Bond Valuation

Assignment Tips
There is no restriction on how you should write your
assignment
However, your assignment should have a clear
structure you should use the general marking
criteria to guide your report
the
th target
t t is
i to
t provide
id a high
hi h quality
lit professional
f i l
analysis that will inform and convince a reasonably
sophisticated reader the marker!
Remember: DO NOT copy and paste any materials
from anywhere.
- You will be caught by the auto-checking system, and the
consequence is severe

Topics Covered Today

We have been focusing on capital structure
in the past two weeks where we learned the
importance of debt in corporate finance
This week we will take a look at how
corporations manage their bonds
- Real and Nominal Rates of Interest
- How interest rate changes affect bond prices
(Duration)
- The Term Structure and YTM
- Bond risk

1
 Debt & Interest Rates
Classical Theory of Interest Rates (Economics), developed by
Irving Fisher

1+rr = (1+rn)/(1+i)
where rr = real interest rate;
rn = nominal interest rate ;
i = expected inflation rate

Nominal Interest Rate = The rate you actually pay when you
borrow money
Real Interest Rate = The real rate you pay after accounting
for changes in the purchasing power of money

Debt & Interest Rates

Approximation:
1 + rn = (1 + rr)(1 + i)
14
1 + rn = 1 + rr + i + rri UK real and nominal bond yields
12
rn = rr + i + rri 10
Nominal Yield on UK 10 yr bonds
rn = rr + i,
Perrcent

as rri is relatively
relati el small 6

Real r is theoretically 2 Real Yield on UK 10 yr bonds

somewhat stable, 0
Jan-85
Jan-86
Jan-87
Jan-88
Jan-89
Jan-90
Jan-91
Jan-92
Jan-93
Jan-94
Jan-95
Jan-96
Jan-97
Jan-98
Jan-99
Jan-00
Jan-01
Jan-02
Jan-03
Jan-04

while inflation is a
large variable

2
 Valuing a Bond

T
C F
PV
t 1 (1 r ) (1 r )T
t

Value of a bond is comprised of:

1) PV of all coupons
2) PV of the face value

Valuing a Bond
Example
If today is October 2005, what is the value of the following
bond? An IBM Bond pays $115 every Sept for 5 years. In
Sept 2010 it pays an additional $1000 and retires the bond.
The bond is rated AAA ((WSJ AAA YTM is 7.5%))

Cash Flows
Sept 06 07 08 09 10
115 115 115 115 1115

3
 Valuing a Bond
Example continued
If today is October 2005, what is the value of the following
bond? An IBM Bond pays $115 every Sept for 5 years. In
Sept 2010 it pays an additional $1000 and retires the bond.
The bond is rated AAA ((WSJ AAA YTM is 7.5%))
115 115 115 115 1,115
PV
1.075 1.0752 1.0753 1.0754 1.0755

$1,161.84

Bond Prices and Yields

1600

1400

1200

1000
Prrice

800

600 Longer maturity bonds are

400 more price sensitive to
200 interest rate changes
0
0 2 4 6 8 10 12 14

5 Year 9% Bond 1 Year 9% Bond

Yield

Duration
Duration is the sensitivity of a bond's price to
interest rate movements.

A Linear estimate of Duration is:

n
PV (Ci ) ti
D
i 1 V

4
 Duration Calculation

How to calculate
Proportion of Total Value Proportion of Total
Year Ct PV(Ct) at 2.75% [PV(Ct)/V] Value Time
1 55 53.53 0.049 0.049
2 55 52.1 0.047 0.094
3 55 50.7 0.046 0.138
4 1055 946.51 0.858 3.433
V = 1102.83 1 Duration= 3.714 years

Duration
Example (Bond 1)
Calculate the duration of a 5-year 6 7/8% bond @ 4.9% YTM
with a face value of $1,000
Year CF PV@YTM % of Total PV % x Year
1 68.75 65.54 .060 0.060
2 68.75 62.48 .058 0.115
3 68.75 59.56 .055 0.165
4 68.75 56.78 .052 0.209
5 1068.75 841.39 .775 3.875
1085.74 1.00 Duration 4.424

Duration
Example (Bond 2)
Given a 5 year, 9.0%, $1000 bond, with a 8.5% YTM, what is
this bonds duration?

