Chapter 6 Bonds and Bond Valuation Copyright 2010

Learning Objectives 1. Understand basic bond terminology and apply the time value of money equation in pricing bonds. 2. Understand the difference between annual and semiannual bonds and note the key features of zero-coupon bonds. 3. Explain the relationship between the coupon rate and the yield to maturity. 4. Delineate bond ratings and why ratings affect bond prices. 5. Appreciate bond history and understand the rights and obligations of buyers and sellers of bonds. 6. Price government bonds, notes, and bills. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 6 -2

6. 1 Application of the Time Value of Money Tool: Bond Pricing • • Bonds – Long-term debt instruments Provide periodic interest income – annuity series Return of the principal amount at maturity – future lump sum Prices can be calculated by using present value techniques, i. e. , discounting of future cash flows • Combination of present value of an annuity and of a lump sum Copyright © 2010 Pearson Prentice Hall. All rights reserved. 6 -3

Table 6. 1 Bond Information August 1, 2008 Copyright © 2010 Pearson Prentice Hall.

6. 1 (A) Key Components of a Bond • Par value: Principal or face value; typically $1000 t • Coupon rate: Annual rate of interest paid. • Coupon: Regular interest payment received by holder per year. • Maturity date: Expiration date of bond when par value is paid back. • Yield to maturity: Expected rate of return, based on price of bond. FIGURE 6. 1 Merrill Lynch corporate bond. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 6 -5

6. 1 (A) Key Components of a Bond Example 1: Key Components of a Corporate Bond Let’s say you see the following price quote for a corporate bond: Issue Price Hertz Corp. 91. 50 Coupon(%) Maturity YTM% Current Yld. 6. 35 15 -Jun-2010 15. 438 6. 94 Rating B Price = 91. 5% of $1000 $915; $915 Annual coupon = 6. 35% *1000 $63. 50 Maturity date = June 15, 2010; 2010 If bought and held to maturity Yield = 15. 438% Current Yield = $ Coupon/Price = $63. 5/$915 6. 94% Copyright © 2010 Pearson Prentice Hall. All rights reserved. 6 -6

6. 1 (B) Pricing a Bond in Steps Since a bond involves a combination of an annuity (coupons) and a lump sum (par value), its price is best calculated by using the following steps: FIGURE 6. 2 How to price a bond. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 6 -7

6. 1 (B) Pricing a Bond in Steps (continued) Example 2: Calculating the Price of a Corporate Bond Calculate the price of an AA-rated, 20 -year, 8% coupon (paid annually) corporate bond (par value = $1, 000), which is expected to earn a yield to maturity of 10%. Year 0 1 2 3 $80 $80 18 … $80 19 $80 20 $80 $1, 000 Annual coupon = Coupon rate * Par value =. 08 * $1, 000 = $80 = PMT YTM = r = 10% Maturity = n = 20 Price of bond = Present value of coupons + Present value of par value Copyright © 2010 Pearson Prentice Hall. All rights reserved. 6 -8

6. 1 (B) Pricing a Bond in Steps (continued) Example 2: Calculating the price of a corporate bond Present value of coupons = = = $80 x 8. 51359 = $681. 09 Present Value of par value = $1, 000 x 0. 14864 = $148. 64 Price of bond = $681. 09 + $148. 64 = $829. 73 Copyright © 2010 Pearson Prentice Hall. All rights reserved. 6 -9

6. 1 (B) Pricing a Bond in Steps (continued) Method 2. Using a financial calculator Mode: P/Y=1; C/Y = 1 Input: N I/Y PV PMT FV Key: 20 10 ? 80 1000 Output -829. 73 Copyright © 2010 Pearson Prentice Hall. All rights reserved. 6 -10

6. 2 Semiannual Bonds and Zero. Coupon Bonds • Most corporate and government bonds pay coupons on a semiannual basis. • Some companies issue zero-coupon bonds by selling them at a deep discount. • For computing the price of these bonds, the values of the inputs have to be adjusted according to the frequency of the coupons (or absence thereof). – For example, for semiannual bonds, the annual coupon is divided by 2, the number of years is multiplied by 2, and the YTM is divided by 2. – The price of the bond can then be calculated by using the TVM equation, a financial calculator, or a spreadsheet. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 6 -11

6. 2 Semiannual Bonds and Zero-Coupon Bonds (continued) FIGURE 6. 4 Coca-Cola semiannual corporate

