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CHAPTER 8

Bonds and Their


Valuation
7-1

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.

7-2

Bond Valuation

A bond issue represents borrowing


from many lenders at one time
under a single agreement

While one person may not be willing


to lend a single company $10 million,
10,000 investors may be willing to
lend the firm $1,000 each

7-3

Bond Terminology

A bonds term (or maturity) is the time from


the present until the principal is to be returned

Bonds mature on the last day of their term

A bonds face value (or par) represents the


amount the firm intends to borrow (the
principal) at the coupon rate of interest

Bonds typically pay interest (coupon rate) every six


months
Bonds are non-amortized (meaning the principal is
repaid at once when the bond matures rather than
being repaid in increments throughout the bonds
life)
7-4

Bond Terminology

Coupon interest rate stated interest


rate (generally fixed) paid by the issuer.
Multiply by par to get dollar payment of
interest.
Issue date when the bond was issued.

7-5

Bond ValuationBasic
Ideas

Adjusting to interest rate changes

Bonds are sold in both primary (original


sale) and secondary markets
(subsequent trading among investors)
Interest rates change all the time
Most bonds pay a fixed interest rate

What happens to the price of a bond paying


a fixed interest rate in the secondary
market when interest rates change?
7-6

Other types (features) of


bonds

Convertible bond may be exchanged for


common stock of the firm, at the holders
option.
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.
7-7

The value of financial


assets
0

k
Value

...
CF1

CF2

CFn

CF1
CF2
CFn
Value

...
1
2
n
(1 k)
(1 k)
(1 k)
7-8

What is the value of a 10-year,


10% annual coupon bond, if kd =
10%?
0

k
VB = ?

...
100

100

100 + 1,000

$100
$100
$1,000
VB
...

1
10
(1.10)
(1.10)
(1.10)10
VB $90.91 ... $38.55 $385.54
VB $1,000
7-9

Determining the Price of a


Bond

The Bond Valuation Formula

The price of a bond is the present


value of a stream of interest
payments plus the present value of
the principal repayment
Interest payments
are
Principal
repayment is a lump
PB = PV(interest
payments)
+
PV(principal
annuitiescan use the
sum in the futurecan use
repayment)
present value of an annuity
the future value formula:
formula: PMT[PVFAk,n]

FV[PVFk,n]

7-10

Cash Flow Time Line for a


Bond

This is an
ordinary
annuity.

This is a
single
sum.

7-11

Value of a Bond

VB = PMT [ {1- (1/(1+kd)N)} / kd ] + (M /


(1+kd)N )

7-12

Determining the Price of a


Bond

Two Interest Rates and One More

Coupon rate

Determines the size of the interest payments

Kthe current market yield on comparable


bonds

The appropriate discount rate that makes the


present value of the payment equal to the price of
the bond in the market

AKA yield to maturity (YTM)

Current yieldannual interest payment


divided by bonds current price
7-13

Value of the bond


Bond C has a $1,000 face value and provides an
8% annual coupon for 30 years. The appropriate
Market Rate is 10%. What is the value of the
coupon bond?

= $80 (PVIFA10%, 30) + $1,000 (PVIF10%, 30)


= $80 (9.427) + $1,000 (.057)
[Table IV]

[Table II]

= $754.16 + $57.00

= $811.16.
$811.16
7-14

Zero Coupon Bond


A zero-coupon bond is a bond that pays no
interest but sells at a deep discount from its face
value
it provides compensation to investors in the form
of price appreciation.

V=

MV
(1 + kd)n

= MV (PVIFk

d, n

7-15

Semi-annual Compounding
Most bonds pay interest twice a
year (1/2 of the annual coupon).
Adjustments needed:
(1) Divide kd by 2
(2) Multiply n by 2
(3) Divide I by 2
7-16

Semi-annual Compounding
A non-zero coupon bond adjusted for
semiannual compounding.

I
/
2
I
/
2
I
/
2
+
MV
V =(1 + k /2 )1 +(1 + k /2 )2 + ... +
2 n
d

2*n

t=1

I/2
(1 + kd /2 )

= I/2 (PVIFAk

(1 + kd/2 ) *

MV
(1 + kd /2 ) 2*n

) + MV (PVIFkd /2 , 2*n)

/2 ,2*n

7-17

Semi-annual Compounding
Bond C has a $1,000 face value and provides an
8% semiannual coupon for 15 years. The
appropriate market rate is 10% (annual rate). What
is the value of the coupon bond?

