2009 Cengage Learning/South-Western

Valuing Bonds
Chapter 4
2
Valuation Basics
Present Value of Future Cash Flows
Link Risk & Return
Expected Return
on Assets
Valuation
3
The Fundamental Valuation Model
) r + (1
CF
+ . . . +
) r + (1
CF
+
) r + (1
CF
=
P
n
n
2
2
1
1
0
P
0
= Price of asset at time 0 (today)
CF
t
= Cash flow expected at time t
r = Discount rate (reflecting assets risk)
n = Number of discounting periods (usually years)
This model can express the price of any asset at
t = 0 mathematically.
Marginal benefit of owning the asset: right to receive the
cash flows
Marginal cost: opportunity cost of owning the asset
4
Bond Vocabulary
Principal
The amount of money on which interest is
paid.
Maturity date
The date when a bonds life ends and the
borrower must make the final interest
payment and repay the principal.
Par value
The face value of a bond, which the
borrower repays at maturity.
Coupon
A fixed amount of interest that a bond
promises to pay investors.
Indenture
A legal document stating the conditions
under which a bond has been issued.
5
Bond Vocabulary
Coupon rate
The rate derived by dividing the bonds
annual coupon payment by its par value.
Coupon yield
The amount obtained by dividing the
bonds coupon by its current market price
(which does not always equal its par
value). Also called current yield.
6
Bond Valuation: The Basic Equation
Bond Price = PV of coupons + PV of principal
Assuming annual interest:
) r (1
M
) r (1
. . .
) r (1

) r (1

n n 2 1
0
)
) r (1
M
r
r

n
n

-
1
1
1
7
Time Line for Bond Valuation
(Annual Interest Payments)
Worldwide United
9-1/8% Coupon,
$1,000 Par Value
Bond, Maturing at
End of 2019;
Required Return
Assumed To Be 8%
8
Yield to Maturity (YTM)
Estimate of return investors earn if they buy
the bond at P
0
and hold it until maturity
The YTM on a bond selling at par will always equal
the coupon rate.
YTM is the discount rate that equates the
PV of a bonds cash flows with its price.
9
What happens to bond values if the required
return is not equal to the coupon rate?
The bond's price will differ from its par value.
P
0
< par value r > Coupon Interest Rate
DISCOUNT
=
P
0
> par value r < Coupon Interest Rate
PREMIUM
=
Bond Premiums and Discounts
10
On Discount Rates
Generally,
the greater the uncertainty about an assets
future benefits,
the higher the discount rate investors will apply
when discounting those benefits to the present.
11
Semiannual Compounding
An example....
Value a T-Bond
Par value = $1,000
Maturity = 2 years
Coupon rate = 4%
r = 4.4% per year
43 . 992 $ 97 . 934 $ 74 . 18 $ 15 . 19 $ 57 . 19 $
) 022 . 1 (
020 , 1 $
) 022 . 1 (
20 $
) 022 . 1 (
20 $
) 022 . 1 (
20 $
2
044 . 0
1
000 , 1
2
40 $
2
044 . 0
1
2
40 $
2
044 . 0
1
2
40 $
2
044 . 0
1
2
40 $
4 3 2
4 3 2 1
0
! !
! !

! P
= $992.43
n
r
F
C
r
C
r
C
r
C
2 3 2 1
)
2
1 (
2
....
)
2
1 (
2
)
2
1 (
2
)
2
1 (
2
Price