6. 2 Semiannual Bonds and Zero- Coupon Bonds (continued) FIGURE 6. 5 Future cash

6. 2 Semiannual Bonds and Zero- Coupon Bonds (continued) Method 1: Using the TVM

6. 2 Semiannual Bonds and Zero-Coupon Bonds (continued) Method 3: Using a spreadsheet We note again that the spreadsheet wants the periodic rate of 4. 4%, not the annual yield to maturity rate of 8. 8%. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 6 -15

6. 2 (A) Pricing Bonds after Original Issue The price of a bond is a function of the remaining cash flows (i. e. , coupons and par value) that would be paid on it until expiration. As of August 2008, the 8. 5%, 2022 Coca-Cola bond has only 27 coupons left to be paid on it until it matures on Feb. 1, 2022. FIGURE 6. 6 Remaining cash flow of the Coca-Cola bond. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 6 -16

6. 2 (A) Pricing Bonds after Original Issue (continued) Example 3: Pricing a Semiannual Coupon Bond after Original Issue Four years ago, the XYZ Corporation issued an 8% coupon (paid semiannually), 20 -year, AA-rated bond at its par value of $1000. Currently, the yield to maturity on these bonds is 10%. Calculate the price of the bond today. Remaining number of semiannual coupons = (20 -4)*2 = 32 coupons = n Semiannual coupon = (. 08*1000)/2 = $40 Par value = $1000 Annual YTM = 10% YTM/2 5% = r Copyright © 2010 Pearson Prentice Hall. All rights reserved. 6 -17

6. 2 (A) Pricing Bonds after Original Issue (continued) Copyright © 2010 Pearson Prentice

6. 2 (A) Pricing Bonds after Original Issue (continued) Method 2: Using a financial calculator Mode: P/Y=2; C/Y = 2 Input: N I/Y PV PMT FV Key: 32 10 ? 40 1000 Output -841. 97 Copyright © 2010 Pearson Prentice Hall. All rights reserved. 6 -19

6. 2 (B) Zero-Coupon Bonds • Known as “pure” discount bonds and sold at a discount from face value • Do not pay any interest over the life of the bond. • At maturity, the investor receives the par value, usually $1000. • Price of a zero-coupon bond is calculated by merely discounting its par value at the prevailing discount rate or yield to maturity. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 6 -20

Table 6. 2 Amortized interest on a Zero. Coupon Bond Copyright © 2010 Pearson

6. 2 (C) Amortization of a Zero-Coupon Bond • The discount on a zero-coupon bond is amortized over its life. • Interest earned is calculated for each 6 -month period. • For example, . 04*790. 31=$31. 62 • Interest is added to price to compute ending price. • Zero-coupon bond investors have to pay tax on annual price appreciation, even though no cash is received. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 6 -22

6. 2 (C) Amortization of a Zero-Coupon Bond (continued) Example 4: Price of and Taxes Due on a Zero-Coupon Bond: John wants to buy a 20 -year, AAA-rated, $1000 par value, zero-coupon bond being sold by Diversified Industries, Inc. The yield to maturity on similar bonds is estimated to be 9%. A) How much will he have to pay for it? B) How much will he be taxed on the investment after 1 year, if his marginal tax rate is 30%? Copyright © 2010 Pearson Prentice Hall. All rights reserved. 6 -23

6. 2 (C) Amortization of a Zero-Coupon Bond (continued) Example 4 (Answer) Method 1: Using the TVM equation Bond Price = Par Value * [1/(1+r)n] Bond Price = $1000*(1/(1. 045)40 Bond Price = $1000 *. 1719287 = $171. 93 Method 2: Using a financial calculator Mode: P/Y=2; C/Y = 2 Input: N I/Y PV PMT FV Key: 40 9 ? 0 1000 Output -171. 93 Copyright © 2010 Pearson Prentice Hall. All rights reserved. 6 -24

6. 2 (C) Amortization of a Zero-Coupon Bond (continued) Example 4 (Answer—continued): The Tax Piece Calculate the price of the bond at the end of 1 year. Mode: P/Y=2; C/Y = 2 Input: N I/Y PV PMT FV Key: 38 9 ? 0 1000 Output -187. 75 Taxable income = $187. 75 - $171. 93 = $15. 82 Taxes due = Tax rate * Taxable income = 0. 30*$15. 82 = $4. 75 Copyright © 2010 Pearson Prentice Hall. All rights reserved. 6 -25

