bonds masters in financial engineering spring 2012

7/29/2019 Bonds Masters in Financial Engineering Spring 2012

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Corporate Bonds


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Know the important bond features and bondtypes

Understand bond values and why they fluctuate Understand bond ratings and what they mean

Understand the impact of inflation on interestrates

Understand the term structure of interest ratesand the determinants of bond yields

Key Concepts


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Abond is a debt instrument issued for a period ofmore than one year with the purpose of raisingcapital by borrowing. It is a debt obligation.

It represents a promise to pay bondholders a fixedsum of money (called the bondsprincipal, or paror face value) at a future maturity date, along with

periodic payments of interest (called coupons).

Bond Basic Definition


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Bond Basics Bondholders are lending the corporation

funds for some stated period of time.

The corporation promises to makecertain payments to the owner of thebond.


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Most bonds are owned by life insurance companiesand pension funds.

These institutions can eliminate much of theirfinancial risk via cash flow matching.

Cash flow matching is a process ofhedging in which a company orother entity matches its cash outflows (i.e. financial obligations) with itscash inflows.

They can also diversify away most default risk byincluding a large number of different bond issuesin their portfolios.
http://en.wikipedia.org/wiki/Hedge_(finance)http://en.wikipedia.org/wiki/Hedge_(finance)


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Bonds

Bond Selling Price

Bond Certificate

Interest Payments

Face Value Payment atEnd of Bond Term

At Bond Issuance DateCompanyIssuingBonds

Subsequent Periods

InvestorBuying BondsCompanyIssuingBonds

InvestorBuying Bonds


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Bond Basics Indenture

Definition: the contract between thecorporation and the investor

Provisions included in the indenture:

par value

coupon rate and payment dates

maturity date

any special features


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Par Value

(e.g. $1,000) also called Face Value

Coupon Interest Rate The stated rate of interest. The rate that

is multiplied by the par value to determinethe annual dollar interest paid.

Maturity

Time at which the original principal (ParValue) is repaid to the bondholder.

Bond Basics


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Corporate Bond Example


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Bond Value = PV of coupons + PV of par

Bond Value = PV of annuity + PV of lump sum

Calculating the Bond

Value


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Bond Value = C1-

1

(1+ r)t

r

+F

(1+ r)t

The Bond Pricing

Equation


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Determining the Selling PriceOn January 1, 2009, Masterwear Industries issued $700,000 of

12% bonds, dated January 1. Interest is payable semiannuallyon June 30 and December 31. The bonds mature in three

years. The market yield for bonds of similar risk and maturity is14%.

Present Values

Interest $ 42,000 4.76654 = 200,195$

Principal $700000 0.66634 = 466,438

Present value (price) of bonds 666,633$

Calculation of the Price of the Bonds

Because interest is paid semiannually, the present value calculations use: (a)the semiannual statedrate (6%), (b) the semiannual marketrate (7%), and

(c) 6 (3 x 2) semi-annualperiods.

Present value of an ordinary annuity of $1: n=6, i=7%

present value of $1: n=6, i=7%


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Present Value of Cash Flows as RatesChange

Remember, as interest rates increasepresent values decrease

So, as interest rates increase, bondprices decrease and vice versa


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Concept of Yield to

Maturity The yield to maturity or the discount

rate is the rate of return required by

bondholders


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Determining the Selling Price

Stated interest rate is: The bonds sells:

Below market rateAt a discount

(Cash received is less

than face amount)

Equal to market rateAt face amount

(Cash received is equal

to face amount)

Above market rateAt a premium

(Cash received is greater

than face amount)


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Impact on Bond Price Given aChange in Yield to Maturity


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Time to Maturity

The longer the maturity of a bond, themore sensitive the price is to a given

change in interest rate.


