1. The Valuation and Characteristics of Bonds Chapter 6 © 2003 South-Western/Thomson Learning

2. 2 The Basis of Value Securities are worth the present value of the future cash income associated with owning them The security should sell in financial markets for a price very close to that value However, I might think Security A has a different intrinsic value then someone else thinks, because we have different estimates for the Discount rate Expected future cash flows

3. 3 The Basis for Value Investing Using a resource to benefit the future rather than for current satisfaction Putting money to work to earn more money Common types of investments Debt—lending money Equity—buying ownership in a business A return is what the investor receives divided by what s/he invests Debt investors receive interest

4. 4 The Basis for Value Rate of return is the interest rate that equates the present value of its expected future cash flows with its current price PV = FV  (1 + k) Return is also known as Yield Interest k = return

5. 5 Bond Valuation A bond issue represents borrowing from many lenders at one time under a single agreement While one person may not be willing to lend a single company $10 million, 10,000 investors may be willing to lend the firm $1,000 each See Bondval.xls for this chapter.

6. 6 Bond Terminology and Practice A bond’s term (or maturity) is the time from the present until the principal is to be returned Bonds mature on the last day of their term A bond’s face value (or par) represents the amount the firm intends to borrow (the principal) at the coupon rate of interest Bonds typically pay interest (coupon rate) every six months Bonds are non-amortized (meaning the principal is repaid at once when the bond matures rather than being repaid in increments throughout the bond’s life)

7. 7 Bond Valuation—Basic Ideas Adjusting to interest rate changes Bonds are sold in both primary (original sale) and secondary markets (subsequent trading among investors) Interest rates change all the time Most bonds pay a fixed interest rate What happens to the price of a bond paying a fixed interest rate in the secondary market when interest rates change?

8. 8 Bond Valuation—Basic Ideas You buy a 20-year, $1,000 par bond today for par (meaning you pay $1,000 for it) when the coupon rate is 10% This implies that your required rate of return was 10% For that purchase price, you are promised 20 years of coupon payments of $100 each, and a principal repayment of $1,000 in 20 years After you’ve held the bond investment for a week, you decide that you need the money (cash) more than you need the investment You decide to sell the bond Unfortunately, interest rates have risen Other investors now have a required rate of return of 11% They can buy new bonds with an 11% coupon rate in the market for $1,000 Will they buy your bond from you for $1,000? NO! They’ll buy it for less than $1,000

9. 9 Determining the Price of a Bond Remember, Intrinsic Value is the present value of all future expected cash flows With a bond, predicting the future cash flows is somewhat ‘easy,’ because the promised cash flows are specified Interest (usually) Principal (usually) Maturity (in years) In practice, most bonds pay interest semi-annually.

10. 10 Determining the Price of a Bond The Bond Valuation Formula The price of a bond is the present value of a stream of interest payments plus the present value of the principal repayment P B = PV(interest payments) + PV(principal repayment) Interest payments are annuities—can use the present value of an annuity formula: PMT[PVFA k,n ] Principal repayment is a lump sum in the future—can use the future value formula: FV[PVF k,n ]

11. 11 Determining the Price of a Bond Two Interest Rates and One More Coupon rate Determines the size of the interest payments K—the current market yield on comparable bonds The appropriate discount rate that makes the present value of the payment equal to the price of the bond in the market AKA yield to maturity (YTM) Current yield—annual interest payment divided by bond’s current price

12. 12 Solving Bond Problems with a Financial Calculator Financial calculators have five time value of money keys With a bond problem, all five keys are used N—number of periods until maturity I—market interest rate PV—price of bond FV—face value (par) of bond PMT—coupon interest payment per period The unknown will be either the interest rate or the present value When solving for the interest rate, the price of the bond must be inputted as a negative value while the PMT and FV must be inputted as a positive value Sophisticated calculators have a ‘bond’ mode allowing easy calculations dealing with accrued interest

13. 13 Maturity Risk Revisited Relates to term of the debt Longer term bonds fluctuate more in response to changes in interest rates than shorter term bonds AKA price risk and interest rate risk As time passes, if interest rates don’t change the price of a bond will approach its par

14. 14 Finding the Yield at a Given Price We’ve been calculating the intrinsic value of a bond, but we could calculate the bond yield (based on its current value in the market) and compare that yield to our required rate of return P B = PMT [PVFA k, n ] + FV [PVF k, n ] Involves solving for k, which is more complicated because it involves both an annuity and a FV. Use trial and error to solve for k, or use a financial calculator.

