Presentation on theme: "Bonds and Their Valuation"— Presentation transcript:
1Bonds and Their Valuation Chapter 7Bonds and Their Valuation
2Chapter 7 Topic Overview Bond CharacteristicsAnnual and Semi-Annual Bond ValuationReading Bond QuotesFinding Returns on BondsBond Risk and Other Important Bond Valuation Relationships2
3Bond CharacteristicsPar (or Face) Value (M) = stated face value that is the amount the issuer must repay, usually $1,000Coupon Interest RateCoupon (INT) = Coupon Rate x Face ValueMaturity Date = when the face value is repaid.A legal contract called the bond indenture specifies these values.This makes a bond’s cash flows look like this:3
4Bond Valuation INT INT INT+M 0 1 2 . . . n Discount the bond’s cash flows at the investor’s required rate of return.the coupon payment (INT) stream (an annuity).the par (M) value payment (a lump sum).V = INT (PVA r, n) + M /(1+r)nnINT INT INT+M
5Bond Valuation Example #1 Duff’s Beer has $1,000 par value bonds outstanding that make annual coupon payments. These bonds have a 7.5% annual coupon rate and 15 years left to maturity. Bonds with similar risk have a required return of 9%, and Moe Szyslak thinks this required return is reasonable.What’s the most that Moe is willing to pay for a Duff’s Beer bond?6
9Let’s Play with Example #1 some more. Barney (belch!) Gumble is interested in buying a Duff Beer bond and demands on a 6 percent required return.What is the most Barney (belch!) would pay for this bond?7
11Lesson from Example 1: Bond Prices and Interest Rates have an inverse relationship!
12Another Example 1 Lesson: Bond Premiums and Discounts What happens to bond values if required return is not equal to the coupon rate?The bond's price will differ from its par valueP0 < par valuer > Coupon Interest RateDISCOUNT=When r is greater than the coupon interest rate, P0 will be less than par value, and the bond will sell at a discountFor Sun, if r >5%, P0 will be less than $1,000For practice:Value Sun Company, 10-year, 5% coupon rate bond if required return, r =6% and again if r = 4%.Premiums & discounts change systematically as r changes.P0 = par valuer = Coupon Interest RatePAR=P0 > par valuer < Coupon Interest RatePREMIUM=
13Bonds with Semiannual Coupons Double the number of years, and divide required return and annual coupon by 2.Vd = INT/2(PVAr/2,2n) + M /(1+r/2)2n15
14Semiannual ExampleKwickee-Mart has an $1000 par value bond with an annual coupon rate of 6% that pays coupons semiannually with 20 years left to maturity. What is the most you would be willing to pay for this bond if your required return is 7% APR?Semiannual coupon = 6%/2($1000) = $3020x2 = 40 remaining coupons16
16Bond YieldsCurrent Yield - Annual coupon payments divided by bond price.Yield To Maturity - Interest rate for which the present value of the bond’s payments equal the price. Also known as the market’s required rate of return.Yield To Maturity = total expected return = current yield + expected capital gains yield (change in price)17
18Bond YieldsCalculating Yield to Maturity (YTM=r) If you are given the price of a bond (PV) and the coupon rate, the yield to maturity can be found by solving for r.19
19Yield to Maturity Example Burns Power $1000 face value bond with a 5% coupon rate paid annually with 10 years left to maturity sells for $890.What is this bond’s yield to maturity?13
201000What is bond’s YTM?What is the bond’s current yield?
21U.S. Treasury Bond Quotations RATEMATURITYMO/YRBIDASKEDCHGASKYLDGovernment Bonds & Notes8.50Feb 20136:30136:31+424.67RateCoupon rate of 8.5%Bid pricesAsk prices(percentage of par value)Bid price: the price traders receive if they sell a bond to the dealer. Quoted in increments of 32nds of a %age of parAsk price: the price traders pay to the dealer to buy a bondBid-ask spread: difference between ask and bid prices.-Yield to Maturity (YTM) is the rate of return investors earn if they buy the bond at P0 and hold it until maturity.The YTM on a bond selling at par (P0 = Par) will always equal the coupon interest rate.When P0 Par, the YTM will differ from the coupon rate.YTM is the discount rate that equates the PV of a bond’s cash flows with its price. If P0, CFs, n known, can find YTMUse T-Bond with n=2 years, 2n=4, C/2=$20, P0=$992.43Ask YieldYield to maturity on the ask price
22Verifying the T-bond’s YTM (Ask Yld) Par Value = $1000, semi-annual couponsAsk Price = %($1000) = $1,369.69INT/2 = 8.5%($1000)/2 = $42.50N = = 13, 2N = 26
23Causes of Bond Price Changes Since a bond’s cash flows are fixed:Changes in interest rates, andPassage of time.cause changes in a bond’s price.
