Approximation = Adj interest Avg investment Example: M = $1, 000, INT = $100, N = 5, Vd= $1, 123 19

Bond Valuation—YTM Financial Calculator Solution Bond Characteristics: Face (maturity) value, M $1, 000 Coupon rate of interest, C 10% Annual interest payment, INT $100 Years to maturity, N 5 Market price, Vd $1, 123 5 ? -1, 123 N I/Y PV 100 PMT 1, 000 FV 7. 0 20

Bond Valuation—Yield to Call Bond Characteristics: Face (maturity) value, M Call price Coupon rate of interest, C Annual interest payment, INT Years to maturity, N Date to first call Market price, Vd $1, 000 $1, 060 10% $100 5 3 $1, 123 3 ? -1, 123 100 1, 060 N I/Y PV PMT FV 7. 44 21

Bond Valuation Semiannual Payment of Interest Most bonds pay interest semiannually Adjustments to computations N = # years x m; m = # of interest payments per year r = rd/m INT = interest payment period = Annual INT/m Example: M = $1, 000, C = 5%, Yrs to maturity = 8, rd = 6% 16 3. 0 ? 25 1, 000 N I/Y PV PMT FV -931. 23 22

Changes in Bond Values Over Time Whenever the going rate of interest, rd, equals the coupon rate, a bond will sell at its par value An increase (decrease) in interest rates will cause the price of an outstanding bond to fall (rise). The market value of a bond will always approach its par value as its maturity date approaches, provided the firm does not go bankrupt. 23

Bond Valuation Relationship of YTM, Coupon, and Price Example: N = 10 yrs; C = 6%; M = 1, 000 Relationship of rates Market rate, rkdd = Coupon rate, C Market rate, rkdd > Coupon rate, C Market rate, rkdd < Coupon rate, C Market Price, Vd par; Vd = M discount; Vd < M premium Vd > M If rd = Vd = 6% $1, 000. 00 10% $754. 22 4% $1, 162. 22 24

Interest-Rate Risk When market rates change, bondholders are affected in two ways: bond prices change in an opposite direction—price risk the rates investors earn change—reinvestment risk Bond Characteristics: M = $1, 000. 00 INT = $60. 00 N = 5 yrs Annual Interest Rate, rd 4% Value, Vd $1, 089. 04 6 1, 000. 00 8 920. 15 10 848. 37 12 783. 71 25

Bond Return on = investment rd Rate of return Income yield = INT Vd 0 = Current yield + Capital gains yield + Vd 1 – Vd 0 + Capital gains yield 26

Bond Valuation—Change in Value Over Time Bond Characteristics: M = $1, 000. 00, INT = $60. 00, rd = 8% Years to Maturity End of Year Value, Vd Capital Gain = (Vd 1 -Vd 0)/Vd 0 Current Yield = INT/Vd 0 Total Return 5 920. 15 4 933. 76 1. 48% 6. 52% 8. 00% 3 948. 46 1. 57 6. 43 8. 00% 2 964. 33 1. 67 6. 33 8. 00% 1 981. 48 1. 78 6. 22 8. 00% 0 1, 000. 00 1. 89 6. 11 8. 00% 27

Bond Valuation—Change in Value Over Time INT = $60 (C = 6%) N = 5 yrs Market Value ($), Vd 1, 100. 00 1, 089. 04 if rd = 4% < C = 6% Premium bond, Vd > M 1, 050. 00 1, 000. 00 Par bond, Vd = M; rd = C = 6% 950. 00 M = 1, 000 Discount bond, Vd < M 900. 00 920. 15 if rd = 8% > C = 6% 850. 00 800. 00 5 4 3 2 1 0 Years to Maturity 28

Long-Term versus Short-Term Bonds Coupon = 10% Current market Interest rate rd 6% 8 10 12 14 16 Value of 1 -year 15 -year bond $1, 037. 74 $1, 388. 49 1, 018. 52 1, 171. 19 1, 000. 00 982. 14 863. 78 964. 91 754. 31 948. 28 665. 47 29

Long-Term versus Short-Term Bonds 15 -Year Bond 30

Bonds (Debt) Characteristics and Valuation What is debt? Debt represents a loan What are bond ratings? Ratings give an indication of the default risk associated with a bond How are bond prices determined? Value = PV of the cash flows the bond is expected to pay during its life 31

Bonds (Debt) Characteristics and Valuation How are bond yields determined? YTM is the average annual rate of return that an investor will earn if he or she buys the bond at the current market price and holds it until it matures YTC is the average annual rate of return that an investor will earn if he or she buys the bond at the current market price and holds it until the first date the bond can be called What is the relationship between bond prices and interest rates? When interest rates increase, bond prices decrease, and vice versa 32