Chapter 7

Valuation and Characteristics of Bonds

Characteristics of Bonds  Bonds pay fixed coupon (interest) payments at fixed intervals (usually every 6 months) and pay the par value at maturity.

Characteristics of Bonds  Bonds pay fixed coupon (interest) payments at fixed intervals (usually every 6 months) and pay the par value at maturity n $I $I $I $I $I $I+$M

example: AT&T 8 24 n par value = $1000 n coupon = 8% of par value per year. = $80 per year ($40 every 6 months). = $80 per year ($40 every 6 months). n maturity = 24 years (matures in 2024). n issued by AT&T.

example: AT&T 8 24 n par value = $1000 n coupon = 8% of par value per year. = $80 per year ($40 every 6 months). = $80 per year ($40 every 6 months). n maturity = 24 years (matures in 2024). n issued by AT&T. (Assume year is 2000) 0 12… 48 $40 $40 $40 $40 $40 $40+$1000 $40 $40 $40 $40 $40 $40+$1000

Types of Bonds n Debentures - unsecured bonds. n Subordinated debentures - unsecured “junior” debt. n Mortgage bonds - secured bonds. n Zeros - bonds that pay only par value at maturity; no coupons. (example: Series EE government savings bonds.)

Types of Bonds n Eurobonds - bonds denominated in one currency and sold in another country. (Borrowing overseas). n example - suppose Disney decides to sell $1,000 bonds in France. These are U.S. denominated bonds trading in a foreign country. Why do this? u If borrowing rates are lower in France, u To avoid SEC regulations.

The Bond Indenture n The bond contract between the firm and the trustee representing the bondholders. n Lists all of the bond’s features: coupon, par value, maturity, etc. coupon, par value, maturity, etc. n Lists restrictive provisions which are designed to protect bondholders. n Describes repayment provisions.

Value n Book Value: value of an asset as shown on a firm’s balance sheet; historical cost. n Liquidation value: amount that could be received if an asset were sold individually. n Market value: observed value of an asset in the marketplace; determined by supply and demand. n Intrinsic value: economic or fair value of an asset; the present value of the asset’s expected future cash flows.

Bond Ratings n 1. Moodys n 2. Standard & Poor’s n 3. Fitch Investor Service n Affected by: u Greater reliance on equity for financing firm u Profitable Operations u Low Variability in Earnings u Large Firm

Security Valuation n In general, the intrinsic value of an asset = the present value of the stream of expected cash flows discounted at an appropriate required rate of return. n Can the intrinsic value of an asset differ from its market value?

Valuation n C t = cash flow to be received at time t. n k = the investor’s required rate of return. n V = the intrinsic value of the asset. V = t = 1 n $C t (1 + k) t

Bond Valuation n Discount the bond’s cash flows at the investor’s required rate of return. u the coupon payment stream (an annuity). u the par value payment (a single sum).

Bond Valuation V b = $I t (PVIFA k b, n ) + $M (PVIF k b, n ) $I t $M (1 + k b ) t (1 + k b ) n V b = + n t = 1 

Bond Example n Suppose our firm decides to issue 20-year bonds with a par value of $1,000 and annual coupon payments. The return on other corporate bonds of similar risk is currently 12%, so we decide to offer a 12% coupon interest rate. n What would be a fair price for these bonds?

P/YR = 1 N = 20 I%YR = 12 FV = 1,000 PMT = 120 Solve PV = -$1,000 Note: If the coupon rate = discount rate, the bond will sell for par value.

n Suppose interest rates fall immediately after we issue the bonds. The required return on bonds of similar risk drops to 10%. n What would happen to the bond’s intrinsic value?

P/YR = 1 Mode = end N = 20 I%YR = 10 PMT = 120 FV = 1000 Solve PV = -$1,170.27

P/YR = 1 Mode = end N = 20 I%YR = 10 PMT = 120 FV = 1000 Solve PV = -$1, Note: If the coupon rate > discount rate, the bond will sell for a premium. the bond will sell for a premium.

n Suppose interest rates rise immediately after we issue the bonds. The required return on bonds of similar risk rises to 14%. n What would happen to the bond’s intrinsic value?

P/YR = 1 Mode = end N = 20 I%YR = 14 PMT = 120 FV = 1000 Solve PV = -$867.54

P/YR = 1 Mode = end N = 20 I%YR = 14 PMT = 120 FV = 1000 Solve PV = -$ Note: If the coupon rate < discount rate, the bond will sell for a discount.

Suppose coupons are semi-annual P/YR = 2 Mode = end N = 40 I%YR = 14 PMT = 60 FV = 1000 Solve PV = -$866.68

Yield To Maturity n The expected rate of return on a bond. n The rate of return investors earn on a bond if they hold it to maturity. $I t $M (1 + k b ) t (1 + k b ) n P 0 = + n t = 1 

YTM Example n Suppose we paid $ for a $1,000 par 10% coupon bond with 8 years to maturity and semi-annual coupon payments. n What is our yield to maturity?

P/YR = 2 Mode = end N = 16 PV = PMT = 50 FV = 1000 Solve I%YR = 12% YTM Example

Current Yield n Current yield:the ratio of the interest payment to the bond’s current market price. u Calculated by dividing the annual interest payment by the market price of the bond u A $1,000 bond with 10% coupon rate and market price of $700 Current yield = $100 / $700 = %

Zero Coupon Bonds n No coupon interest payments. n The bond holder’s return is determined entirely by the price discount.

Zero Example n Suppose you pay $508 for a zero coupon bond that has 10 years left to maturity. n What is your yield to maturity? $508 $1000

Zero Example P/YR = 1 Mode = End N = 10 PV = -508 FV = 1000 Solve: I%YR = 7%

The Financial Pages: Corporate Bonds Cur Net Yld Vol Close Chg Polaroid 11 1 / n What is the yield to maturity for this bond? P/YR = 2, N = 12, FV = 1000, PV = $-1,030, (assume it is year 2000) PMT = n Solve: I/YR = 10.81%

The Financial Pages: Corporate Bonds Cur Net Yld Vol Close Chg Honywll zr / 8 -1 n What is the yield to maturity for this bond? P/YR = 1, N = 9, FV = 1000, PV = $ , PMT = 0 (assume it is year 2000) n Solve: I/YR = 8.85%

The Financial Pages: Treasury Bonds Rate Mo/Yr Bid Asked Chg Yld 9 Nov 18127:16 127: Nov 18127:16 127: n What is the yield to maturity for this Treasury bond? (assume it is year 2000) P/YR = 2, N = 36, FV = 1000, PMT = 45, PV = - 1, ( % of par) n Solve: I/YR = 6.39%