MBF2273 Fund Management L2: Bonds and Bonds Valuation

L2: Bonds and Bonds Valuation www.notes638.wordpress.com MBF2273 | Fund Management Prepared by Dr Khairul Anuar L2: Bonds and Bonds Valuation www.notes638.wordpress.com

Introduction Bonds are like money market instruments, but they have maturities that exceed one year. These include Treasury bonds, corporate bonds, mortgages, and the like.

What is Bond Market? The bond market is a financial market where participants buy and sell debt securities , usually in the form of bonds. The bond market primarily includes: Government-issued securities. Corporate debt securities.

Types of Bond Domestic of Bonds Bonds issued in the country and currency in which they are traded. Unlike international bonds, domestic bonds are not subject to currency risk. They usually carry less risk, as the regulatory and taxation requirements are usually known to investors in domestic bonds, or at least to their brokers and accountants. International Bond A bond issued in a country or currency other than that of the investor or broker. They include : Eurobonds, which are issued in a foreign currency, foreign bonds, which are issued by a foreign government or corporation in the domestic market, and global bonds, which are issued in both domestic and international markets.

Deutsche Telekom Global Bond The largest corporate global bond issue to date is the $14.6 billion Deutsche Telekom multicurrency offering (year 2000). The issue includes three U.S. dollar tranches with 5-, 10-, and 30-year maturities totaling $9.5 billion, two euro tranches with 5- and 10-year maturities totaling €3 billion, two British pound sterling tranches with 5- and 30-year maturities totaling £950 million, and one 5-year Japanese yen tranche of ¥90 billion

Corporate Bonds: Characteristics of Corporate Bonds Registered Bonds Replaced “bearer” bonds IRS can track interest income this way Restrictive Covenants Mitigates conflicts with shareholder interests May limit dividends, new debt, ratios, etc. Usually includes a cross-default clause

Corporate Bonds: Characteristics of Corporate Bonds Call Provisions Higher yield Mechanism to adhere to a sinking fund provision Interest of the stockholders Alternative opportunities Conversion Some debt may be converted to equity Similar to a stock option, but usually more limited

Bond Terminology

Application of the Time Value of Money Tool: Bond Pricing Bonds - Long-term debt instruments Provide periodic interest income – annuity series Return of the principal amount at maturity – future lump sum Prices can be calculated by using present value techniques i.e. discounting of future cash flows. Combination of present value of an annuity and of a lump sum 10

Table 1: Bond Information August 1, 2008 11

Key Components of a Bond Figure 1: Merrill Lynch corporate bond. Par value : Typically $1000 Coupon rate: Annual rate of interest paid. Coupon: Regular interest payment received by holder per year. Maturity date: Expiration date of bond when par value is paid back. Yield to maturity: Expected rate of return based on price of bond 12

Key Components of a Bond Example 1: Key components of a corporate bond Let’s say you see the following price quote for a corporate bond:  Issue Price Coupon(%) Maturity YTM% Current Yld. Rating Hertz Corp. 91.50 6.35 15- Jun-2010 15.438 6.94 B Price = 91.5% of $1000$915; Annual coupon = 6.35% *1000  $63.50 Maturity date = June 15, 2010; If bought and held to maturityYield = 15.438% Current Yield = $ Coupon/Price = $63.5/$915  6.94% 13

Pricing a Bond in Steps Figure 2: How to price a bond. 14 Since bonds involve a combination of an annuity (coupons) and a lump sum (par value) its price is best calculated by using the following steps: Figure 2: How to price a bond. 14

Pricing a Bond in Steps (continued) Example 2: Calculating the price of a corporate bond. Calculate the price of an AA-rated, 20-year, 8% coupon (paid annually) corporate bond (Par value = $1,000) which is expected to earn a yield to maturity of 10%. Annual coupon = Coupon rate * Par value = .08 * $1,000 = $80 = PMT YTM = r = 10% Maturity = n = 20 Price of bond = Present Value of coupons + Present Value of par value Year 0 1 $80 2 3 20 $1,000 18 19 … 15

