Financial Instruments and Valuation

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SEU_FIN500_Module09_PPT_Ch07.pptx

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Chapter 7

The Valuation and Characteristics of Bonds

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Learning Objectives

Distinguish between different kinds of bonds.

Explain the more popular features of bonds.

Define the term value as used for several different purposes.

Explain the factors that determine value.

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Learning Objectives

Describe the basic process for valuing assets.

Estimate the value of a bond.

Compute a bond’s expected rate of return and its current yield.

Explain three important relationships that exist in bond valuation.

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TYPES OF BONDS

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Bonds

Meaning: A bond is a type of debt or long-term promissory note, issued by a borrower, promising to its holder a predetermined and fixed amount of interest per year and repayment of principal at maturity.

Bonds are issued by Corporations, U.S. Government, State and Local Municipalities.

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Debentures

Debentures are unsecured long-term debt.

For an issuing firm, debentures provide the benefit of not tying up property as collateral.

For bondholders, debentures are more risky than secured bonds and provide a higher yield than secured bonds.

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Subordinated Debentures

There is a hierarchy of payout in case of insolvency.

The claims of subordinated debentures are honored only after the claims of secured debt and unsubordinated debentures have been satisfied.

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Mortgage Bonds

Mortgage bond is secured by a lien on real property.

Typically, the value of the real property is greater than that of the bonds issued, providing bondholders a margin of safety.

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Eurobonds

Securities (bonds) issued in a country different from the one in whose currency the bond is denominated.

For example, a bond issued by an American corporation in Japan that pays interest and principal in dollars.

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Convertible Bonds

Convertible bonds are debt securities that can be converted into a firm’s stock at a prespecified price.

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TERMINOLOGY AND CHARACTERISTICS OF BONDS

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Claims on Assets and Income

Seniority in claims

In the case of insolvency, claims of debt, including bonds, are generally honored before those of common or preferred stock.

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Par Value

Par value is the face value of the bond, returned to the bondholder at maturity.

In general, corporate bonds are issued at denominations or par value of $1,000.

Prices are represented as a % of face value. Thus, a bond quoted at 104 can be bought at 104% of its par value in the market. Bonds will return the par value at maturity, regardless of the price paid at the time of purchase.

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Coupon Interest Rate

The percentage of the par value of the bond that will be paid periodically in the form of interest.

Example: A bond with a $1,000 par value and 5% annual coupon rate will pay $50 annually (=0.05*1000) or $25 (if interest is paid semiannually).

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Zero Coupon Bonds

Zero coupon bonds have zero or very low coupon rate. Instead of paying interest, the bonds are issued at a substantial discount below the par or face value.

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Maturity

Maturity of bond refers to the length of time until the bond issuer returns the par value to the bondholder and terminates or redeems the bond.

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Call Provision

Call provision (if it exists on a bond) gives a corporation the option to redeem the bonds before the maturity date. For example, if the prevailing interest rate declines, the firm may want to pay off the bonds early and reissue at a more favorable interest rate.

Issuer must pay the bondholders a premium.

There is also a call protection period where the firm cannot call the bond for a specified period of time.

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Indenture

An indenture is the legal agreement between the firm issuing the bond and the trustee who represents the bondholders.

It provides for specific terms of the loan agreement (such as rights of bondholders and issuing firm).

Many of the terms seek to protect the status of bonds from being weakened by managerial actions or by other security holders.

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Bond Ratings

Bond ratings reflect the future risk potential of the bonds.

Three prominent bond rating agencies are Standard & Poor’s, Moody’s, and Fitch Investor Services.

Lower bond rating indicates higher probability of default. It also means that the rate of return demanded by the capital markets will be higher on such bonds.

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Factors Having a Favorable Effect on Bond Rating

A greater reliance on equity as opposed to debt in financing the firm

Profitable operations

Low variability in past earnings

Large firm size

Little use of subordinated debt

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Junk Bonds

Junk bonds are high-risk bonds with ratings of BB or below by Moody’s and Standard & Poor’s.

Junk bonds are also referred to as high-yield bonds as they pay a high interest rate, generally 3 to 5% more than AAA-rated bonds.

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DEFINING VALUE

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Defining Value

Book value: Value of an asset as shown on a firm’s balance sheet.

Liquidation value: The dollar sum that could be realized if an asset were sold individually and not as part of a going concern.

Market value: The observed value for the asset in the marketplace.

Intrinsic or economic value: Also called fair value—represents the present value of the asset’s expected future cash flows.

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Value and Efficient Markets

In an efficient market, the values of all securities at any instant fully reflect all available public information.