7-18

Bond Price-Yield
relationship
Discount Bond -- The market required rate of return
exceeds the coupon rate (Par > P0 ).
Premium Bond -- The coupon rate exceeds the
market required rate of return (P0 > Par).
Par Bond -- The coupon rate equals the market
required rate of return (P0 = Par).
If interest rate rise so that market required rate of
return increases, the bonds price will fall.
If interest rate fall, so that market required rate of
return decreases, the bonds price will rise.
7-19

The price path of a bond

VB

What would happen to the value of this


bond if its required rate of return remained
at 10%, or at 13%, or at 7% until maturity?

1,372
1,211

kd = 7%.
kd = 10%.

1,000
837
775

kd = 13%.
30

25

20

15

10

Years
to Maturity
7-20

Bond values over time

At maturity, the value of any bond must


equal its par value.
If kd remains constant:
The value of a premium bond would
decrease over time, until it reached
$1,000.
The value of a discount bond would
increase over time, until it reached
$1,000.
A value of a par bond stays at $1,000.
7-21

Definitions
Annual coupon payment
Current yi
eld(CY)
Currentprice
Changein price
Capitalgainsyield(CGY)
Beginningprice
Expected
Expected

Expectedtotalreturn YTM
CY CGY

7-22

An example:
Current and capital gains yield

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

= 0.1015 = 10.15%
7-23

Calculating capital gains


yield
YTM = Current yield + Capital gains yield
CGY = YTM CY
= 10.91% - 10.15%
= 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.
7-24

Call Provisions

If interest rates have dropped substantially since


a bond was originally issued, a firm may wish to
refinance, or retire their old high interest bond
issue
However, the issuing corporation would have to
get all the bondholders to agree to this
From the bondholders viewpoint, this could be
a bad ideathey would be giving up high
coupon bonds and would have to reinvest their
cash in a market with lower interest rates
To ensure that the corporation can refinance their
bonds should they wish to do so, the corporation
7-25
makes the bonds callable

Call provision

Which gives the issuing corporation the right


to call the bond for redemption.
The call provision generally states that
company must pay the bondholders an
amount greater than the par value if they
are called.
The additional sum, which is termed a call
premium.
It is often set equal to one years interest if
the bonds are called during the first year,
and the premium declines at a constant rate
7-26
of INT/N every year there after.

Call Provisions

Call provisions allow bond issuers to


retire bonds before maturity by paying
a premium (penalty) to bondholders
Many corporations offer a deferred call
period (meaning the bond wont be
called for at least x years after the
initial issuing date)

Known as the call-protected period


7-27

Call Provisions

The Effect of A Call Provision on


Price

When valuing a bond that is probably


going to be called when the callprotected period is over

Cannot use the traditional bond valuation


procedure

Cash flows will not be received through


maturity because bond will probably be called
7-28

The Refunding Decision

When current interest rates fall below


the coupon rate on a bond, company
has to decide whether or not to call in
the issue

Compare interest savings of issuing a new


bond to the cost of making the call

Calling in the bond requires the payment of a


call premium
Issuing a new bond to raise cash to pay off the
old bond requires payment of administrative
expenses and flotation costs
7-29

Yield to Call

To calculate the YTC, solve this


equation for Kd,

VB = PMT [ {1- (1/(1+kd)N)} / kd ] + (Call Price /


(1+kd)N )

7-30

What is reinvestment rate


risk?

The risk of an income decline due


to drop in interest rates is called
reinvestment risk.
This risk is high on callable bonds.
It is also high on short term
maturity bonds

7-31

Conclusions about interest rate


and reinvestment rate risk
Short-term
AND/OR High
coupon bonds

Long-term
AND/OR Low
coupon bonds

Interest
rate risk

Low

High

Reinvestme
nt rate risk

High

Low

CONCLUSION: Nothing is riskless!

7-32

Default Risk

If an issuer defaults, investors receive


less than the promised return.

Influenced by the issuers financial


strength and the terms of the bond
contract.

Investor need to asses a bonds


default risk before making a
purchase.
7-33

Bond Refunding

Bond may be refunded by the


company prior to maturity through
either the issuance of serial bond
or exercising a call privilege on a
straight bond.

7-34

Bond Indentures
Controlling Default Risk

As a bondholder, you would like to ensure


that you will receive your promised interest
and principal payments

Bond indentures attempt to prevent firms from


becoming riskier after the bonds are purchased,
and includes such protective covenants as:

Limits to managements salary


Limits to dividends
Maintenance of certain financial ratios
Restrictions on additional debt issues

Sinking funds provide money for the repayment


of bond principal
7-35

Sinking Fund

Is a series of payments made into an account thats


dedicated to paying off a bonds principal at maturity.
Deposits are planned so that the amount in the bank
on the date the bonds mature will just equal the
principal due.
If lenders require a sinking fund for security, its
included a provision in the bond agreement.
Company can call randomly call in some bonds for
retirement before maturity.
Another approach is to issue serial bonds, splitting
the total amount borrowed into several separate
issues.
7-36

The Bond Indenture

Indenture Written agreement between the company (the


borrower) and the bondholders (the lenders/creditors) and
includes:
The rights of the bondholders and the duties of the
issuing corporation
The basic terms of the bonds

The total amount of bonds issued


A description of property used as security, if applicable

Face value, coupon rate, maturity, etc

Describes collateral (bonds, stocks, etc) and/or mortgage


(real property, i.e., land, buildings, etc) used as pledge.

