CHAPTER FOURTEEN BOND ANALYSIS CAPITALIZATION OF INCOME METHOD
CHAPTER FOURTEEN BOND ANALYSIS
CAPITALIZATION OF INCOME METHOD n PROMISED YIELD-TO-MATURITY • In equation form where P=the current market price of bond n=the number of years to maturity Ct=the annual coupon payment y=the prevailing yield to maturity
CAPITALIZATION OF INCOME METHOD n INTRINSIC VALUE • In equation form
CAPITALIZATION OF INCOME METHOD n SOLVING FOR V, • Given the current market price (P), the investment decision is 3 if V is the intrinsic value and V>P buy the bond V<P don’t buy
CAPITALIZATION OF INCOME METHOD n ALTERNATIVELY • SOLVING FOR y* y*>y bond overprice y*<y bond underpriced
BOND ATTRIBUTES n SIX ATTRIBUTES that affect a bonds value • LENGTH OF TIME TO MATURITY • COUPON RATE • CALL PROVISIONS • TAX STATUS • MARKETABILITY • LIKELIHOOD OF DEFAULT
LENGTH OF TIME TO MATURITY n COUPON RATE AND LENGTH TO MATURITY • these attributes determine size and timing of cash flow • yield-to-maturity
CALL PROVISIONS n CALL PROVISIONS • DEFINITION: a provision in some bond indentures that permits an issuer to retire some or all of the bonds in a particular issue prior to maturity date stated
CALL PROVISIONS n CALL PROVISIONS • Issuer may find it advantageous to call existing bond 3 if market interest rate is lower 3 replace existing bonds with lower rate bonds
TAX STRUCTURE n TAX STRUCTURE • Taxation affects bond prices and yields 3 low-coupon bonds selling at a discount provide return in – – coupon payments gains from price appreciations 3 taxes on appreciations may be deferred until bond sale or maturity 3 discount bonds have a tax advantage
TAX STRUCTURE n TAX STRUCTURE • Taxation affects bond prices and yields 3 because of tax effect, discount bonds should have a slightly lower before-tax yield 3 low-coupon bonds will have a slightly higher intrinsic value
MARKETABILITY n MARKETABILITY • refers to the ability of the investor to resell
MARKETABILITY n MARKETABILITY • bid-ask spread is one indicator of marketability 3 the higher the spread, the less marketable 3 the lower the spread, the more marketable • bonds that are actively traded should have a lower YTM and a higher V
MARKETABILITY n MARKETABILITY • bonds that are actively traded should have a lower YTM and a higher V
LIKELIHOOD OF DEFAULT n LIKELILHOOD OF DEFAULT • Bond ratings provided by professional services.
LIKELIHOOD OF DEFAULT n LIKELILHOOD OF DEFAULT • Two most famous include 3 Moody’s Investors Services, Inc. 3 Standard & Poor’s Corporate ratings
LIKELIHOOD OF DEFAULT n LIKELILHOOD OF DEFAULT • Categories 3 investment grade usually the bonds in the top four ratings 3 speculative 3 often called junk bonds
LIKELIHOOD OF DEFAULT n LIKELILHOOD OF DEFAULT • Bond ratings provided by professional services. 3 better ratings are generally associated with – – – larger financial leverage larger firm size larger and steadier profits large cash flows lack of subordination to other debt series
END OF CHAPTER 14
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