1. FIN 360: Corporate Finance
Topic 9: Bonds and their Valuation
Larry Schrenk, Instructor

2. Bond Valuation Bond Basics Valuing Bonds
The Comparative Statics of Bonds
Interest Rate Risk
Technical Features of Bonds

3. Bond Basics

4. What is a Bond?
A long-term debt instrument in which a borrower agrees to make payments of principal and interest, on specific dates, to the holders of the bond.

5. Bond Markets Primarily traded in the over-the-counter (OTC) market.
Most bonds are owned by and traded among large financial institutions.
Full information on bond trades in the OTC market is not published, but a representative group of bonds is listed and traded on the bond division of the NYSE.

6. Bond Basics Coupons Par Value/Face Value/Principal
Coupon Rate (cr)
Fixed Payment
Bankruptcy Trigger
Par Value/Face Value/Principal
Period (typically semi-annual)
Maturity
Interest Rate

7. Features of a May Department Stores Bond
Terms Explanations
Amount of issue $125 million The company will issue $125 million worth of bonds.
Date of issue 2/28/86 The bonds were sold on 2/28/86.
Maturity 3/1/16 The principal will be paid in 30 years.
Annual coupon The denomination of the bonds is $1,000. Each bondholder will receive $92.50 per bond per year (9.25% of the face value).
Offer price 100 The offer price will be 100% of the $1,000 face value per bond.

8. Features of a May Department Stores Bond (concluded)
Terms Explanations
Coupon payment dates 3/1, 9/31 Coupons of $92.50/2 = $46.25 will be paid on these dates.
Security None The bonds are debentures.
Sinking fund Annual, toward The firm will make annual payments the sinking fund. beginning 3/1/97 Call Provision Not callable The bonds have a deferred call before 2/28/93
Call price initially, After 2/28/93, the company can buy declining to 100 back the bonds for $1, per bond, declining to $1,000 on 2/28/05.
Rating Moody’s A2 This is one of Moody’s higher ratings. The bonds have a low probability of default.

9. Bond Types Consols Zero-Coupon Bonds Fixed-Coupon Bonds
Variable Rate Coupon Bonds

10. Issuers of Bonds Government Corporate Home Mortgages
U.S. Treasury Securities
Treasury Inflation-Protected Securities (TIPS)
State and Local (‘Muni’s’)
Corporate
Corporate Bonds
Short-Term Debt
Commercial Paper
Home Mortgages

11. Bond Rating Agencies Agencies Distinction Standard & Poor's Moody's
Fitch Ratings
Distinction
Investment Grade Bonds
Junk Bonds

12. Bond Ratings Standard & Poor's System Investment Grade
AAA: the best quality companies, reliable and stable
AA: quality companies, a bit higher risk than AAA
A: economic situation can affect finance
BBB: medium class companies, which are satisfactory at the moment
Non-Investment Grade (also known as junk bonds)
BB: more prone to changes in the economy
B: financial situation varies noticeably
CCC: currently vulnerable and dependent on favorable economic conditions to meet its commitments
CC: highly vulnerable, very speculative bonds
C: highly vulnerable, perhaps in bankruptcy or in arrears but still continuing to pay out on obligations
CI: past due on interest
R: under regulatory supervision due to its financial situation
SD: has selectively defaulted on some obligations
D: has defaulted on obligations and S&P believes that it will generally default on most or all obligations
NR: not rated

13. Valuing Bonds

14. Valuing Bonds Bond Value = PV(cash flows) Two cash flows:
(semi-annual) fixed coupons
Par value at maturity.

15. Valuing Bonds Bond Value = PV(coupons) + PV(par value)
Coupons are an annuity
Par value is one time payment

16. Valuing Bonds
Formula for Bond Valuation
PV(Coupons) PV(Par Value)

17. Valuing Bonds
EXAMPLE
What is the present value of a four year, semi-annual bond with a par value of $1, and a coupon rate of 8% if the discount rate is 6%?

18. Valuing Bonds: Calculator
EXAMPLE
What is the present value of a four year, semi-annual bond with a par value of $1, and a coupon rate of 8% if the discount rate is 6%?
P/Y = 2; N = 8; I/Y = 6;
PV = $1,070.20; PMT = -40; FV = -1000
P/Y = 2 (semi-annual bond)
N = 8 (= 4 x 2)
PMT = 40 (= (1,000 x 0.08)/2) PMT = Period Cash Flow
Why these negative signs?

19. Yield to Maturity (YTM)
Discount rate such that
Price = PV(cash flows).
Expected return if the bond purchased at a fair value.

