1. Finance 300 Financial Markets Lecture 19 Fall, 2001© Professor J. Petry http://www.cba.uiuc.edu/broker/fin300/fin300pp.htm

2. 2 Chapter VII – Corporate & Other Issues Corporate Bonds Accrued Accounting (cont’d): Things to Do VII-1 –On June 13 th, 2000 you put in an order for a $1,000,000 12 3/8 May 15 th 2007, corporate bond quoted at 132 ¾. 1.What is the purchase price of this bond before accrued interest? 2.Accrued interest for how many days, adds how much to the price of the bond? 3.What is the total invoice price of the bond? 4.When will you receive your first coupon? 5.How much will you receive on the first coupon date? 6.On the first coupon payment date, you will have earned how much interest over how many days? 7.What is the yield to maturity of this bond? What is the invoice price? 8.What would the yield to maturity be if this bond were a Treasury Bond, instead of a corporate? What is the invoice price?

3. 3 Chapter VII – Corporate & Other Issues Corporate Bonds Accrued Accounting (cont’d): Things to Do VII-1

4. 4 Chapter VI – Government Bonds

5. 5 Treasury Notes & Treasury Bonds: Secondary Market – Example: You buy the 4-3/4 of 01 on June 13, 2000 What is the YTM of this instrument assuming the quote from the previous page is actual? What is the invoice price? If the instrument were a corporate bond, instead what would the YTM be? What is the accrued interest? (Assume August 15 th maturity).

6. 6 Chapter VII – Corporate & Other Issues Corporate Bonds Sinking Fund Provisions: Some bonds require the issue to be repaid on a regular basis before maturity. A Sinking Fund is one way to accomplish this. A reserve account is established to repay the principal on the bond once it becomes due. If the firm is unable to meet the sinking fund requirements, the bondholders can demand that the issue be redeemed. Call provisions Allows the issuer to redeem all or part of the issue prior to maturity. Terms vary, but they typically provide that the issuer can call the bond at par value plus a declining premium. Many callable bonds are restricted in the first few years of the issue, some bonds are non-callable, and some are non-callable for refunding. Being non- callable for refunding means the firm cannot use new bond funding to call back their previous bond, though they can use other funds to call the bond. Bond callability significantly impacts the value of the bond for issuer and buyer.

7. 7 Chapter VII – Corporate & Other Issues Corporate Bonds Call provisions impact on issuer: The call provision gives the issuer an option to call the old bond and refinance in whatever way they would like if circumstances so warrant. Generally, if interest rates go down, they will want to refinance, taking advantage of lower interest rates. Assume IBM issues a 30 year bond at 7% on June 15 th 1985. Therefore IBM is agreeing to pay $35 dollars every six months per $1000 face value of bond issued—let’s assume they issue 10,000 such bonds for a total face value of $10,000,000.00. Assume this bond is callable after 10 years, with a 10% premium to face value which declines ½ % every year thereafter. It is now June 30 th, 1995, and interest rates have fallen from 7% to 5%. Without the callable feature what should the investor in this bond be able to sell this bond for? According to the terms of the indenture, the bond can be called at a premium of 10%, or $1,100 per bond. Call10,000 7% bonds at $1,100 each-$11,000,000.00 Issue 11,000 5% bonds at $1,000 each $11,000,000.00

8. 8 Chapter VII – Corporate & Other Issues Corporate Bonds Call provisions impact on issuer (cont’d): Principal Payment in 2015 under 7% bond-$10,000,000.00 Principal Payment in 2015 under 5% bond Less-$11,000,000.00 Principal Savings under 7% bond+ $1,000,000.00 Semi-annual Coupon under 7% bond($35*10,000=)- $350,000.00 Semi-annual Coupon under 5% bond ($25*11,000=) Less - $275,000.00 Semi-annual coupon savings under 7% bond- $ 75,000.00 Semi-annual coupon savings under 5% bond+ $ 75,000.00 The value of having the call under these conditions is equivalent to the summation of these cash flows. The corporation has to pay an additional $1,000,000 in principal at maturity of the 5% bond compared to the 7% bond, but gains the benefit of having the lower coupon payments along the way.

9. 9 Chapter VII – Corporate & Other Issues Corporate Bonds Call provisions impact on issuer (cont’d): Let’s rely on our old price valuation formula to help us find out what these flows net out to be worth to the corporation: Recall that this equation did nothing more than find the NPV of a series of constant cash flows evaluated at a constant interest rate (the first portion of the equation), and then add this value to the NPV of a single cash flow (the second portion of the equation). Here Price is the price difference between two principal values owed in ’15 (which favors the 7% bond) and C is the $75,000 per period (which favors the 5% bond). n=20, y=.05.

10. 10 Chapter VII – Corporate & Other Issues Corporate Bonds Call provisions impact on issuer (cont’d): Looking at this same series of cash flows from the investors’ viewpoint: –The initial investment, from the perspective of 1985 offers what promised yield? –Now, in 1995, with yields at 5%, and ignoring any call provisions John Q. Investor calculates his holding period yield if he were to sell immediately. He calculates that yield to be: –Unfortunately for J.Q., his much more successful brother G.Q. informs him that he should have calculated the YTC (yield to call) which he is shown, works out to be: –He then is further instructed on how to calculate his realized yield to maturity (1985 to 2015 investing at the 5% bond in 1995), which he finds is:

11. 11 Chapter VII – Corporate & Other Issues Corporate Bonds Call provisions impact on issuer (cont’d):

12. 12 Chapter VII – Corporate & Other Issues Corporate Bonds Call provisions impact on issuer (cont’d):

13. 13 Chapter VII – Corporate & Other Issues Corporate Bonds Call provisions impact on issuer (cont’d): Calculating the Realized yield to maturity requires calculating what the combined yield for 10 years (7%) assuming purchase of the original bonds, and the yield from the 20 year (5%) bonds which he purchased with the proceeds of the called 10 year bonds. We do this by tracking the cash flows: In June 1985 he purchases 10 ‘15 with 7% coupon for $1,000 each –net cost of 10,000 –he receives 350 every 6 months for 10 years (20 payments). We have to NPV this cash flow to determine its worth. –he also receives $1,100 for each of 10 bonds ($11,000), which he trades in for 11 new $1,000 bonds with a 5% coupon. This is net cash flow of zero. –He then receives 275 every 6 months for 19-1/2 years, plus the final payment of 11,275 at maturity. Both of these cash flows also must be NPV’d.

14. 14 Chapter VII – Corporate & Other Issues Corporate Bonds Call provisions impact on issuer (cont’d):

15. 15 Chapter VII – Corporate & Other Issues Corporate Bonds-- Accrued Accounting (cont’d): TTD VII-2 Assume that in 1995 the required yield for the IBM 7% 2015 bond (described in the above example) is 7%. –What is the price of this bond in 1995? If market yields are at 7% will IBM call the bond? Why? –If John Q. Investor sells the bond in 1995 at this price, what is his holding period yield? By the year 2000 the interest rates fall again. Market yields are now 5%, but the call penalty declines 1/2% for every year. (10% in 1995, 91/2% in 1996, etc.). –What is the call price in 2000? –If IBM calls the issue and finances the recall with a new 15 year bond issue at 5% how much does IBM save on its semi-annual coupon payment? What is the net present value of the saving? –What is the yield-to-call if the IBM bond is called in 2000? –If John Q. Investor uses the proceeds from the called bonds to buy the new IBM 5% 2015 bonds what is his realized yield-to-maturity on the original bond purchase?