Year CF PV@YTM % of Total PV% x Year

1 90 82 95
82.95 .081
081 0 081
0.081
2 90 76.45 .075 0.150
3 90 70.46 .069 0.207
4 90 64.94 .064 0.256
5 1090 724.90 .711 3.555
1019.70 1.00 D= 4.249

5
 Duration
What does duration measure really?
P
n
PV (Ci ) ti
D P
i 1 V (1 r )
(1 r )

Duration measures the percentage of price

change given a certain percentage change in
interest rate
Mathematically it is the first partial derivative of
the bond price with respects to 1+r.

Duration & Bond Prices

Bond Pricce, percent

Interest rate, percent

An important application of duration is bond risk immunization
See Excel example on sensitivity of during to yield and coupon

Term Structure
The Term Structure of Interest Rates (also called Yield Curve)
is the relation between the interest rate and the time to maturity
of the debt.
5
4.5
4
3.5
Percent

3
2.5
2
1.5
1
0.5
0
Maturity Year

6
 Spot/Forward rates
Spot Rate the (annualized) interest rate charged for
money held from now to time t.
Forward Rate the rate of interest charged for money
held between two periods in the future, but agreed upon
today.
For j>i:

(1 s j ) j (1 si ) i (1 f i , j ) j i
1
(1 s j ) j ( j i )
fi, j i
1
(1 si )

Spot/Forward rates
Why must the spot/forward rate relationships hold
true?

(1 s j ) j (1 si ) i (1 f i , j ) j i

Say you have the option of taking a 2 year investment, or

two 1 year investments
investments
- The two year investment pays the 2-year spot rate of
10%
- The one year investment today offers 9% today, and
expected to return 12% from years 1 to 2
- Then there are arbitrage opportunities!

Spot/Forward rates
Example
What is the 3rd year forward rate?
2 year zero-coupon treasury YTM = 8.995 (2 year spot)
3 year zero-coupon treasury YTM = 9.660 (3 year spot)
1

(1 s ) j ( j i )

Answer: f 1
j

(1 s )
i, j i
i
1

(1 s ) 3 ( 3 2 )

f 1
3

(1 s )
2,3 2
2

(1 0.09660) 3

f 1
(1 0.08995)
2,3 2

f 11%
2,3

7
 Spot/Forward rates
Example
Bond A: 8% 10 yr bond, price = 85.89
Bond B: 10% 10 yr bond, price = 98.72
Bond C: 9 yr zero coupon bond, price = 37.54
All with a face value of $100
Calculate the 10 year spot rate, and the forward
rate between years 9 and 10.

Spot/Forward rates
To calculate 10 year spot price:
Spot rates can be determined using two coupon bonds
that have identical maturity, but different coupon rates.
The idea is to construct a portfolio of the two bonds in
such a way, that the coupons cancel each other out,
and youre
you re left with a zero coupon bond.
bond

- Buy 1.0 of A and -0.8 of B, costing you 6.914

- There are no coupons, as they net out, and youre left
with a zero coupon bond with a face value of 20
- 20 = 6.914 x (1+s10)10
- s10=11.2%

Spot/Forward rates
To calculate spot rate from year 9 to 10:
- Using Bond C, a zero coupon bond, we calculate the interest rate
from now to year 9, which is the 9 year spot rate
- 37.54 = 100/(1+s9)9
- s9= 11.5%
- Th
Then use the
h spot/forward
/f d rate formula
f l to calculate
l l fforward
d rate
from year 9 to 10
1
(1 s10 )10 (10 9 )
f 9,10 9
1
(1 s9 )
(1 0.112)10
f 9,10 9
1
(1 0.115)
f 9,10 8.54%

8
 Term Structure
YTM (r)

Year
1 5 10 20 30
What Determines the Shape of the Term Structure?
1 - Expectations Theory
Forward rates are unbiased estimators of future interest rates
2 - Liquidity Premium Theory
Forward rates are upwardly biased estimators of expected future spot rates
3 - Market Segmentation Hypothesis
The yield curve reflects the actions and preferences of certain major
participants in the bond market

Term Structure
Term Structure & Capital Budgeting/Valuation
CF should be discounted using Term Structure info

p rate incorporates
Since the spot p all forward rates,,
then you should use the spot rate that equals the
term of your project.

If the spot/forward rates are inconsistent, arbitrage!

Yield to Maturity
Yield to maturity is the average rate of return you
earn on the bond over its life.

The term structure tells us the spot rate for each CF

in our bond. The YTM gives us an average, over
many different spot rates.

It is calculated as the IRR of an investment, setting

NPV as zero.

9
 Yield to Maturity
Example
A $1000 treasury bond expires in 5 years. It pays a
coupon rate of 10.5%. If the market price of this
bond is 1078.80, what is the YTM?