24Bond Value Changes Over Time Returning to the Duff’s Beer original example #1, where r = 9%, N = 15, C (PMT) = $75, par (FV) = $1000, & PV = $What is bond value one year later when N = 14 and r is still = 9%?
25Bond values over timeAt maturity, the value of any bond must equal its par value.If rd remains constant:The value of a premium bond would decrease over time, until it reached $1,000.The value of a discount bond would increase over time, until it reached $1,000.A value of a par bond stays at $1,000.
26Changes in Bond Value over Time What would happen to the value of these three bonds is bond if its required rate of return remained at 10%:VB1,1841,00081613% coupon rate10% coupon rate.7% coupon rateYearsto Maturity
27What about this?What if Barney buys Duff Bond at $ with n =15 and sells at r = 7% with n = 14. What is his return?
29Interest Rate RiskMeasures Bond Price Sensitivity to changes in interest rates.In general, long-term bonds have more interest rate risk than short-term bonds.Also, for bonds with same time to maturity, lower coupon bonds have more interest rate risk than higher coupon bonds.
30Interest Rate Risk Example Recall from our earlier example (#1), the 15-year, 7.5% annual coupon bond has the following values at kd = 6%, 7.5%, & 9%. Let’s compare with a 2-yr, 7.5% annual coupon bond.15-year bond 2-year bondr=6%: PV = $1, PV = $1,027.50r=7.5%: PV = $1,000 PV = $1,000r=9%: PV = $ PV = $973.61
31Interest Rate Risk: Bond Price Sensitivity Graph
32Reinvestment rate risk Reinvestment rate risk is the concern that rd will fall, and future CFs will have to be reinvested at lower rates, hence reducing income.EXAMPLE: Suppose you just won$500,000 playing the lottery. Youintend to invest the money andlive off the interest.
33Reinvestment rate risk example You may invest in either a 10-year bond or a series of ten 1-year bonds. Both 10-year and 1-year bonds currently yield 10%.If you choose the 1-year bond strategy:After Year 1, you receive $50,000 in income and have $500,000 to reinvest. But, if 1-year rates fall to 3%, your annual income would fall to $15,000.If you choose the 10-year bond strategy:You can lock in a 10% interest rate, and $50,000 annual income.
34Conclusions about interest rate and reinvestment rate risk Short-term AND/OR High coupon bondsLong-term AND/OR Low coupon bondsInterestrate riskLowHighReinvestment rate riskCONCLUSION: Nothing is riskless!
37Callable Bonds & the effect of a call provision Allows issuer to refund the bond issue if rates decline (helps the issuer, but hurts the investor).Borrowers are willing to pay more, and lenders require more, for callable bonds.Most bonds have a deferred call and a declining call premium.
38A 10-year, 10% semiannual coupon bond selling for $1,135 A 10-year, 10% semiannual coupon bond selling for $1, can be called in 4 years for $1,050, what is its yield to call (YTC)?The bond’s yield to maturity can be determined to be 8%. Solving for the YTC is identical to solving for YTM, except the time to call is used for N and the call premium is FV.8501050INPUTSNI/YRPVPMTFVOUTPUT3.568
39Yield to call 3.568% represents the periodic semiannual yield to call. YTCNOM = rNOM = 3.568% x 2 = 7.137% is the rate that a broker would quote.The effective yield to call can be calculatedYTCEFF = ( )2 – 1 = 7.26%
40If you bought these callable bonds, would you be more likely to earn the YTM or YTC? The coupon rate = 10% compared to YTC = 7.137%. The firm could raise money by selling new bonds which pay 7.137%.Could replace bonds paying $100 per year with bonds paying only $71.37 per year.Investors should expect a call, and to earn the YTC of 7.137%, rather than the YTM of 8%.
41When is a call more likely to occur? In general, if a bond sells at a premium, then (1) coupon rate > rd, so (2) a call is more likely.So, expect to earn:YTC on premium bonds.YTM on par & discount bonds.
42Sinking FundProvision to pay off a loan over its life rather than all at maturity.Similar to amortization on a term loan.Reduces risk to investor, shortens average maturity.But not good for investors if rates decline after issuance.
43How are sinking funds executed? Call x% of the issue at par, for sinking fund purposes.Likely to be used if rd is below the coupon rate and the bond sells at a premium.Buy bonds in the open market.Likely to be used if rd is above the coupon rate and the bond sells at a discount.
44Other types (features) of bonds Convertible bond – may be exchanged for common stock of the firm, at the holder’s option.Warrant – long-term option to buy a stated number of shares of common stock at a specified price.Putable bond – allows holder to sell the bond back to the company prior to maturity.Income bond – pays interest only when interest is earned by the firm.Indexed bond – interest rate paid is based upon the rate of inflation.