Bonds and Their Valuation:
The subprime mortgage crisis
Sizing Up Risk in the Bond
Market
Many people view Treasury securities
as a lackluster but ultra-safe
investment. From a default
standpoint, Treasuries are indeed our
safest investments; but their prices
can still decline in any given year if
interest rates increase. This is
especially true for long-term bonds,
which lost nearly 9% in 1999.
However, bonds can perform wellin
fact, they outgained stocks in 5 of the
8 years between 2000 and 2007. All
bonds arent alike, and they dont
necessarily all move in the same
direction. For example, corporate
bonds are callable and they can
default, whereas Treasury bonds are
not exposed to these risks. This
results in higher nominal yields on
corporates, but the spread between
corporate and Treasury yields differs
widely depending on the risk of the
particular corporate bond. Moreover,
yield spreads vary substantially over
time, especially for lower-rated
securities. For example, as information
about WorldComs deteriorating
condition began coming out in 2002,
the spread on its 5-year bonds jumped
from 1.67% to over 20% in mid-2002.
These bonds subsequently defaulted,
so greedy people who bought them
expecting a high return ended up with
a large loss. When the economy is
strong, corporate bonds generally
produce higher returns than Treasuries
their promised returns are higher,
and most make their promised
payments because few go into
default. However, when the economy
weakens, concerns about defaults
rise, which leads to declines in
corporate bond prices. For example,
from the beginning of 2000 to the end
of 2002, a sluggish economy and a
string of accounting scandals led to
some major corporate defaults, which
worried investors. All corporate bond
prices then declined relative to
Treasuries, and
the result was an increase in yield
spreads. As the economy rebounded
in 2003, yield spreads declined to
their former levels, which resulted in
good gains in corporate bond prices.
The situation is once again worrisome
1
in 2008.
has led to fears of recession; and this
has caused spreads to rise
dramatically, especially for lower-
rated bonds.
For example, the spread on junk
bonds over Treasuries rose from 2.4%
to 7.5% in the 6 months from mid-
2007 to January 2008. Bond investors
are rightly worried today. If a
recession does occur, this will lead to
increased defaults on corporate
bonds. A recession might benefit
investors in Treasury bonds. However,
because there have already been
several rounds of Federal Reserve rate
cuts, Treasury rates may not have
much room to fall. Also, there is
concern that recent Fed easing is
sowing the seeds for higher inflation
down the road, which would lead to
higher rates and lower bond prices. In
the face of similar risks in 2001, a
BusinessWeek Online article gave
investors the following advice, which
is still applicable today:
Take the same diversified
approach to bonds as you do
with stocks. Blend in U.S.
government, corporateboth
high-quality and high-yieldand
perhaps even some foreign
government debt. If youre
investing taxable dollars,
consider tax-exempt municipal
bonds.
And it doesnt hurt to layer in
some inflation-indexed bonds.
(Sources: Scott Patterson, Ahead of the Tape: Junk
Yields Flashing Back to 01 Slump, The Wall Street
Journal, January 30, 2008, p. C1; Stocks, Bonds,
Bills, and Inflation: (Valuation Edition) 2008
Yearbook (Chicago: orningstar, Inc., 2008); and
Susan Scherreik, Getting the Most Bang Out of
Your Bonds, BusinessWeek Online, November 12,
2001.)
WHO ISSUES BONDS?
A bond is a long-term contract under
which a borrower agrees to make
payments of interest and principal on
specific dates to the holders of the
bond. Bonds are issued by
corporations and government
agencies that are looking for long-
term debt capital. For example, on
January 3, 2009, Allied Food Products
borrowed $50 million by issuing $50
million of bonds. For convenience, we
assume that Allied sold 50,000
individual bonds for $1,000 each.
Actually, it could have sold one $50
million bond, 10 bonds each with a $5
million face value, or any other
combination that totaled $50 million.
In any event, Allied received the $50
million; and in exchange, it promised
to make annual interest payments and
to repay the $50 million on a specified
maturity date.
Until the 1970s, most bonds were
beautifully engraved pieces of paper
and their key terms, including their
face values, were spelled out on the
bonds. Today, though, virtually all
bonds are represented by electronic
data stored in secure computers,
much like the money in a bank
checking account. Bonds are grouped
in several ways. One grouping is
based on the issuer: the U.S. Treasury,
corporations, state and local
governments, and foreigners. Each
bond differs with respect to risk and
consequently its expected return.
Treasury bonds, generally called
Treasuries and sometimes referred to
as government bonds, are issued by
the federal government.1 It is
reasonable to assume that the U.S.
government will make good on its
promised payments, so Treasuries
have no default risk. However, these
bonds prices do decline when interest
rates rise; so they are not completely
riskless. Corporate bonds are issued
by business firms. Unlike Treasuries,
corporate are exposed to default risk
if the issuing company gets into
trouble, it may be unable to make the
promised interest and principal
payments and bondholders may suffer
losses. Different corporate bonds have
different levels of default risk
depending on the issuing companys
characteristics and the terms of the
specific bond. Default risk is often
referred to as credit risk; the larger
this risk, the higher the interest rate
investors demand.
