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 C t =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