Valuation and Characteristics of Bonds

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Valuation and Characteristics of Bonds
Chapter 7
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Chapter Objectives

• Different types of bonds
• Features of bonds
• Understand the term Value
• Understand the process for valuing assets in
  general
• How to Value a bond in particular
• Expected rate of return
• Relationships in bond valuation

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Bond Definition

• Type of debt or long-term promissory note issued
  by a borrower, promising to pay the holder a
  fixed amount of interest per year.

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Bond Terminology

• Claims on Assets and Income In the event of
  insolvency, claims of debt , including bonds are
  honored before those of common or preferred
  stock.
• Par Value Face value of the bond, returned to
  the bondholder at maturity (typically 1,000)
• Coupon Interest Rate The percentage of the par
  value of the bond that will be paid out in the
  form of interest

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Bond Terminology

• Maturity the length of time until the bond
  issuer returns the par value to the bondholder
  and terminates or redeems the bond.
• Indenture the legal agreement between the
  organization issuing the bond and the trustee who
  represents the bondholders

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Bond Terminology

• Current yield the ratio of the interest payment
  to the bonds current market price.
• Calculated by dividing the annual interest
  payment by the market price of the bond
• Example A 1,000 bond with 10 coupon rate and
  market price of 700
• Current yield 100 / 700 14.286

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Bond Ratings

• Bond ratings are favorably affected by
• Greater reliance on equity as opposed to debt
  financing
• Profitable operations
• Low variability in past earnings
• Large firms size
• Little use of subordinated debt

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Bond Rating Agencies

• Three agencies rate bonds
• Moodys
• Standard Poors
• Fitch Investor Services
• Why it matters The lower the rating, the higher
  the return demanded in the market
• ( cost of capital for the firm is higher )

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Bond Ratings

• AAA is the highest rating assigned by Standard
  Poors, D is the lowest
• AAA indicates a strong capacity to pay principal
  and interest, D indicates bonds are in default

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Types of Bonds

• Debentures
• Subordinated Debentures
• Mortgage Bonds
• Zero Coupon Bonds
• Junk Bonds

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Mortgage Bond (Secured Debt)

• A bond secured by a lien on real property
• Typically the value of the real property is
  greater than that of the bonds issued
• Claim Order Highest in hierarchy of payout in
  case of bankruptcy

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Debentures

• Any unsecured long-term debt
• Viewed as more risky than secured debt and
  provide a higher yield than secured debt
• Claim Order Intermediate in hierarchy of payout
  in case of bankruptcy

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Subordinated Debenture

• Claim Order Lowest in hierarchy of payout in
  case of bankruptcy
• The claims of subordinated debentures are honored
  only after the claims of secured debt and
  unsubordinated debentures have been satisfied

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Zero Coupon Bonds

• Do not make regular interest payments
• Issued at a significant discount to face value
  (normally 1,000)
• Return comes from appreciation of the bond
• Example Series EE government savings
  bondspurchase for 500, payback is 1,000

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Junk Bonds

• High risk debt with low (credit) ratings by
  Moodys and Standard Poors
• High yieldtypically pay 3 to 5 percent more than
  AAA grade long-term bonds

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Definitions of Value

• Book value value of an asset as shown on a
  firms balance sheet
• Liquidation value the dollar amount 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 the present value of the assets
  expected future cash flows

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Efficient Market Defined

• The values of all securities at any instant fully
  reflect all available public information, which
  results in the market value and the intrinsic
  value being the same
• Assumption used in our Valuation Models and
  discussions

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Basic Factors Determining Value The Valuation
Big Picture
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Definition of (Intrinsic) Value

• For our purposes The value of an asset is its
  intrinsic value or the present value of its
  expected future cash flows, when these cash flows
  are discounted back to the present using the
  investors required rate of return

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Bond Valuation

• The (intrinsic) value of a bond is a combination
  of
• The present value of the interest payments
• Plus
• The present value of the par or face value
• Data Requirements

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Bondholders Required Rate of Return (Yield to
Maturity)

• Key Point Even though different investors could
  have different required rates of return for the
  bond, but the consensus required rate of return
  will be reflected in the current market price of
  the bond
• The Yield to Maturity (YTM) of a bond reflects
  the rate of return of a bond if held to maturity
• Calculate YTM by finding out the discount rate
  that equates the present value of the future cash
  flows of the bond with the current market price
  of the bond

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Bond Valuation Relationships

• 1. The value of a bond is inversely related to
  changes in the investors present required rate
  of return (the current interest rate). As
  interest rates increase, the value of the bond
  decreases.
• 2. The market value of a bond will be less than
  the par value if the investors required rate of
  return is above the coupon interest rate the
  value will be above par value if the investors
  required rate of return is below the coupon
  interest rate.
• 3. Long-term bonds have greater interest rate
  risk than do short-term bonds.

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Bond Relationship 1

• Value of a bond is inversely related to the
  investors present required rate of return

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Bond Relationship 2

• The market value of a bond will be less than the
  par value if the investors required rate of
  return is above the coupon interest rate the
  value will be above par value if the investors
  required rate of return is below the coupon
  interest rate

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Par Value

• When the investors required rate of return is
  equal to the coupon interest rate, the bond has a
  market value of par or face value
• The bond will sell at the face value

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Premium

• The market value of a bond will be above the par
  or face value when the investors required rate
  is lower than the coupon interest rate.
• The bond will sell at a Premium or above face
  value.

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Discount

• The market value of a bond will be below the par
  or face when the investors required rate is
  greater than the coupon interest rate.
• The bond will sell at a Discount or below face
  value.

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Value of a Bond (Par)

• Calculate the market value of a 5-year 1,000
  bond with an 8 coupon rate and the investors
  required rate of return is 8.
• Present Value of the interest payments --plus
  the Present Value of the par or face value
• Interest payments 1,000 x 8 80
• PMT 80 , N 5 , I/Y 8
• CPT PV 319.42
• PV of the face or par value
• FV 1000 , N 5 , I/Y 8
• PV 680.60
• Total value 1,000

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Value of a Bond (Premium)

• Calculate the market value of price of a 5-year
  1,000 bond with an 8 coupon rate and the
  investors required rate of return is 6.
• Present Value of the interest payments --plus
  the Present Value of the par or face value
• Interest payments 1,000 x 8 80
• Change I/Y 6
• PV 336.99
• PV of the face or par value
• PV 747.30
• Total value 1,084.29

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Value of a Bond (Discount)

• Calculate the market value of price of a 5-year
  1,000 bond with an 8 coupon rate and the
  investors required rate of return is 10.
• Present Value of the interest payments --plus
  the Present Value of the par or face value
• Interest payments 1,000 x 8 80
• Change I/Y 10
• PV 303.26
• PV of the face or par value
• PV 620.90
• Total value 924.16

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Bond Relationship 3

• Long term bonds have greater interest rate risk
  than short term bonds
• Bond Prices fluctuate more for long term bonds in
  response to interest rate changes