CHAPTER TWENTYONE BOND ANALYSIS 1 CAPITALIZATION OF INCOME

CHAPTER TWENTY-ONE BOND ANALYSIS 1

CAPITALIZATION OF INCOME METHOD • 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 2

CAPITALIZATION OF INCOME METHOD • INTRINSIC VALUE – In equation form 3

CAPITALIZATION OF INCOME METHOD • SOLVING FOR V, – Given the current market price (P), the investment decision is • if V is the intrinsic value and V>P buy the bond V<P don’t buy 4

CAPITALIZATION OF INCOME METHOD • ALTERNATIVELY – SOLVING FOR y* y*>y bond overprice y*<y bond underpriced 5

BOND ATTRIBUTES • SIX ATTRIBUTES that affect a bond’s value – LENGTH OF TIME TO MATURITY – COUPON RATE – CALL PROVISIONS – TAX STATUS – MARKETABILITY – LIKELIHOOD OF DEFAULT 6

LENGTH OF TIME TO MATURITY • COUPON RATE AND LENGTH TO MATURITY – these attributes determine size and timing of cash flow – yield-to-maturity 7

TAX STRUCTURE • TAX STRUCTURE – Taxation affects bond prices and yields • low-coupon bonds selling at a discount provide return in – coupon payments – gains from price appreciations • taxes on appreciations may be deferred until bond sale or maturity • discount bonds have a tax advantage 8

TAX STRUCTURE • TAX STRUCTURE – Taxation affects bond prices and yields • because of tax effect, discount bonds should have a slightly lower before-tax yield • low-coupon bonds will have a slightly higher intrinsic value 9

MARKETABILITY • MARKETABILITY – refers to the ability of the investor to resell 10

MARKETABILITY • MARKETABILITY – bid-ask spread is one indicator of marketability • the higher the spread, the less marketable • the lower the spread, the more marketable – bonds that are actively traded should have a lower YTM and a higher V 11

MARKETABILITY • MARKETABILITY – bonds that are actively traded should have a lower YTM and a higher V 12

LIKELIHOOD OF DEFAULT • LIKELILHOOD OF DEFAULT – Bond ratings provided by professional services. 13

LIKELIHOOD OF DEFAULT • LIKELILHOOD OF DEFAULT – Two most famous include • Moody’s Investors Services, Inc. • Standard & Poor’s Corporate ratings 14

LIKELIHOOD OF DEFAULT • LIKELIHOOD OF DEFAULT – Categories • investment grade usually the bonds in the top four ratings • speculative • often called junk bonds 15

LIKELIHOOD OF DEFAULT • LIKELIHOOD OF DEFAULT – Bond ratings provided by professional services. • 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 16