The repayment arrangements schedule of repayments


Call provisions: giving the issuer the option to repurchase
the bond at a specific price prior to maturity
Details of protective covenants positive (should) and
negative (should not)
37

7-37

Bond Indenture

Standard provision

Specify certain record keeping and general


business practices that the bond issue must
follow.
The borrower commonly must

Maintain satisfactory accounting records in


accordance with generally accepted accounting
principles (GAAP)
Periodically supply audited financial statements
Pay taxes and other ;liabilities when due
Maintain all facilities in good working order
7-38

Bond Indenture

Restrictive provisions

Which place operating and financial constraints on the


borrower
Theses provisions help protect the bondholder against
increase in borrower risk
Require a minimum level of liquidity
Prohibit the sale of accounts receivables to generate cash
Impose fixed asset restrictions (maintain a specific level
of fixed assets)
Constrain subsequent borrowing (subordination)
Limit the firms annual cash dividend payments to a
specified percentage or amount
7-39

Bond Indenture

Sinking Fund Requirements

Security Interest

Objective is to provide for the systematic retirement of


bonds prior to their maturity

The bond indenture identifies any collateral pledged


against the bond specifies how it is to be maintained

Trustee

A trustee is a third party to a bond indenture


The trustee can be one individual, a corporation, or a
commercial bank trust department
7-40

Types of bonds

Unsecured bonds

Secured bonds

41

Debentures
Subordinated debentures
Income bonds
Mortgage bonds
Collateral trust bonds
Equipment trust certificate
7-41

Debentures

42

Unsecured bonds that only credit


worthy firms can issue
Convertible bonds are normally
debentures
Claims are the same as those of any
general creditors
May have other unsecured bonds
subordinated to them
7-42

Types of bonds

Subordinated debentures

Claims are not satisfied until those of the creditors holdings


certain (senior) debts have been fully satisfied
Claims is that of a general creditor but not as good as a
senior debt claim

Income bonds

Payment of interest is required only when earnings are


available
Claims is that of a general creditor
Are not default when interest payments are missed, because
they are contingent only on earnings being available.
7-43

Types of bonds

Mortgage bonds

Secured by real estate or buildings.


Claims is on proceeds from sale of mortgaged assets; if
not fully satisfied, the lender becomes general creditors
A number of mortgages can be issued against the same
collateral

Collateral trust bonds

Secured by stocks or bonds that are owned by the issuer


Collateral value is generally 25% to 35% greater than
bond value
7-44

Types of bonds

Equipment trust certificate

45

Used to finance rolling stock


airplanes, trucks, boats, railroad cars
Claim is on proceeds from the sale of
the asset; if proceeds do not satisfy
outstanding debt, trust certificate
lenders become general creditors

7-45

Contemporary types of
bonds

Zero coupon bonds


is a bond that pays no interest but sells at a
deep discount from its face value
it provides compensation to investors in the
form of price appreciation
Generally callable at par value
Treasury Bills are good examples of zeroes

Junk bonds
High risk bonds high yields often yielding 2% to
3% more than the best quality corporate debt.

7-46

Contemporary types of
bonds

Floating rate bonds

Stated interest rate is adjusted periodically


within stated limits in response to changes
in specified money market and capital
market rates.
Tend to sell at close to par because of the
automatic adjustment to changing markets
conditions
Some issues provide for annual redemption
at par at the option of the bondholder
7-47

Contemporary types of
bonds

Extendible notes

Short maturities, typically 1 to 5 years, that


can be renewed for a similar period at the
option of holders
An issue might be a series of 3 year renewable
notes over a period of 15 years; every 3
years ; the notes could be extended for
another 3 years, at a new rate competitive
with market interest rates at the time of
renewal.
7-48

Contemporary types of
bonds

Putable bonds

Bonds that can be redeemed at par at the


option of their holder either at specified dates
after the date of issue and every 1 to 5 years
thereafter or when and if the firm takes
specified actions, such as being acquired,
acquiring another company, or issuing a large
amount of additional debt
The bonds yield is lower than that of a non
putable bond
7-49

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