5. Part A: Bond valuation
Relationship between Bonds Market Value and Market Rate
Bonds market value and required returns got inverse relationship. - When the market interest rate fall, bonds market value increase.
Speculative Bonds /Junk Bonds, or High-Yield Bonds/
Bonds rated BB or lower considered as speculative bonds or very risky investments.
Investment Grade Bonds
Bonds rated BBB or higher considered as investment grade bonds which financially stable, and reliable institutions offer.
Impact of Bond Maturity
Generally, long-term debt pays higher interest rates than short-term debt. In a practical sense, the longer the maturity of a bond, the less accuracy there is in predicting future interest rates, and therefore the greater the bondholders' risk of giving up an opportunity to lend money at a higher rate. In addition, the longer the term, the greater the chance that the issuer might default.
Foreign Bond
Bond sold outside the borrower's country and denominated in the currency of the country in which it is sold
Straight Bond (plain-vanilla bond)
Bond that doesn't have any feature included is sometimes called straight bond.
Premium Bond
A bond that sells above its par value; occurs whenever the going rate of interest is below the coupon rate.
Par Value Bond
A bond that sells at its par value; occurs whenever the going rate of interest is equals to the coupon rate.
Discount Bond
A bond that sells below its par value; occurs whenever the going rate of interest is above the coupon rate
Deflation
A decrease in the general level of prices
Inverted Yield Curve
A downward-sloping yield curve indicates that short-term interest rates are generally higher than long-term interest rates. - Inverted yield curve occurs infrequently and is often a sign that the economy is weakening. Most recessions in the United States have been preceded by an inverted yield curve.
Callable bond
A feature included in nearly all corporate bond issues that gives the issuer the opportunity to repurchase bonds at a stated call price prior to maturity.
Conversion feature
A feature of convertible bonds that allows bondholders to change each bond into a stated number of shares of common stock.
Inflation
A general increase in prices and fall in the purchasing value of money. - Typically, savers demand higher returns (that is, higher interest rates) when inflation is high because they want their investments to more than keep pace with rising prices.
Yield curve
A graphic depiction of the term structure of interest rates. - A quick glance at the yield curve tells analysts how rates vary between short-, medium-, and long-term bonds, but it may also provide information on where interest rates and the economy in general are headed in the future. - The shape of the yield curve may affect the firm's financing decisions.
Corporate bonds
A long-term debt instrument indicating that a corporation has borrowed a certain amount of money and promises to repay it in the future under clearly defined terms.
Trustee
A paid individual, corporation, or commercial bank trust department that acts as the third party to a bond indenture and can take specified actions on behalf of the bondholders if the terms of the indenture are violated.
Inflation Premium (IP)
A premium equal to expected inflation that investors add to the real risk-free rate of return. - Investors will demand a higher nominal rate of return if they expect higher inflation.
Bond Ratings
A rating assigned to a firm to measure the probability of default by a company like S&P or Moody's.
Sinking-fund requirement
A restrictive provision often included in a bond indenture, providing for the systematic retirement of bonds prior to their maturity
Nominal risk-free rate Rf
A return on an investment that is guaranteed for a specified period. - Usually government securities a considered to have no default or liquidity risk.
Flat Yield Curve
A yield curve that indicates that interest rates do not vary much at different maturities
Nominal rate of interest
Actual rate of interest charged by the supplier of funds and paid by the demander. - The nominal rate of interest differs from the real rate of interest, r*, as a result of two factors, inflation and risk.
Current Yield
Bond's annual coupon interest divided by purchase price; measure of a bond's return for that specific period.
Normal Yield Curve
An upward-sloping yield curve indicates that long-term interest rates are generally higher than short-term interest rates. - Upward-sloping yield curves result from expectations of rising interest rates, lender preferences for shorter-maturity loans, and greater supply of short-term loans than of long-term loans relative to demand.
Eurobond
Bond denominated in a currency other than that of the country in which it is sold.
Impact of Offering Size
Bond flotation and administration costs per dollar borrowed are likely to decrease with increasing offering size. On the other hand, the risk to the bondholders may increase, because larger offerings result in greater risk of default. - Investors needs to make trade-offs or balance between decreasing costs and increasing default risk.
Yield to maturity (YTM)
Compound annual rate of return earned on a debt security purchased on a given day and held to maturity. - Market rate of return when bond offered to investors first time.
Risk
Degree of uncertainty of return on an asset; in business, the likelihood of loss or reduced profit. - When people perceive that a particular investment is riskier, they will expect a higher return on that investment as compensation for bearing the risk.
Timing
In addition to making cash flow estimates, we must know the timing of the cash flows. The combination of the cash flow and its timing fully defines the return expected from the asset.
Stock purchase warrants
Instruments that give their holders the right to purchase a certain number of shares of the issuer's common stock at a specified price over a certain period of time.
Bond Indenture (Bond contract)
Legal document containing complete details of a bond issue. Included in bond indenture are standard provisions and restrictive provisions.
Standard Covenants
Provisions in a bond indenture specifying certain record-keeping and general business practices that the bond issuer must follow. - Perspective from the creditors viewpoint, its to do list for companies to follow.
Restrictive Covenants
Provisions in a bond indenture that place operating and financial constraints on the borrower. - Perspective from the creditors viewpoint, its not to do list for companies to maintain certain level of financial and operational risk.
Interest rate
Represents the cost of a loan and is expressed as a percent of the amount borrowed. - Term interest rate is usually applied to debt instruments such as bank loans or bonds
Cost of Bonds to the Issuer
The cost of bond financing is generally greater than the issuer would have to pay for short-term borrowing. The major factors that affect the cost, which is the rate of interest paid by the bond issuer, are the bond's maturity, the size of the offering, the issuer's risk, and the basic cost of money.