If the markets are efficient, the market value and the intrinsic value will be the same.

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WHAT DETERMINES VALUE?

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What Determines Value?

Value of an asset = present value of its expected future cash flows using the investor’s required rate of return as the discount rate.

Thus value is affected by three elements:

Amount and timing of the asset’s expected future cash flows

Riskiness of the cash flows

Investor’s required rate of return for undertaking the investment

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VALUATION: THE BASIC PROCESS

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Bond Valuation

The value of a bond (V) is a combination of:

C: Future expected cash flows in the form of interest and repayment of principal

n: The time to maturity of the loan

r: The investor’s required rate of return

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VALUING BONDS

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Example on Bond Valuation

Consider a bond issued by Toyota with a maturity date of 2020 and a stated coupon of 4.5%. In 2015, with 5 years left to maturity, investors owning the bonds are requiring a 2.1% rate of return.

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Toyota Bond Example

Step 1 (CF): Estimate amount and timing of the expected future cash flows:

a. Annual interest payments 0.045  $1,000 = $45 every year for five years

b. Face value to be received in 2020

$1,000

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Summary of Cash Flows (For One Bond)

Time Bondholder Corporation

0 Price = ? Price = ?

1–5 $45 –$45

5 +1,000 –1,000

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Toyota Bond Example

Step 2 (r) Determine the investor’s required rate of return by evaluating the riskiness of the bond’s future cash flows. Remember the investors required rate of return equals the risk-free rate plus a risk premium. Here, the required rate of return (r) is given as 2.1%.

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Toyota Bond Example

Step 3: Calculate the intrinsic value of the bond.

Bond Value = PV (Interest, received every year) + PV (Par, received at maturity)

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Toyota Bond Example

Using calculator:

Annual interest payments (PMT) = $45

Par value (FV) = $1,000

Years until maturity (N) = 5

Required rate of return (I) = 2.1%

Solve for PV = $1,112.80

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BOND YIELDS

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Bond Yields

Yield to Maturity (YTM)

YTM refers to the rate of return the investor will earn if the bond is held to maturity. YTM is also known as bondholder’s expected rate of return.

YTM = Discount rate that equates the present value of the future cash flows with the current market price of the bond.

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Bond Yields

To find YTM, we need to know:

(a) current price

(b) time left to maturity

(d) annual interest payment

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Computing YTM

What is the yield to maturity (YTM) on a 6% bond that is currently trading for $1,100 and matures in 10 years?

current price = $1,100

coupon = $60

time = 10 years

par value = $1,000

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Current Yield

Current yield is the ratio of the interest payment to the bond’s current market price.

Example: The current yield on a $1,000 par value bond with 4% coupon rate and market price of $920

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BOND VALUATION: THREE IMPORTANT RELATIONSHIPS

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Bond Valuation: Three Important Relationships

Relationship #1

The value of a bond is inversely related to changes in the investor’s present required rate of return (the current interest rate).

As interest rates increase (decrease), the value of the bond decreases (increases).

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Bond Valuation: Three Important Relationships

Relationship #2

The market value of a bond will be less than the par value if the investor’s required rate of return is above the coupon interest rate.

Bond will be valued above par value if the investor’s required rate of return is below the coupon interest rate.

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Discount Bonds

The market value of a bond will be below the par when the investor’s required rate is greater than the coupon interest rate. These bonds are known as discount bonds.

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Premium Bonds

The market value of a bond will be above the par or face value when the investor’s required rate is lower than the coupon interest rate. These bonds are known as premium bonds.

If investor’s required rate of return is equal to the coupon interest rate, the bonds will trade at par.

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Bond Valuation: Three Important Relationships

Relationship #3

Long-term bonds have greater interest rate risk than do short-term bonds.

In other words, a change in interest rate will have relatively greater impact on long-term bonds.

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Main Risks for Bondholders

Interest rate risk (if interest rates rise, the market value of bonds will fall)

Default risk (this may mean no or partial payment on debt as in bankruptcy cases)

Call risk (if bonds are called before maturity date)… bonds are generally called when interest rates decrease. Thus, investors will have to reinvest the money received from the corporation at a lower rate.

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Key Terms

Behavioral finance

Bond

Book value

Callable bond

Call protection period

Convertible bond

Coupon interest rate

Current yield

Debenture

Discount bond

Efficient market

Eurobond

Expected rate of return

Fixed-rate bond

Fair value

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Key Terms

High-yield bond

Indenture

Interest rate risk

Intrinsic value

Junk bond

Liquidation value

Market value

Maturity

Mortgage bond

Par value

Premium bond

Subordinated debentures

Yield to maturity

Zero coupon bond

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