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Bonds and Their Valuation

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Bonds and Their Valuation Bonds and Their Valuation After reading this chapter, students should be able to: • List the four main classifications of bonds and differentiate among them. • Identify the key characteristics common to all bonds. • Calculate the value of a bond with annual or semiannual interest payments. • Explain why the market value of an outstanding fixed-rate bond will fall when interest rates rise on new bonds of equal risk, or vice versa. • Calculate the current yield, the yield to maturity, and/or the yield to call on a bond. • Differentiate between interest rate risk, reinvestment rate risk, and default risk. • List major types of corporate bonds and distinguish among them. • Explain the importance of bond ratings and list some of the criteria used to rate bonds. • Differentiate among the following terms: Insolvent, liquidation, and reorganization. • Read and understand the information provided on the bond market page of your newspaper Characteristics of Bonds A bond is a long-term contract under which a borrower (the issuer) agrees to make payments of interest and principal, on specific dates, to the holders (creditors) of the bond. Bearer bond - Bonds that are not registered on the books of the issuer. Such bonds are held in physical form by the owner, who receives interest payments by physically detaching coupons from the bond certificate and delivering them to the paying agent. Registered bond - A bond whose issuer records ownership and interest payments. Differs from a bearer bond, which is traded without record of ownership and whose possession is the only evidence of ownership. 1 Par value - Also called the maturity value or face value; the amount that an issuer agrees to pay at the maturity date. Coupon interest rate - With bonds, notes, or other fixed income securities, the stated percentage rate of interest, usually paid twice a year (semiannually). Coupon payments - A bond's dollar interest payments. Maturity date - Date on which the principal amount of a bond or other debt instrument becomes due and payable. Call provision - An embedded option granting a bond issuer the right to buy back all or part of an issue prior to maturity. Bond indenture - Contract that sets forth the promises of a corporate bond issuer and the rights of investors. Sinking fund - A fund to which money is added on a regular basis that is used to ensure investor confidence that promised payments will be made and that is used to redeem debt securities or preferred stock issues. Sinking fund provision - A condition included in some corporate bond indentures that requires the issuer to retire a specified portion of debt each year. Convertible bond - General debt obligation of a corporation that can be exchanged for a set number of common shares of the issuing corporation at a prestated conversion price. Warrant - A security entitling the holder to buy a proportionate amount of stock at some specified future date at a specified price, usually one higher than current market price. Warrants are traded as securities whose price reflects the value of the underlying stock. Corporations often bundle warrants with another class of security to enhance the marketability of the other class. Warrants are like call options, but with much longer time spans-sometimes years. And, warrants are offered by corporations, while exchange-traded call options are not issued by firms. Bond Valuation The value of any financial asset -– a stock, a bond, etc., or even a physical asset -– is simply the present value of the cash flows (discounted at the asset’s required rate of return) which the asset is expected to generate over its lifetime. 2 CF CF CF CF n CF VALUE = PV = 1 + 2 + 3 + ... + n = ∑ t . + 1 + 2 + 3 + n + t (1 k) (1 k) (1 k) (1 k) t = 1 (1 k) Bond terminology: kd = the bond’s market rate of interest or required rate of return; also called the yield to maturity (YTM); (can change many times over the bond’s life). N = the number of years before the bond matures. M = the par, or maturity, value of the bond (usually $1,000). CIR = the coupon interest rate (does not change over the bond’s life). INT = the dollar amount of interest the bond pays per year (INT = CIR x M). Note: Always discount the bond’s cash flows with kd. Bond valuation model with annual coupons: N ∑ INT + M t N INT(PVIFA kd,n) + M(PVIF kd,n) VB = = + + = t 1 (1 kd) (1 kd) Bond valuation model with semi-annual coupons: ∑2N INT/2 M t 2N INT/2(PVIFA kd/2,2n) + M(PVIF VB = = + + + = t 1 (1 kd/2) (1 kd /2) kd/2,2n) Zero Coupon bond valuation model: n VZero = M/(1 + kd) = M(PVIFkd,n) Bond Valuation: Important Relationships • A decrease in interest rates (required rates of return) will cause the value of a bond to increase; an interest rate increase will cause a decrease in value. The change 3 in value caused by changing interest rates is called interest rate risk. A bondholder owning a long-term bond is exposed to greater interest rate risk than when owning a short-term bonds. • The market value of the bond will always approach its par value as its maturity date approaches, provided the firm does not go bankrupt. • If the bondholder's required rate of return (current interest rate) equals the coupon interest rate, the bond will sell at "par," or maturity value. • If the current interest rate exceeds the bond's coupon rate, the bond will sell below par value or at a "discount." • If the current interest rate is less than the bond's coupon rate, the bond will sell above par value or at a "premium." Bond Yields Yield to maturity - The percentage rate of return paid on a bond, note, or other fixed income security if the investor buys and holds it to its maturity date. The calculation for YTM is based on the coupon rate, length of time to maturity, and market price. It assumes that coupon interest paid over the life of the bond will be reinvested at the same rate. INT + [(M – VB)/n] Estimated YTM = -------------------------- (M + 2VB)/3 Current yield - The annual interest payment on a bond divided by the bond's current price. Current yield = INT/VB Capital gains (loss) yield - The price change portion of a bond's return. Capital gains (loss) yield = (VB+1 - VB)/VB Therefore, the total return on a bond is equal to the bond's YTM, and the YTM = Current yield + Capital gains (loss) yield. YTM = INT/VB + (VB+1 - VB)/VB 4 Yield to call - The percentage rate of return on a bond or note if the investor buys and holds the security until the call date. This yield is valid only if the security is called prior to maturity. Generally bonds are callable over several years and normally are called at a slight premium. The calculation of yield to call is based on coupon rate, length of time to call, call price and market price. INT + [(Call Price – VB)/Years to Call] Estimated YTC = ----------------------------------------- (Call Price + 2VB)/3 Yield to maturity on a zero coupon bond: 1/n YTMZero = (M/VZero) - 1.0 Types of bonds • Treasury bonds - Debt obligations of the US Treasury that have maturities of 10 years or more. • Municipal bond - State or local governments offer muni bonds or municipals, as they are called, to pay for special projects such as highways or sewers. The interest that investors receive is exempt from some income taxes. • Foreign bond - A bond issued on the domestic capital market of another country. • Corporate bonds - Debt obligations issued by corporations. 1. Mortgage bond - A bond in which the issuer has granted the owner a lien against the pledged assets. 2. Debenture - Any debt obligation backed strictly by the borrower's integrity, e.g. an unsecured bond. A debenture is documented in an indenture. 3. Subordinated debenture bond - An unsecured bond that ranks after secured debt, after debenture bonds, and often after some general creditors in its claim on assets and earnings. Bond Ratings Bond ratings are critical to a company's ability to issue debt at an acceptable interest rate. 5 1. What is the purpose of rating debt? Answer: Unrated debt is extremely difficult, if not impossible to sell. Corporations desiring to sell bonds must submit their proposals to an independent rating company like Moody's Investor Service or Standard & Poor’s Corporation for the debt to be assigned a rating. This rating, coupled with market rates of interest and the special features of the debt, will determine how much the company will have to pay in interest. 2. Why would a company's debt rating be changed subsequent to issue? Answer: Any time new information relevant to the company's ability to repay the debt (i.e. changes in the company's financial health) is discovered and determined to be of sufficient impact, that company's debt rating might be changed. Obviously, good information should result in a better rating or upgrade and bad information should result in a downgrade. 3. What impact would a change in debt rating have on the value of an outstanding bond? Answer: Bonds of companies that suffered downgrades would decline in value to equate the yield to the new level of risk. Conversely, bonds that were upgraded should increase in price. Bond ratings are important for firms raising capital via a debt offering. Companies that are financially sound enough to get a higher rating will be able to sell debt with lower interest payments than their riskier counterparts.
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