Impact of the Cost of Money
The cost of money in the capital market is the basis for determining a bond's coupon interest rate. Government securities of equal maturity is used as the lowest-risk cost of money. To that basic rate is added a risk premium.
Risk Premium (RP)
The difference between the expected rate of return on a given risky asset and that on a risk-free asset. Typical risk that investors require premiums: 1. Default risk 2. Maturity risk 3. Liquidity risk - The risk premium varies with specific issuer and issue characteristics. The risk premium consists of a number of issuer- and issue-related components, including business risk, financial risk, interest rate risk, liquidity risk, and tax risk, as well as the purely debt-specific risks—default risk, maturity risk, and contractual provision risk
Default Risk
The event in which companies or individuals will be unable to make the required payments on their debt obligations.
Required return
The expected return of an investment that is necessary to compensate for the risk of undertaking the investment. - Term required return is applied to equity investments, such as common stock, that give the investor an ownership stake in the issuer.
Impact of Issuer's Risk
The greater the issuer's default risk, the higher the interest rate. Some of this risk can be reduced through inclusion of appropriate restrictive provisions in the bond indenture.
Maturity Risk
The increase in risk due to the increase in the maturity of a debt obligation due to possible changes in interest rates or inflation rates.
Risk and Required Return
The level of risk associated with a given cash flow can significantly affect its value. In general, the greater the risk of (or the less certain) a cash flow, the lower its value. Greater risk can be incorporated into a valuation analysis by using a higher required return or discount rate.
Real rate of interest /r*/
The nominal rate of interest minus the anticipated rate of inflation. - Change in purchasing power - The real rate of interest creates equilibrium between the supply of savings and the demand for funds. It represents the most basic cost of money.
Coupon Interest Rate
The percentage of a bond's par value that will be paid annually, typically in two equal semiannual payments, as interest.
Liquidity Risk
The potential loss that could occur as a result of converting an investment into cash.
Market Price of a Bond
The present value of the cash flow the owner of the bond can expect to receive over the life of the bond.
Face value (par value)
The principal amount of a bond that is repaid at the end of the term.
Valuation
The process that links risk and return to determine the worth of an asset. To determine an asset's worth at a given point in time, a financial manager uses the time-value-of-money techniques and the concepts of risk and return.
Term structure of interest rates
The relationship between the maturity and rate of return for bonds with similar levels of risk.
Coupon Payment (PMT)
The stated interest payment made on a bond.
Expectations theory
The theory that the yield curve reflects investor expectations about future interest rates; an expectation of rising interest rates results in an upward-sloping yield curve, and an expectation of declining rates results in a downward-sloping yield curve. - If investors believe that inflation will rise in the future, yield curve depicts upward-sloping or normal yield curve.
Cash flows (returns)
The value of any asset depends on the cash flow(s) it is expected to provide over the ownership period. To have value, an asset does not have to provide an annual cash flow; it can provide an intermittent cash flow or even a single cash flow over the period.
Bond Yields
The yield, or rate of return, on a bond is frequently used to assess a bond's performance over a given period of time. The three most widely cited bond yields are (1) current yield, (2) yield to maturity (YTM), and (3) yield to call (YTC). - Each of these yields provides a unique measure of the return on a bond.
Liquidity theory
Theory suggesting that long-term rates are generally higher than short-term rates (hence, the yield curve is upward sloping) because investors perceive short-term investments to be more liquid and less risky than long-term investments. Borrowers must offer higher rates on long-term bonds to entice investors away from their preferred short-term securities.
Market Segmentation Theory
Theory suggesting that the market for loans is segmented on the basis of maturity and that the supply of and demand for loans within each segment determine its prevailing interest rate; the slope of the yield curve is determined by the general relationship between the prevailing rates in each market segment.
Valuation Process
Three key inputs to the valuation process: (1) cash flows (returns), (2) timing, and (3) a measure of risk
Theories of Term Structure
Three theories are frequently cited to explain the general shape of the yield curve: 1. Expectations theory 2. Liquidity preference theory 3. Market segment theory - All three term structure theories have merit. From them we can conclude that at any time the slope of the yield curve is affected by (1) interest rate expectations, (2) liquidity preferences, and (3) the comparative equilibrium of supply and demand in the short- and long-term market segments.
Features of Bond Contract
Typical features that can be included in bond indenture is call feature, conversion feature, and stock purchase warrants.
Time to maturity and bond values.
When the required return is different from the coupon interest rate and is constant until maturity, the value of the bond will approach its par value as the passage of time moves the bond's value closer to maturity.
Common standard provisions /positive covenants/
· Maintain satisfactory accounting records in accordance with IFRS or GAAP · Periodically supply audited financial statements · Pay taxes and other liabilities when due · Maintain all facilities in good working order.
Common restrictive provisions /negative covenants/
· Require a minimum level of liquidity, to ensure against loan default. · Prohibit the sale of accounts receivable to generate cash. Selling receivables could cause a long-run cash shortage if proceeds were used to meet current obligations. · Impose fixed-asset restrictions. The borrower must maintain a specified level of fixed assets to guarantee its ability to repay the bonds. · Constrain subsequent borrowing. Additional long-term debt may be prohibited, or additional borrowing may be subordinated to the original loan. Subordination means that subsequent creditors agree to wait until all claims of the senior debt are satisfied. · Limit the firm's annual cash dividend payments to a specified percentage or amount.