C0 C1 C2 C3 C4 C5
-1078.80 105 105 105 105 1105

Calculated IRR = 8.5% (approx)

Valuing Risky Bonds

The risk of default changes the price of a bond and the YTM.
Example
We have a 5% 1 year bond. The bond is priced at par of $1000. But,
there is a 20% chance the company will go into bankruptcy and only pay
$500. What is the bonds value?

Valuing Risky Bonds

Example
We have a 5% 1 year bond. The bond is priced at par of $1000.
But, there is a 20% chance the company will go into bankruptcy
and only pay $500. What is the bonds value?
A: Bond Value Prob
1,050 .80 = 840.00
500 .20 = 100.00 .
940.00 = expected CF

940
Value $895
1.05
1050
YTM 1 17.3%
895

10
 Valuing Risky Bonds

Example Continued
Conversely - If on top of default risk, investors require an additional 3
percent market risk premium, the price and YTM is as follows:

940
Value $870.00
1.08
1050
YTM 1 20.7%
870.00

Key to Bond Ratings

Moody's S&P's & Fitch
Investment Grade
Aaa AAA
Aa AA
A A
Baa BBB
Junk Bonds Th highest
The hi h t quality
lit bonds
b d
Ba BB are rated triple-A.
B B Investment grade bonds
Caa CCC
have to be equivalent of
Ca CC
Baa or higher. Bonds that
C C
dont make this cut are
called high-yield or
junk bonds.

Bond Ratings and Default

Default rates of corporate bonds 1981-2003 by
S&Ps rating at time of issue

Percentage Defaulting W ithin

Rating at Time 1 Year after 5 Years after 10 Years after
of Issue iss ue Is sue Iss ue
AAA 0 0.1 0.5
AA 0 0.3 0.9
A 0.1 0.7 2
BBB 0.4 3.4 6.9
BB 1.4 12.4 21
B 6.1 26.8 35.4
CCC 30.9 53 58.4

11
 Bond Ratings and Yield Spreads
Yield spreads between corporate and 10 year
treasury bonds for 2003
12
Moody's Aaa

10
Moody's Baa
Yield spread, percent

8 High yield - "Junk"

bonds
6

0
78

80

82

84

86

88

90

92

94

96

98

00

02
19

19

19

19

19

19

19

19

19

19

19

20

20

Bond Ratings and Financial

Ratios
Three years of median ratio data by bond
rating (2002 2004).

Ratio AAA AA A BBB BB B CCC

EBIT interest cover * 23.8 19.5 8 4.7 2.5 1.2 0.4
return on capital % 27.6 27 17.5 13.4 11.3 8.7 3.2
Total debt/capital % 22.9 28.3 37.5 42.5 53.7 75.9 113.5

* Earnings before interst and tax divided by interest

Credit Analysis
Predicting Default - William Beaver, Maureen McNichols, and
Jung-Wu Rhie, studied defaulting and non-defaulting firms and
concluded the chance of failing during the next year relative to the
chance of not failing was best estimated by the following equation:

Log (relative chance of failure)

6.445 1.192 ROA 2.307liabilitie s / assets .346 EBITDA / liabilitie s

Relative chacne of failure e L

12
 Value at Risk (VaR)
Value at Risk = VaR

Newer term
Attempts to measure risk
Risk defined as potential loss
Limited use to risk managers

Factors
Asset value
Daily Volatility
Days
Confidence interval

Value at Risk (VaR)

Standard Measurements
10 days
10 day 10

99% confidence interval

99% 2.33

VaR ( 10 2.33) asset value

VaR

Value at Risk (VaR)

Example
You own a $10 mil portfolio of IBM bonds. IBM has
a daily volatility of 2%. Calculate the VaR over a
10 day time period at a 99% confidence level.
10 .02 10
6.32%

99%( ) .0632 2.33

14.74%

VaR .1473 10,000,000

$1,473,621

13
 Value at Risk (VaR)

Example
You also own $5 mil of AT&T, with a daily volatility of
1%. AT&T and IBM have a .7 correlation coefficient.
What is the VaR of AT&T and the combined portfolio?
VaRIBM $1,473,621
VaRAT &T $368,405
DiversificationBenefit
VaRAT &T IBM $1,842,026 $90,647

VaRPortfolio $1,751,379

Australia one of only 12 countries with an AAA credit rating risks a

ratings downgrade for the first time since 1989, United States investment
bank Goldman Sachs has warned, saying the country could be hit with a
"negative outlook" within months. - SMH, 30 April 2015
What is likely to be the impact of a credit rating cut for Australia economy,
corporations and investors?

14