6. 2 (C) Amortization of a Zero-Coupon Bond (continued) Example 4 (Answer—continued) Alternatively, we can calculate the semiannual interest earned, for each of the two semiannual periods during the year. $171. 93 *. 045 = $7. 736 Price after 6 months $171. 93+7. 736 = $179. 667 *. 045=$8. 084 Price at end of year $179. 667+8. 084 = $187. 75 Total interest income for 1 year = $7. 736+$8. 084 $15. 82 Tax due = 0. 30 * $15. 82 = $4. 75 Copyright © 2010 Pearson Prentice Hall. All rights reserved. 6 -26

6. 3 Yields and Coupon Rates • A bond’s coupon rate differs from its yield to maturity (YTM). • Coupon rate is set by the company at the time of issue. It is fixed (except for newer innovations that have variable coupon rates). • YTM is dependent on market, economic, and company-specific factors and is therefore variable. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 6 -27

6. 3 (A) The First Interest Rate: Yield to Maturity • Expected rate of return on a bond if held to maturity. • The price that willing buyers and sellers settle at determines a bond’s YTM at any given point. • Changes in economic conditions and risk factors will cause bond prices and their corresponding YTMs to change. • YTM can be calculated by entering the coupon amount (PMT), price (PV), remaining number of coupons (n), and par value (FV) into the TVM equation, financial calculator, or spreadsheet. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 6 -28

6. 3 (B) The “Other” Interest Rate: Coupon Rate • The coupon rate on a bond is set by the issuing company at the time of issue. • It represents the annual rate of interest that the firm is committed to pay over the life of the bond. • If the rate is set at 7%, the firm is committing to pay. 07*$1000 = $70 per year on each bond. • It is paid either in a single check or two checks of $35 paid six months apart. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 6 -29

6. 3 (C) Relationship of Yield to Maturity and Coupon Rate • An issuing firm gets the bond rated by a rating agency such as Standard & Poor’s or Moody’s. • Then, based on the rating and planned maturity of the bond, it sets the coupon rate to equal the expected yield, as indicated in the Yield Book (available in the capital markets at that time), and sells the bond at par value ($1000). • Once issued, if investors expect a higher yield on the bond, its price will go down and the bond will sell below par or as a discount bond, and vice-versa. • Thus, a bond’s YTM can be equal to (par bond), higher than (discount bond) or lower than (premium bond) its coupon rate. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 6 -30

Table 6. 3 Premium Bonds, Discount Bonds, and Par Value Bonds Copyright © 2010

Figure 6. 8 Bond prices and interest rates move in opposite directions Copyright ©

6. 3 (C) Relationship of Yield to Maturity and Coupon Rate (continued) Example 5: Computing YTM Last year, The ABC Corporation had issued 8% coupon (semiannual), 20 -year, AA-rated bonds (par value = $1000) to finance its business growth. If investors are currently offering $1200 on each of these bonds, what is their expected yield to maturity on the investment? If you are willing to pay no more than $980 for this bond, what is your expected YTM? Remaining number of coupons = 19*2 = 38 Semiannual coupon amount =(. 08*$1000)/2 = $40 Copyright © 2010 Pearson Prentice Hall. All rights reserved. 6 -33

6. 3 (C) Relationship of Yield to Maturity and Coupon Rate (continued) PV = $1200 Mode: P/Y=2; C/Y = 2 Input: N I/Y PV PMT FV Key: 38 ? -1200 40 1000 Output 6. 19 Note: This is a premium bond, so its YTM < coupon rate of 8% Copyright © 2010 Pearson Prentice Hall. All rights reserved. 6 -34

6. 3 (C) Relationship of Yield to Maturity and Coupon Rate (continued) PV = $980 Mode: P/Y=2; C/Y = 2 Input: N I/Y PV PMT FV Key: 38 ? -980 40 1000 Output 8. 21% Note: This would be a discount bond, so its YTM>coupon rate of 8%. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 6 -35

6. 4 Bond Ratings • Ratings are produced by Moody’s, Standard and Poor’s, and Fitch • Range from AAA (top-rated) to C (lowest-rated) or D (default). • Help investors gauge likelihood of default by issuer. • Help issuing companies establish a yield on newly issued bonds. – – Junk bonds: the label given to bonds that are rated below BBB. These bonds are considered to be speculative in nature and carry higher yields than those rated BBB or above (investment grade). Fallen angels: the label given to bonds that have had their ratings lowered from investment to speculative grade. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 6 -36

6. 4 Bond Ratings (continued) TABLE 6. 4 Bond Ratings Copyright © 2010 Pearson

6. 5 Some Bond History and More Bond Features • Corporate bond features have gone through some major changes over the years. – – – – Bearer bonds Indenture or deed of trust Collateral, or security of a bond Mortgaged security Debentures Senior debt and junior debt Sinking fund Protective covenants Copyright © 2010 Pearson Prentice Hall. All rights reserved. 6 -38