!
12
Economic Forces Affecting Bond Prices
Time to maturity: bond prices converge to par
value (plus final coupon) with passage of time.
Interest rates: bond prices and interest rates
move in opposite directions.
Changes in interest rates have larger impact on
long-term bonds than on short-term bonds.
13
The Relationship Between
Bond Prices and Required Returns
6% coupon rate
for both
14
Interest Rate Risk
Interest Rate
Risk
The risk that changes in market interest
rates will cause fluctuations in a bonds
price. Also, the risk of suffering losses as a
result of unanticipated changes in market
interest rates.
Real return
Approximately, the difference between an
investments stated or nominal return and
the inflation rate.
Nominal
return
The stated return offered by an
investment unadjusted for the effects of
inflation.
15
Treasury Bond Yields and Inflation Rates
16
Primary versus Secondary Markets
Primary market: the initial sale of bonds by issuers
to large investors or syndicates
Secondary market: the market in which investors
trade with each other
Trades in the secondary market do not raise any
capital for issuing firms.
17
Types of Bonds: By Issuer
Corporate
Bonds
Usually with par $1000 and semi-annual
coupon
Bonds if maturity > 10 years; notes if
maturity < 10 years
Municipal
Bonds
Issued by local and state government
Interest on municipal bonds tax-free
Treasury
Bonds
If maturity < 1 year: Treasury Bills
If 1 year < maturity < 10 years: Treasury
Notes
Maturity > 10 years: Treasury Bonds
Used to fund budget deficits
Agency
Bonds
Issued by government agencies: FHLB,
FNMA (Fannie Mae), GNMA (Ginnie Mae),
FHLMC (Freddie Mac)
18
Types of Bonds: By Features
Fixed vs.
Floating
Rates
Floating-rate bonds: coupon tied to prime
rate, LIBOR, Treasury rate or other
interest rate
Floating rate = benchmark rate + spread
Floating rate can also be tied to the
inflation rate: TIPS, for example
Secured vs.
Unsecured
Bonds
Unsecured bonds (debentures) are backed
only by general faith and credit of issuer
Secured bonds are backed by specific
assets (collateral)
Mortgage bonds, collateral trust bonds,
equipment trust certificates
19
Types of Bonds: By Features
Zero-Coupon
Bonds
Zero-coupon bonds pay no interest
Also known as Discount bonds or pure
discount bonds
Sell below par value
Treasury Bills (Tbills)
Treasury STRIPs
Convertible
and
Exchangeable
Bonds
Convertible bonds, in addition to paying
coupon, offers the right to convert the
bond into common stock of the issuer of
the bond
Exchangeable bonds are convertible in
shares of a company other than the
issuers
20
Table 4.1 Zero-Coupon Bond Prices and
Taxable Income
21
Types of Bonds: By Features
Callable and
Putable
Bonds
Callable bonds: bond issuer has the right
to repurchase the bonds at a specified
price (call price).
Firms could retire and reissue debt if
interest rates fall.
Putable bonds: the investors have the
right to sell the bonds to the issuer at the
put price.
Protection
from Default
Risk
Sinking fund provisions: the issuer is
required to gradually repurchase
outstanding bonds.
Protective covenants: requirements the
bond issuer must meet
Positive and negative covenants
22
Types of Bonds: By Features
Treasury
Inflation-
Protected
Securities
(TIPS)
Notes and bonds issued by
the federal government that
make coupon payments that
vary with the inflation rate.
23
Bond Markets
The U.S bond market has grown from $250 billion
in 1950 to $22 trillion in 2004
Amount Oustanding in 2004
$1,900
$3,700
$4,500
$2,700
$5,300
$3,900
Municipal Bonds
Treasury Bonds
Corporate Bonds
Federal Agency Bonds
Mortgage-related debt
Other
24
U.S. Treasury Bond Quotations
RATE
MATURITY
MO/YR
BID ASKED CHG
ASK
YLD
Government Bonds & Notes
5.500 May 09n 107:13 107:14 3 3.83
Rate
Coupon rate of 5.5%
Bid prices
Ask prices
(percentage of
par value)
Bid price: the price traders receive if they
sell a bond to the dealer. Quoted in
increments of 32
nds
of a dollar
Ask price: the price traders pay to the
dealer to buy a bond
Bid-ask spread: difference between ask
and bid prices.
Ask Yield
Yield to maturity on the ask price
25
Corporate Bond Quotations
Company
(Ticker)
Coupon Maturity Last Price Last Yield
Estimated
Spread
UST
Est $ Vol
(000s)
SBC Comm
(SBC)
5.875
Aug
15,2012
107.161 4.836 80 10 73,867
Corporate prices are quoted as percentage of par, without
the 32
nds
of a dollar quoting convention
Yield spread: the difference in yield-to-maturities between a
corporate bond and a Treasury bond with same maturity
The greater the default risk, the higher
the yield spread
26
Bond Ratings
Bond ratings: grades assigned to bond issues based
on degree of default risk
Investment-
grade bonds
Moodys Aaa to Baa3 ratings
S&P and Fitch AAA to BBB-
ratings
Junk bonds
Moodys Ba1 to Caa1 or lower
S&P and Fitch BB to CCC+ or
lower
27
Figure 4.2 Bond Ratings
28
Table 4.3 The Relationship Between Bond Ratings
and Spreads at Different Maturities at a Point in Time
29
Term Structure of Interest Rates
Relationship between yield and maturity is called
the Term Structure of Interest Rates
Graphical depiction called a Yield Curve
Usually, yields on long-term securities are higher than on short-
term securities.
Generally look at risk-free Treasury debt securities
Yield curves normally upwards-sloping
Long yields > short yields
Can be flat or even inverted during times of financial stress
What do you think a Yield Curve would look like
graphically?
30
Fig. 4-5 Yield Curves for U.S. Government
Bonds
31
The Expectations Hypothesis
32
Advanced Bond Valuation
Liquidity
Preference
Theory
States that the slope of the yield curve is
influenced not only by expected interest
rate changes, but also by the liquidity
premium that investors require on long-
term bonds.
Preferred
Habitat
Theory
A theory that recognizes that the shape of
the yield curve may be influenced by
investors who prefer to purchase bonds
having a particular maturity regardless of
the returns those bonds offer compared to
returns available at other maturities.
33
Valuing Bonds
Bond price = present value of coupons +
present value of principal
Bond prices are inversely related to interest
rates.
Bonds can have features like convertibility and
callability.