1. Chapter 7 Bonds and their valuation
Finance
Chapter 7
Bonds and their valuation

2. 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)

3. 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

4. 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

5. 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

6. 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

7. 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

8. 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)

9. 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

10. 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)

11. 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)
… 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

12. 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.

13. 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

14. 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

15. 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.

16. 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

17. 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

18. 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’

19. 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

20. 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
Changes in ratings effect ability to borrow long-term capital and the cost of that capital

21. 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