Chapter 7 Bonds and their valuation Finance Chapter 7 Bonds and their valuation

Introduction to bonds A bond is a long-term promissory note issued by a business or governmental unit. The issuer receives money in exchange for promising to make interest payments and to repay the principal on a specified future date. U.S. Treasury bonds (government bonds) Issued by the U.S. Government No default risk Prices decline when interest rates rise (risk)

Types of bonds Treasury bonds Corporate bonds Default risk (credit risk) Municipal bonds (“munis”) Default risk lower than corporate bonds Tax exempt Foreign bonds Default risk Exchange rate risk

Characteristics of bonds Differences in bonds, e.g.: corporate bonds have provisions for early repayment Underlying corporate strengths vary Par value = the face value, the amount of money borrowed Coupon payment = the number of dollars interest paid each period (usually 6 months) Coupon interest rate = the stated annual interest rate on a bond

Coupon interest rates Floating bond rate = interest rate tied to Treasuries or some other interest rate Convertible – to a fixed rate Cap – upper limit Floor – lower limit Zero coupon bond = pays no annual interest rate but sold at a discount (below par) “Zeros” Compensation is not interest but in capital appreciation Original issue discount (OID) bond = some interest paid but not enough to issue the bond at par

Bond characteristics Maturity date = a specified date on which the par value of a bond must be repaid. Original maturity = the number of years to maturity at the time the bond is issued Call provisions = a contract provision giving the bond issuer the right to redeem the bonds under specified conditions prior to the maturity date Call premium Deferred call & call protection Protects a company when interest rates fall, but may be create a loss for the investor

Bond characteristics Sinking funds = a bond provision requiring the issuer to retire a portion of the bond issue each year using the least cost method: Company can call in bonds for redemption at par value if interest rates have fallen (no call premium paid) Buy the bonds on the open market at a discount if interest rates have risen causing the price of bonds to fall Cash drain on the issuer Subject to default

Other bond features Convertible bonds = a bond that can be exchanged for common stock at a fixed price Lower coupon rates Opportunity for capital gains if stock prices rise See website article link Warrants = a long term option to buy a stated number of shares of common stock at a specified price (similar to convertible bonds)

Other bond features Putable bonds = bond holder may sell the bonds back to the issuer at a prearranged price prior to maturity. Cf. callable bonds Income bond = a bond that pays interest only if the interest is earned Protects company from bankruptcy Riskier for the investor Indexed (purchasing power) bond = interest payment is based on an inflation index to protect the investor

Junk bonds Junk bonds are high risk, high-yield instruments issued by firms with very high debt ratios. Reasons for issuing: About 2/3 are issued for takeovers (including LBO’s) Revise a firm’s capital structure (proceeds used to buy back stock)

Bond valuation The value of the bond is the present value of cash flows the bond is expected to produce: Interest payments (annuity) during the life of the bond + The amount borrowed (principal) 0 1 2 3 4 5 6 ….. N kd% is the discount rate used to calculate the PV of the bond’s cash flows. kd% is not the coupon rate unless the the bond is selling at par. kd% Bond’s value INT INT INT INT INT INT INT kd% = bond’s market rate of interest M

Bond valuation kd% = bond’s market rate of interest Kd = the bond’s market rate of interest. This is the discount rate that is used to calculate the PV of the bond’s cash flow. Kd equals the coupon rate only if the bond is selling at par. Generally, most coupon rates are issued at par, thereafter, the rate will change.

Changes in bond value over time New issue = a bond that has been within the past 30 days Outstanding bond (seasoned issue) = a bond whose issue date is greater than 30 days Discounted bond = a bond that sells below its par value; occurs whenever the going rate of interest is above the coupon rate Premium bond = a bond that sells above its par value; occurs whenever the going rate of interest is below the coupon rate

Changes in bond value over time Whenever kd is equal to the coupon rate, a fixed-rate bond will sell at its par value. Normally, the coupon rate is set equal to the going rate when a bond is issued. Interest rates do change over time, but the coupon rate remains the same If interest rates rise above the coupon rate, a fixed bond’s price will fall below its par value = discount bond If interest rates fall below the coupon rate, a fixed bond’s price will rise above its par value = premium bond

Changes in bond value over time An increase in interest rates will cause the prices of outstanding bonds to fall, while a decrease in rates will cause bond prices to rise. The market value of a bond will always approach par value as its maturity date approaches.

Bond yields Bond yields change daily depending on market conditions. Yields are calculated 3 ways Yield to maturity (YTM) = the rate of return if the bond is held to maturity; generally the same as the market rate of interest, Kd Yield to call (YTC) = the rate of return if it is called before maturity; likely if interest rates are significantly below the coupon rate Current yield = the annual interest payment on a bond divided by the bond’s current price

Assessing a bond’s riskiness Interest rate risk = the risk of a decline in a bond’s price due (value) to an increase in interest rates. The longer the maturity of a bond, the more its price changes in response to interest rate changes. Reinvestment rate risk = the risk that a decline in interest rates will lead to a decline in income from a bond portfolio Callable bonds Investment horizon = the period of time an investor plans to hold a particular investment

Default risk Investors will pay less for bonds with greater risk for default. Bond type affects risk: Mortgage bond = a bond backed by a fixed asset. First mortgage bonds are senior in priority to claims of second mortgage bonds Indenture = a formal agreement between the issuer of bond and the bondholders spelling out the rights of the bondholder and the corporation Places limits on the %age of total property that can be used to back a bond offering Indenture terms may limit the amount of new bonds that can be issued to a fixed percentage of total ‘bondable property’

Default risk Debentures = a long-term bond not secured (unsecured) by a mortgage on a specific property Strong companies have no need to put up property as security for their debt (Exxon Mobil) Weak companies may use if already pledged most of their assts as collateral for mortgage loans. High risk – will bear high interest rates Subordinated debentures = a bond having a claim on assts only after the senior debt has been pad off in the event of liquidation

Bond ratings Rating agencies: Moody’s Investor Services Standard & Poor’s Corporation (S&P) Fitch Investors Service Investment-grade bonds = Bonds rated triple-B or higher Junk bond = a high-risk, high-yield bond Bond rating criteria: pages 288-289 Changes in ratings effect ability to borrow long-term capital and the cost of that capital

Bankruptcy & Reorganization Insolvent = insufficient cash to meet interest & principal payments Remedies Liquidation – dissolve the firm Reorganization – usually with a restructuring of the debt Decision depends on whether the value of the firm is more or less than the value of its assets sold off piecemeal