Chapter 7 - The Valuation and Characteristics of Bonds

Bonds

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 issues by the Corporations, U.S. Gov, and State and Local Municipalities

Bond Valuation

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

Asset Value Equation

AV = cash flow in year 1/ (1 + required rate of return) + "" V= C1/(1+r)1

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

Toyota Bond Example (pt. 4)

Annual interest payments (PMT)= $45 Par Value (FV) =$1,000 Year until maturity (N) = 5 Required rate of return (I) =2.1% Solve for PV= $1,112.80

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

Definition of Values

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

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 ti 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.

Bond Valuation EX

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

Convertible Bonds

Convertible bonds are debt securities that can be converted into a firm's stock at a pre-specified price

Current Yield

Current yield = annual interest payment/ current market price of the bond EX: the current yield on a $1,000 par value bond with a 4% coupon rate and market price of $920 Current yield = .04 X 1,000/ $920 = .0435 = 4.35%

Debentures

Debentures are unsecured long-term debt. For an issuing firm, debentures provides 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.

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

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.

Maturity

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

Mortgage Bond

Mortgage bond is secured by a lien on real property. Typically, the value of the real property is greater than that of the bonds issues, providing bondholders a margin of safety

Par Value

Par value is the face value of the bond, returned to the bondholder at maturity. In general, corporate bonds are issued at the 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.

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). So, as interest rates increase, the value of the bond decreases. 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 called above par value if the investor's required rate of return is below the coupon interest rate. 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.

Euro Bonds

Securities issued in a country different from the one in whose currency the bond is denominated For example, a bond issues by an American corporation in Japan that pays interest and principal in dollars

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

Toyota Bond Example (pt. 1)

Step 1: Estimate amount and timing of the expected future cash flows: a. Annual interest payments 0.045 X$1,000 = $45 every year for five years b. Facevalue to be received in 2020 $1,000

Toyota Bond Example (pt. 2)

Step 2: 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%

Toyota Bond Example (pt. 3)

Step 3: Calculate the intrinsic value of the bond. Bond Value = PV(interest, EY) + PV(Par, received at maturity)

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, the bonds will trade at par.

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 bounds.

Coupon Interest Rate

The percentage of the par value of the bond that will be paid periodically in the form of interest. EX: A bond with a $1,000 par value and 5% annual coupon rate will pay $50 annually (=.05*1000) or $25 (if interest is payed semi-annually

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 un subordinated debentures have been satisfied.

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: 1. Amount and timing of the asset's expected future cash flows 2. Riskiness of the cash flows 3. Investor's required rate of return for undertaking the investment

Bond Yields Info

We need to know: a) current price b) time left to maturity c) par value, and d) annual interest payment

YTM Example

What is the 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

Bonds 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 a 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

Zero Coupon Bonds

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