Pricing a Bond in Steps (continued) Example 2: Calculating the price of a corporate bond   Present value of coupons = = = $80 x 8.51359 = $681.09 Present Value of Par Value = Present Value of Par Value = $1,000 x 0.14864 = $148.64 Price of bond = $681.09 + $148.64 = $829.73 16

Pricing a Bond in Steps (continued) Method 2. Using a financial calculator Mode: P/Y=1; C/Y = 1 Input: N I/Y PV PMT FV Key: 20 10 ? 80 1000 Output -829.73 17

Semiannual Bonds and Zero-Coupon Bonds Most corporate and government bonds pay coupons on a semiannual basis. Some companies issue zero-coupon bonds by selling them at a deep discount. For computing price of these bonds, the values of the inputs have to be adjusted according to the frequency of the coupons (or absence thereof). For example, for semi-annual bonds, the annual coupon is divided by 2, the number of years is multiplied by 2, and the YTM is divided by 2. The price of the bond can then be calculated by using the TVM equation, a financial calculator, or a spreadsheet. 18

Semiannual Bonds and Zero-Coupon Bonds Figure 2: Coca-Cola semiannual corporate bond. 19

Semiannual Bonds and Zero-Coupon Bonds Figure 5: Future cash flow of the Coca-Cola bond. Using TVM Equation Using Financial Calculator 20

Semiannual Bonds and Zero-Coupon Bonds 21

Pricing Bonds after Original Issue The price of a bond is a function of the remaining cash flows (i.e. coupons and par value) that would be paid on it until expiration. As of August, 2008 the 8.5%, 2022 Coca-Cola bond has only 27 coupons left to be paid on it until it matures on Feb. 1, 2022 Figure 6.6 Remaining cash flow of the Coca-Cola bond. 22

Pricing Bonds after Original Issue Example 3: Pricing a semi-annual coupon bond after original issue: Four years ago, the XYZ Corporation issued an 8% coupon (paid semi-annually), 20-year, AA-rated bond at its par value of $1000. Currently, the yield to maturity on these bonds is 10%. Calculate the price of the bond today. Remaining number of semi-annual coupons = (20-4)*2 = 32 coupons = n Semi-annual coupon = (.08*1000)/2 = $40 Par value = $1000 Annual YTM = 10% YTM/25% = r 23

Pricing Bonds after Original Issue 24

Pricing Bonds after Original Issue Method 2: Using a financial calculator   Mode: P/Y=2; C/Y = 2 Input: N I/Y PV PMT FV Key: 32 10 ? 40 1000 Output -841.97 25

Zero-Coupon Bonds Known as “pure” discount bonds and sold at a discount from face value Do not pay any interest over the life of the bond. At maturity, the investor receives the par value, usually $1000. Price of a zero-coupon bond is calculated by merely discounting its par value at the prevailing discount rate or yield to maturity. 26

Amortization of a Zero-Coupon Bond Table 2: Amortized Interest on a Zero-Coupon Bond The discount on a zero-coupon bond is amortized over its life. Interest earned is calculated for each 6-month period. for example .04*790.31=$31.62 Interest is added to price to compute ending price. Zero-coupon bond investors have to pay tax on annual price appreciation even though no cash is received. 27

Amortization of a Zero-Coupon Bond Example 4: Price of and taxes due on a zero-coupon bond:   John wants to buy a 20-year, AAA-rated, $1000 par value, zero-coupon bond being sold by Diversified Industries Plc. The yield to maturity on similar bonds is estimated to be 9%. How much would he have to pay for it? How much will he be taxed on the investment after 1 year, if his marginal tax rate is 30%? 28

Amortization of a Zero-Coupon Bond Example 4 Answer Method 1: Using TVM equation Bond Price = Par Value * [1/(1+r)n] Bond Price = $1000*(1/(1.045)40   Bond Price = $1000 * .1719287 = $171.93 Method 2: Using a financial calculator   Mode: P/Y=2; C/Y = 2   Input: N I/Y PV PMT FV Key: 40 9 ? 0 1000 Output -171.93 29

Amortization of a Zero-Coupon Bond Example 4 (Answer) (continued) Calculate the price of the bond at the end of 1 year. Mode: P/Y=2; C/Y = 2 Input: N I/Y PV PMT FV Key: 38 9 ? 0 1000 Output -187.75 Taxable income = $187.75 - $171.93 = $15.82 Taxes due = Tax rate * Taxable income = 0.30*$15.82 = $4.75 30