6. 5 Some Bond History and More Bond Features (continued) – Callable bond – Yield to call – Putable bond – Convertible bond – Floating-rate bond – Prime rate – Income bonds – Exotic bonds Copyright © 2010 Pearson Prentice Hall. All rights reserved. 6 -39

6. 5 Some Bond History and More Bond Features (continued) Example 6: Calculating Yield to Call. Two years ago, the Mid-Atlantic Corporation issued a 10% coupon (paid semiannually), 20 year maturity bond with a 5 -year deferred call feature and a call penalty of one coupon payment in addition to the par value ($1000), if exercised. If the current price on these bonds is $1080, what is its yield to call? Copyright © 2010 Pearson Prentice Hall. All rights reserved. 6 -40

6. 5 Some Bond History and More Bond Features (continued) Remaining number of coupons until first call date = 6 = n Semi-annual coupon = $50 = PMT Call price = $1050 = FV Bond price = $1080 = PV Mode: Input: Key: Output P/Y=2; C/Y = 2 N I/Y PV PMT 6 ? -1080 50 8. 43 FV 1050 YTC Copyright © 2010 Pearson Prentice Hall. All rights reserved. 6 -41

6. 6 U. S. Government Bonds • Include bills, notes, and bonds sold by the Department of the Treasury. • Also include state bonds, issued by state governments • Also include municipal bonds, issued by county, city, or local government agencies. • Treasury bills are zero-coupon, pure discount securities with maturities ranging from 1 -, 3 -, and 6 -months up to 1 year. • Treasury notes have between 2 - to 10 -year maturities. • Treasury bonds have greater than 10 -year maturities, when first issued. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 6 -42

Table 6. 6 Government Notes and Bonds (Prices as of April 8, 2008) Copyright

6. 6 (A) Pricing a U. S. Government Note or Bond • • Similar to the method used for pricing corporate bonds and can be done by using TVM equations, a financial calculator, or a spreadsheet program. For example, let’s assume you are pricing a 7 -year, 6% coupon (semiannual) $100, 000 face value Treasury note, using an expected yield of 8%: FIGURE 6. 11 U. S. Government Treasury Note Cash Flows Copyright © 2010 Pearson Prentice Hall. All rights reserved. 6 -44

6. 6 (B) Pricing a Treasury bill Calculated by discounting the bill’s face value for the number of days until maturity and at the prevailing bank discount yield. Bank discount yield: a special discount rate used in conjunction with Treasury bills under a 360 day- per- year convention (commonly assumed by bankers). Bond equivalent yield (BEY): the APR equivalent of the bank discount yield calculated by adjusting it as follows: BEY = _____365 * Bank discount yield____ 360 - (days to maturity * discount yield) Copyright © 2010 Pearson Prentice Hall. All rights reserved. 6 -45

6. 6 (B) Pricing a Treasury bill (continued) Example 7: Calculating the Price and BEY of a Treasury Bill Calculate the price and BEY of a treasury bill that matures in 105 days, has a face value of $10, 000, and is currently being quoted at a bank discount yield of 2. 62%. Price of T-bill = Face value * [1 -(discount yield * days until maturity/360)] Price of T-bill = $10, 000 * [ 1 - (. 0262 * 105/360)] = $10, 000*0. 9923583 Price of T-bill = $9, 923. 58 BEY = _____365 * Bank discount yield_______ 360 - (days to maturity * discount yield) = __365 *. 0262__ 360 - (105*. 0262) BEY =. 026768 = 2. 68% (rounded to 2 decimals) Copyright © 2010 Pearson Prentice Hall. All rights reserved. 6 -46

Table 6. 7 Selected Historical Treasury Bill Bank Discount Rates Copyright © 2010 Pearson

ADDITIONAL PROBLEMS WITH ANSWERS Problem 1 Pricing a Semiannual Bond: Last year, Harvest Time Corporation sold $40, 000 worth of 7. 5% coupon, 15 -year maturity, $1000 par value, AA-rated, noncallable bonds to finance its business expansion. Currently, investors are demanding a yield of 8. 5% on similar bonds. If you own one of these bonds and want to sell it, how much money can you expect to receive on it? Copyright © 2010 Pearson Prentice Hall. All rights reserved. 6 -48

ADDITIONAL PROBLEMS WITH ANSWERS Problem 1 (ANSWER) Using a financial calculator Mode: P/Y=2; C/Y = 2 Input: Key: Output N 28 I/Y 8. 5 PV PMT ? 37. 5 -919. 03 Copyright © 2010 Pearson Prentice Hall. All rights reserved. FV 1000 6 -49