Municipal bonds, or munis, is the
term given to bonds issued by state
and local governments. Like
corporates, munis are exposed to
some default risk; but they have one
major advantage over all other bonds:
The interest earned on most munis is
exempt from federal taxes and from
state taxes if the holder is a resident
of the issuing state. Consequently, the
market interest rate on a muni is
considerably lower than on a payment, generally referred to as the
2
corporate of equivalent risk. Foreign
bonds are issued by a foreign
government or a foreign corporation.
All foreign corporate bonds are
exposed to default risk, as are some
foreign government bonds. An
additional risk exists when the bonds
are denominated in a currency other
than that of the investors home
currency. Consider, for example, a U.S.
investor who purchases a corporate
bond denominated in Japanese yen. At
some point, the investor will want to
close out his investment and convert
the yen back to U.S. dollars. If the
Japanese yen unexpectedly falls
relative to the dollar, the investor will
have fewer dollars than he originally
expected to receive. Consequently,
the investor could still lose money
even if the bond does not default.
KEY CHARACTERISTICS OF BONDS
Although all bonds have some
common characteristics, different
bonds can have different contractual
features. For example, most corporate
bonds have provisions that allow the
issuer to pay them off early (call
features), but the specific
callprovisions vary widely among
different bonds. Similarly, some bonds
are backed by specific assets that
must be turned over to the
bondholders if the issuer
defaults, while other bonds have no
such collateral backup. Differences in
contractual
provisions (and in the fundamental
underlying financial strength of the
companies backing the bonds) lead to
differences in bonds risks, prices, and
expected returns. To understand
bonds, it is essential that you
understand the
following terms.
Par Value
The par value is the stated face value
of the bond; for illustrative purposes,
we generally assume a par value of
$1,000, although any multiple of
$1,000 (e.g., $5,000 or $5 million) can
be used. The par value generally
represents the amount of money the
firm borrows and promises to repay on
the maturity date.
Coupon Interest Rate
Allied Food Products bonds require
the company to pay a fixed number of
dollars of interest each year. This
coupon payment, is set at the time
the bond is issued and remains in
force during the bonds life. Typically,
at the time a bond is issued, its
coupon payment is set at a level that
will induce investors to buy the bond
at or near its par value. Most of the
examples and problems throughout
this text will focus on bonds with fixed
coupon rates. When this annual
coupon payment is divided by the par
value, the result is the coupon interest
rate. For example, Allieds bonds have
a $1,000 par value, and they pay
$100 in interest each year. The bonds
coupon payment is $100, so its
coupon interest rate is $100/$1,000
10%. In this regard, the $100 is the
annual income that an investor
receives when he or she invests in the
bond. Some bonds pay no coupons at
all, but are offered at a discount below
their par values and hence provide
capital appreciation rather than
interest income. These securities are
called zero coupon bonds (zeros).
Other bonds pay some coupon
interest, but not enough to induce
investors to buy them at par. In
general, any bond originally offered at
a price significantly below its par
value is called an
original issue discount (OID) bond.
Maturity Date
Bonds generally have a specified
maturity date on which the par value
must be repaid. Allieds bonds, which
were issued on January 3, 2009, will
mature on January 2, 2024; thus, they
had a 15-year maturity at the time
they were issued. Most bonds have
original maturities (the maturity at the
time the bond is issued) ranging from
10 to 40 years, but any maturity is
legally permissible.3 Of course, the
effective maturity of a bond declines
each year after it has been issued.
Thus, Allieds bonds had a 15-year
original maturity. But in 2010, a year
later, they will have a 14-year
maturity; a year after that, they will
have a 13-year maturity; and so forth.
Call Provisions
Most corporate and municipal bonds,
but not Treasuries, contain a call
provision that gives the issuer the
right to call the bonds for
redemption.4 The call provision
generally states that the issuer must
pay the bondholders an amount
3
greater than the par value if they are
called. The additional sum, which is
termed a call premium, is often equal
to one years interest. For example,
the call premium on a 10-year bond
with a 10% annual coupon and a par
value of $1,000 might be $100, which
means that the issuer would have to
pay investors $1,100 (the par value
plus the call premium) if it wanted to
call the bonds. In most cases, the
provisions in the bond contract are set
so that the call premium declines over
time as the bonds approach maturity.
Also, while some bonds are
immediately callable, in most cases,
bonds are often not callable until
several years after issue, generally 5
to 10 years. This is known as a
deferred call, and such bonds are said
to have call protection. Companies are
not likely to call bonds unless interest
rates have declined significantly since
the bonds were issued. Suppose a
company sold bonds when interest
rates were relatively high. Provided
the issue is callable, the company
could sell a new issue of low-yielding
securities if and when interest rates
drop, use the proceeds of the new
issue to retire the high-rate issue, and
thus reduce its interest expense. This
process is called a refunding
operation. Thus, the call privilege is
valuable to the firm but detrimental to
long-term investors, who will need to
reinvest the funds they receive at the
new and lower rates. Accordingly, the
interest rate on a new issue of callable
bonds will exceed that on the
companys new noncallable bonds.