15. 15 Call Provisions If interest rates have dropped substantially since a bond was originally issued, a firm may wish to ‘refinance,’ or retire their old high interest bond issue However, the issuing corporation would have to get all the bondholders to agree to this From the bondholder’s viewpoint, this could be a bad idea— they would be giving up high coupon bonds and would have to reinvest their cash in a market with lower interest rates To ensure that the corporation can refinance their bonds should they wish to do so, the corporation makes the bonds ‘callable’

16. 16 Call Provisions Call provisions allow bond issuers to retire bonds before maturity by paying a premium (penalty) to bondholders Many corporations offer a deferred call period (meaning the bond won’t be called for at least x years after the initial issuing date) Known as the call-protected period

17. 17 Call Provisions The Effect of A Call Provision on Price When valuing a bond that is probably going to be called when the call-protected period is over Cannot use the traditional bond valuation procedure Cash flows will not be received through maturity because bond will probably be called

18. 18 Call Provisions Valuing the Sure-To-Be-Called Bond Requires that two changes be made to bond valuation formula P B = PMT [PVFA k, n ] + FV [PVF k, n ] The future value becomes the call price (face value plus call premium). N now represents the number of periods until the bond is likely to be called.

19. 19 The Refunding Decision When current interest rates fall below the coupon rate on a bond, company has to decide whether or not to call in the issue Compare interest savings of issuing a new bond to the cost of making the call Calling in the bond requires the payment of a call premium Issuing a new bond to raise cash to pay off the old bond requires payment of administrative expenses and flotation costs

20. 20 Dangerous Bonds with Surprising Calls Some bonds have contingency call features buried in the fine print For instance, some issuers would like to retire a portion of their bond issue periodically Versus paying a huge principal repayment on the entire issue at maturity This feature does not require a call provision Rather, those bondholders who must retire their bond are determined by lottery

21. 21 Risky Issues Sometimes bonds sell for a price far below what valuation techniques suggest Investors are worried that company may not be able to pay promised cash flows Valuation model should determine a price similar to the market price if the correct discount rate is used Riskier loans should be discounted at a higher interest rate leading to a lower calculated price

22. 22 Institutional Characteristics of Bonds Registration, Transfer Agents, and Owners of Record A record of registered securities is kept by a transfer agent Payments are sent to owners of record as of the dates the payments are made Bearer bonds vs. registered bonds Bearer bonds—interest payment is made to the bearer of the bond Registered bonds—interest payment is made to the holder of record

23. 23 Kinds of Bonds Secured bonds and mortgage bonds Backed by collateral Debentures Unsecured bonds Subordinated debentures Lower in priority than senior debt Convertible bonds Can be exchanged for specified amounts of stock Junk bonds Issued by risky companies and pay high interest rates

24. 24 Bond Ratings—Assessing Default Risk Bond rating agencies (such as Moody’s, S&P) evaluate bonds (and issuing firms) and assign a rating to each bond issued by a corporation These ratings gauge the probability that issuers will fail to meet their obligations

25. 25 Bond Ratings—Assessing Default Risk Why Ratings Are Important Ratings are the primary measure of the default risk associated with bonds Thus, ratings play a big part in the interest rate that investors demand The rating a firm’s bonds receive basically determines the rate at which the firm can borrow A lower quality rating implies a higher borrowing rate

26. 26 Bond Ratings—Assessing Default Risk The differential between the yields on high and low quality bonds is an indicator of the health of the economy The Differential Over Time The quality differential tends to be larger when interest rates are generally high May indicate a recession and marginal firms are more likely to fail, making them riskier The Significance of the Investment Grade Rating Many institutional investors are prohibited from trading below-investment-grade bonds

27. 27 Bond Indentures—Controlling Default Risk As a bondholder, you would like to ensure that you will receive your promised interest and principal payments Bond indentures attempt to prevent firms from becoming riskier after the bonds are purchased, and includes such protective covenants as: Limits to management’s salary Limits to dividends Maintenance of certain financial ratios Restrictions on additional debt issues Sinking funds provide money for the repayment of bond principal