Amortization of a Zero-Coupon Bond Example 4 (Answer) (continued) Alternately, we can calculate the semi-annual interest earned, for each of the two semi-annual periods during the year.  $171.93 * .045 = $7.736  Price after 6 months $171.93+7.736 = $179.667 $179.667 * .045=$8.084 Price at end of year $179.667+8.084 = $187.75 Total interest income for 1 year = $7.736+$8.084 $15.82  Tax due = 0.30 * $15.82 = $4.75 31

Yields and Coupon Rates A bond’s coupon rate differs from its yield to maturity (YTM). Coupon rate - set by the company at the time of issue and is fixed (except for newer innovations which have variable coupon rates) YTM is dependent on market, economic, and company-specific factors and is therefore variable. 32

The First Interest Rate: Yield to Maturity Expected rate of return on a bond if held to maturity. The price that willing buyers and sellers settle at determines a bond’s YTM at any given point. Changes in economic conditions and risk factors will cause bond prices and their corresponding YTMs to change. YTM can be calculated by entering the coupon amount (PMT), price (PV), remaining number of coupons (n), and par value (FV) into the TVM equation, financial calculator, or spreadsheet. 33

The “Other” Interest Rate: Coupon Rate The coupon rate on a bond is set by the issuing company at the time of issue It represents the annual rate of interest that the firm is committed to pay over the life of the bond. If the rate is set at 7%, the firm is committing to pay .07*$1000 = $70 per year on each bond, It is paid either in a single check or two checks of $35 paid six months apart. 34

Relationship of Yield to Maturity and Coupon Rate An issuing firm gets the bond rated by a rating agency such as Standard & Poor’s or Moody’s. Then, based on the rating and planned maturity of the bond, it sets the coupon rate to equal the expected yield as indicated in the Yield Book (available in the capital markets at that time) and sells the bond at par value ($1000). Once issued, if investors expect a higher yield on the bond, its price will go down and the bond will sell below par or as a discount bond and vice-versa. Thus, a bond’s YTM can be equal to (par bond), higher than (discount bond) or lower than (premium bond) its coupon rate. 35

Relationship of Yield to Maturity and Coupon Rate Table 6.3 Premium Bonds, Discount Bonds, and Par Value Bonds 36

Relationship of Yield to Maturity and Coupon Rate Figure 8: Bond prices and interest rates move in opposite directions. 37

Bond Ratings Ratings are produced by Moody’s, Standard and Poor’s, and Fitch Range from AAA (top-rated) to C (lowest-rated) or D (default). Help investors gauge likelihood of default by issuer. Assist issuing companies establish a yield on newly-issued bonds. Junk bonds: is the label given to bonds that are rated below BBB. These bonds are considered to be speculative in nature and carry higher yields than those rated BBB or above (investment grade).   Fallen angels: is the label given to bonds that have had their ratings lowered from investment to speculative grade. 38

Table 4: Bond Ratings 39

Rating Criteria Profitability Capital Structure Business Model Management ·          Quality of earnings ·          EBITDA margins ·          Interest coverage indicators ·          Volatility of earnings ·          Cost Management   ·          Indebtedness ratios ·          Distribution of debt maturities ·          Effects of concentrated ownership on funding capabilities ·          Barriers to entry ·          Competitive environment ·          Market position ·          Diversification: Clients, Products, Geographic ·          Management Structure ·          Strategy and Objectives ·          Performance Record

U.S. Government Bonds Include bills, notes, and bonds sold by the Department of the Treasury State bonds, issued by state governments Municipal bonds issued by county, city, or local government agencies. Treasury bills, are zero-coupon, pure discount securities with maturities ranging from 1-, 3-, and 6-months up to 1 year. Treasury notes have between two to 10 year maturities. Treasury bonds have greater than 10-year maturities, when first issued. 41

6. U.S. Government Bonds Table 6.6 Government Notes and Bonds, Prices as of April 8, 2008 42

FIGURE 7: Goodyear semiannual corporate bond. 43