ADDITIONAL PROBLEMS WITH ANSWERS Problem 2 Yield to Maturity Joe Carter is looking to invest in a four-year bond that pays semiannual coupons at a coupon rate of 5. 6 percent and has a par value of $1, 000. If these bonds have a market price of $1, 035, what yield to maturity is being implied in the pricing? Copyright © 2010 Pearson Prentice Hall. All rights reserved. 6 -50

ADDITIONAL PROBLEMS WITH ANSWERS Problem 2 (ANSWER) Using a financial calculator Mode: P/Y=2; C/Y = 2 Input: N I/Y PV Key: 8 ? -1035 Output 4. 63 PMT 28 FV 1000 The expected YTM is 4. 63% Copyright © 2010 Pearson Prentice Hall. All rights reserved. 6 -51

ADDITIONAL PROBLEMS WITH ANSWERS Problem 3 Price of a Zero-Coupon Bond Krypton Inc. wants to raise $3 million by issuing 10 year zero-coupon bonds with a face value of $1, 000. Its investment banker informs Krypton that investors would use a 9. 25% percent discount rate on such bonds. At what price would these bonds sell in the market place, assuming semiannual compounding? How many bonds would the firm have to issue to raise $3 million? Copyright © 2010 Pearson Prentice Hall. All rights reserved. 6 -52

ADDITIONAL PROBLEMS WITH ANSWERS Problem 3 (ANSWER) Using a financial calculator : Price of a Zero-Coupon Bond Mode: P/Y=2; C/Y = 2 Input: N I/Y PV PMT FV Key: 20 9. 25 ? 0 1000 Output -404. 85 The zero-coupon bond would sell for $404. 85 To raise $3, 000, the company would have to sell: $3, 000/$404. 85 = 7, 411 bonds Copyright © 2010 Pearson Prentice Hall. All rights reserved. 6 -53

ADDITIONAL PROBLEMS WITH ANSWERS Problem 4 Tax on Zero-Coupon Bond Income Let’s say that you buy 100 of the 7411 bonds that were issued by Krypton Inc. , as described in Problem 3 above for $404. 85. At the end of the year, how much money will the bond be worth, and how much tax will you be assessed, assuming that you have a marginal tax rate of 35%? Copyright © 2010 Pearson Prentice Hall. All rights reserved. 6 -54

ADDITIONAL PROBLEMS WITH ANSWERS Problem 4 (ANSWER) Calculate the price of the bond at the end of each semi-annual period during the next year. The change in price for each semi-annual period represents the implied interest income on a zero that is taxed at 35%. Price of Zero after 6 months, assuming YTM of 9. 25%: Mode: P/Y=2; C/Y = 2 Input: N I/Y PV PMT FV Key: 19 9. 25 ? 0 1000 Output -423. 57 Copyright © 2010 Pearson Prentice Hall. All rights reserved. 6 -55

ADDITIONAL PROBLEMS WITH ANSWERS Problem 4 (ANSWER continued) Price of Zero at the end of 2 semiannual periods assuming YTM of 9. 25%: Mode: P/Y=2; C/Y = 2 Input: Key: Output N 18 I/Y 9. 25 PV PMT FV ? 0 1000 -443. 16 Implied interest earned on zero = $443. 16 - $404. 85 = $38. 31 Taxes due =Tax rate*Taxable income = 0. 35 * $38. 31 = $13. 41 Copyright © 2010 Pearson Prentice Hall. All rights reserved. 6 -56

ADDITIONAL PROBLEMS WITH ANSWERS Problem 5 Price and BEY on a Treasury Bill Calculate the price and BEY of a treasury bill that matures in 181 days, has a face value of $10, 000, and is currently being quoted at a bank discount yield of 2. 32%. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 6 -57

ADDITIONAL PROBLEMS WITH ANSWERS Problem 5 (ANSWER) Price of T-bill = Face Value * [1 -(discount yield * days until maturity/360)] Price of T-bill = $10, 000 * [ 1 - (. 0232 * 181/360)] = $10, 000 * 0. 98833555 Price of T-bill = $9, 883. 36 BEY = _____365 * Bank discount yield_______ __365 *. 0232__ = 360 - (days to maturity * discount yield) 360 - (181*. 0232) BEY =. 023799 = 2. 38% (rounded to 2 decimals) Copyright © 2010 Pearson Prentice Hall. All rights reserved. 6 -58