20. Yield to Maturity: Calculator
EXAMPLE
What is the YTM of a five year, semi-annual bond with a par value of $1,000 and a coupon rate of 9% if the bond is selling for $990?
P/Y = 2; N = 10; I/Y = 9.25%;
PV = 990; PMT = -45; FV = -1000
P/Y = 2 (semi-annual bond)
N = 10 (= 5 x 2)
PMT = 45 (= (1,000 x 0.09)/2) PMT = Period Cash Flow
Why these negative signs?

21. Valuing Bonds Two Notes on Yield to Maturity
YTM = expected return only when just purchased.
YTM versus realized/actual yield

22. Definitions

23. An Example: CY
Find the current yield and the capital gains yield for a 10-year, 9% annual coupon bond that sells for $887, and has a face value of $1,000.
Current Yield = $90 / $887
= = 10.15%

24. An Example: CGY YTM = Current Yield + Capital Gains Yield
CGY = YTM – CY
= 10.91% %
= 0.76%
Could also find the expected price one year from now and divide the change in price by the beginning price, which gives the same answer.

25. Yield to Call (YTC)
The yield of a bond if you were to buy and hold the security until the call date.
Calculation─Same as YTM but:
Use the periods to the call date (not maturity) for N
Use the call price (not par value) for FV

26. Yield to Call: Calculator
EXAMPLE
What is the YTC of a five year, semi-annual bond with a par value of $1,000 and a coupon rate of 9% if the bond is selling for $990, the call price is $1,100 and the call date is two years?
P/Y = 2; N = 4; I/Y = 14.09%;
PV = 990; PMT = -45; FV = -1100
P/Y = 2 (semi-annual bond)
N = 4 (= 2 x 2)
PMT = 45 (= (1,000 x 0.09)/2) PMT = Period Cash Flow
Why these negative signs?

27. The Comparative Statics of Bonds

28. T-P-S
You have two identical zero coupon bonds─except that the maturity of one is twice the maturity of the other. Will the price of the shorter bond…
More sensitive to changes in interest rates than the longer bond
As sensitive to changes in interest rates than the longer bond
Less sensitive to changes in interest rates than the longer bond

29. Price versus Interest Rate

30. T-P-S
You have two identical zero coupon bonds─except that the maturity of one is twice the maturity of the other. Will the price of the shorter bond be…
More than half the price of the longer bond
Half the price of the longer bond
Less than half the price of the longer bond

31. Price versus Coupon Rate

32. Price versus Time to Maturity

33. Factors Affecting Default Risk and Bond Ratings
Financial performance
Debt ratio
TIE ratio
Current ratio
Bond contract provisions
Secured vs. Unsecured debt
Senior vs. subordinated debt
Guarantee and sinking fund provisions
Debt maturity

34. Interest Rate Risk

35. Interest Rate Risk Interest Rate Risk Components
Value changes due to interest rate
Components
Price Risk
Reinvestment Risk
Note: Different from Textbook

36. Interest Rate Risk Price Risk Reinvestment Risk
Interest rates up/down ??
Reinvestment Risk

37. Technical Features of Bonds

38. Features of Bonds Examples Bond Covenant Sinking Fund
Technical Default

39. Premium versus Discount Bonds
Premium: cr > r
Price > par value
At par: cr = r
Price = par value
Discount: cr < r
Price < par value

40. Premium versus Discount Bonds
EXAMPLE
Consider a ten year, semi-annual, bond with a par value of $1,000 and a coupon rate of 8%:
r = 6% price = $1,
r = 8% price = $1,
r = 10% price = $

41. Types of Bond Values Book Value Liquidation Value Market Value
Intrinsic/Economic Value

42. Embedded Options
Like derivatives securities, e.g., call or put options
Types of Embedded Options
Call Provision
Conversion Provision

43. T-P-S A bond with a call option is worth… More than a straight bond
The same as a straight bond
Less than a straight bond

44. Other Types (Features) of Bonds
Warrant–Long-term option to buy a stated number of shares of common stock at a specified price.
Putable bond–Allows holder to sell the bond back to the company prior to maturity.
Income bond–Pays interest only when interest is earned by the firm.
Indexed bond–Interest rate paid is based upon the rate of inflation.

45. Protective Covenants Agreements to Protect Bondholders
Negative Covenants (Thou shalt not…):
Pay dividends beyond specified amount
Sell more senior debt and amount of new debt is limited
Refund existing bond issue with new bonds paying lower interest rate
Buy another company’s bonds
Positive Covenants (Thou shalt…):
Use proceeds from sale of assets for other assets
Allow redemption in event of merger or spinoff
Maintain good condition of assets
Provide audited financial information

46. Bond Investment Strategies
Interest Rate Strategy: Select bonds for investment based on interest rate expectations
Purchase long-term bonds if you expect interest rates to fall
Passive Strategy: Invest in a diversified portfolio of bonds that are held for a long period of time
Maturity Matching Strategy: Invest in bonds that will generate payments to match future expenses