Sinking Funds
Some bonds include a sinking fund
provision that facilitates the orderly
retirement of the bond issue. Years
ago firms were required to deposit
money with a trustee, which invested
the funds and then used the
accumulated sum to retire the bonds
when they matured. Today, though,
sinking fund provisions require the
issuer to buy back a specified
percentage of the issue each year. A
failure to meet the sinking fund
requirement constitutes a default,
which may throw the company into
bankruptcy. Therefore, a sinking fund
is a mandatory payment.
Suppose a company issued $100
million of 20-year bonds and it is
required to call 5% of the issue, or $5
million of bonds, each year. In most
cases, the issuer can handle the
sinking fund requirement in either of
two ways:
1. It can call in for redemption, at par
value, the required $5 million of
bonds. The bonds are numbered
serially, and those called for
redemption would be determined by a
lottery administered by the trustee.
2. The company can buy the required
number of bonds on the open market.
The firm will choose the least-cost
method. If interest rates have fallen
since the bond was issued, the bond
will sell for more than its par value. In
this case, the firm will use the call
option. However, if interest rates have
risen, the bonds will sell at a price
below par; so the firm can and will buy
$5 million par value of bonds in the
open market for less than $5 million.
Note that a call for sinking fund
purposes is generally different from a
refunding call because most sinking
fund
calls require no call premium.
However, only a small percentage of
the issue is normally callable in a
given year. Although sinking funds are
designed to protect investors by
ensuring that the bonds are retired in
an orderly fashion, these funds work
to the detriment of bondholders if the
bonds coupon rate is higher than the
current market rate. For example,
suppose the bond has a 10% coupon
but similar bonds now yield only 7.5%.
A sinking fund call at par would
require a long-term investor to give up
a bond that pays $100 of interest and
then to reinvest in a bond that pays
only $75 per year. This is an obvious
disadvantage to those bondholders
whose bonds are called. On balance,
however, bonds that have a sinking
fund are regarded as being safer than
those without such a provision; so at
the time they are issued, sinking fund
bonds have lower coupon rates than
otherwise similar bonds without
sinking funds.
Other Features
Several other types of bonds are used
sufficiently often to warrant mention.
First, convertible bonds are bonds
that are exchangeable into shares of
common stock at a fixed price at the
option of the bondholder. Convertibles
4
offer investors the chance for capital
gains if the stock increases, but that
feature enables the issuing company
to set a lower coupon rate than on
nonconvertible debt with similar credit
risk. Bonds issued with warrants are
similar to convertibles; but instead of
giving the investor an option to
exchange the bonds for stock,
warrants give the holder an option to
buy stock for a stated price, thereby
providing a capital gain if the stocks
price rises. Because of this factor,
bonds issued with warrants, like
convertibles, carry lower coupon rates
than otherwise similar nonconvertible
bonds. Whereas callable bonds give
the issuer the right to retire the debt
prior to maturity, putable bonds
allow investors to require the
company to pay in advance. If interest
rates rise, investors will put the bonds
back to the company and reinvest in
higher coupon bonds. Yet another type
of bond is the income bond, which
pays interest only if the issuer has
earned enough money to pay the
interest. Thus, income bonds cannot
bankrupt a company; but from an
investors standpoint, they are riskier
than regular bonds. Yet another
bond is the indexed, or purchasing
power, bond. The interest rate is
based on an inflation index such as
the consumer price index; so the
interest paid rises automatically when
the inflation rate rises, thus protecting
bondholders against inflation.
BOND VALUATION
The value of any financial asseta
stock, a bond, a lease, or even a
physical asset such as an apartment
building or a piece of machineryis
the present value of the cash flows
the asset is expected to produce.
BOND YIELDS
Unlike the coupon interest rate, which
is fixed, the bonds yield varies from
day to day depending on current
market conditions. To be most useful,
the bonds yield should give us an
estimate of the rate of return we
would earn if we bought the bond
today and held it over its remaining
life. If the bond is not callable, its
remaining life is its years to maturity.
If it is callable, its remaining life is the
years to maturity if it is not called or
the years to the call if it is called. In
the following sections, we explain how
to calculate those two possible yields
and which one is likely to occur.

BOND MARKETS
Corporate bonds are traded primarily
in the over-the-counter market. Most
bonds are owned by and traded
among large financial institutions (for
example, life insurance companies,
mutual funds, hedge funds, and
pension funds, all of which deal in
very large blocks of securities), and it
is relatively easy for over-the-counter
bond dealers to arrange the transfer
of large blocks of bonds among the
relatively few holders of the bonds. It
would be more difficult to conduct
similar operations in the stock market
among the literally millions of large
and small stockholders, so a higher
percentage of stock trades occur on
the exchanges. The Wall Street Journal
routinely reports key developments.

Reference:

Brigham, Eugene, Fundamentals of

Financial Management, 12th edition