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Impact of Time to Maturityon Bond Prices


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Formula for Bond Yield

Weighted average is used to get the average investment over 15 year holdingperiod


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Differences Between Debt andEquity

Debt

Creditors do not have votingrights

Interest is considered a cost

of doing business and is taxdeductible

Creditors have legal recourseif interest or principalpayments are missed

Excess debt can lead to

financial distress andbankruptcy

Equity Ownership interest Common stockholders vote

for the board of directorsand other issues

Dividends are not considereda cost of doing business andare not tax deductible

Dividends are not a liabilityof the firm and stockholdershave no legal recourse if

dividends are not paid An all equity firm can not go

bankrupt merely due to debtsince it has no debt


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Types of Bond Issuers

Government - United States Treasury

- Municipal: State and Local (School, City, DWP)

Corporate

- Investment Grade

- Speculative Grade/Low Quality Junk bond


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Government Bonds

Treasury Securities

Federal government debt

T-bills pure discount bonds with original maturity of oneyear or less

T-notes coupon debt with original maturity between oneand ten years

T-bonds coupon debt with original maturity greater thanten years

Municipal Securities

Debt of state and local governments

Varying degrees of default risk, rated similar to corporatedebt

Interest received is tax-exempt at the federal level thoughnot necessarily from state income taxes. Yield are much

lower because of enormous tax breaks.


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Corporate Bonds

Contract between the company and thebondholders that includes

The basic terms of the bonds

The total amount of bonds issued

A description of property used as security, if

applicable Protective covenants


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Corporate Bond

Classifications Security

Collateral secured by financial securities

Mortgage secured by real property,normally land or buildings

Debentures unsecured


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Special Features of Bond Indentures

Collateral

If the debt is secured by specific assets, the

lender is entitled to take the assets in theevent of default.

Plan for repayment at maturity

Staggered maturities makes it easier for thefirm to raise the necessary funds.

Sinking funds allow the firm to set aside thefunds over time to ensure the ability to repay

the loan.


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Provisions for early repayment

Call provisions allow the issuer to

refinance the debt, usually done ifinterest rates fall.

Issuing new bonds to replace old bonds isknown as refunding.



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Protective Covenants

A bond indenture is likely to contain a number ofprotectivecovenants.

Protective Covenantsare restrictions designed to protectbondholders.

Negative covenant (thoushaltnot) example- The firmcannot pay dividends to stockholders in excess of what is

allowed by a formula based on the firms earnings.

Positive covenant (thoushalt) example- Proceeds fromthe sale of assets must be used either to acquire otherassets of equal value or to redeem outstanding bonds.


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Restrictions on company operationsthat are designed to reduce risk to

bondholders. Restrictions on additional debt

Restrictions on payment of dividends

Minimum working capital required Name of independent trustee to

oversee the bond issue



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Bond Ratings Moodys and Standard & Poors regularly

monitor issuers financial condition and

assign a rating to the debt


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Bond Ratings

Moodys and Standard & Poors regularlymonitor issuers financial condition and assigna rating to the debt

InvestmentGrade

BelowInvestmentGrade

(Junk)

AAA Best QualityAA High QualityA Upper Medium GradeBBB Medium GradeBB SpeculativeB Very SpeculativeCCC Very Very SpeculativeCCC No Interest Being Paid

D Currently in Default


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Types of Bonds

Debenture

Subordinated Debenture


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Types of Bonds

Debenture


A debenture is an unsecured bond.

A subordinated debenture is adebenture that has lower priority forpayment than other debenturesdesignated as senior.


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Types of Bonds

Debenture


A mortgage bond is secured by real

assets such as airplanes, railroad cars,or real estate.

Mortgage Bond


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Types of Bonds

Debenture


Mortgage Bond

Convertible Bond

A convertible bond is a bond that gives the

investor the right to convert the bond into agiven number of shares of stock on or aftera given future date.The conversion ratio is the number of shares

the investor will get for each bond converted.


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Types of Bonds

Debenture


Mortgage Bond Convertible Bond

The conversion value is the market price pershare times the conversion ratio.

e.g. If the stock price = $20 and the conversionratio = 45, the conversion value = $20 x 45 = $900.


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Types of Bonds

Debenture




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Types of Bonds

Debenture




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Types of Bonds

Debenture


Mortgage Bond

Convertible Bond

Junk Bond

A junk bond is a bond that is rated below

investment grade.


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Types of Bonds

Debenture Subordinated Debenture

Mortgage Bond

Convertible Bond Junk Bond

International Bond

International bonds are bonds thatare sold in countries other thanwhere the issuer is domiciled.


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Bond Risk Hierarchy

1st Mortgage Bonds

2nd Mortgage BondsSenior Debentures

Subordinated Debentures

Preferred StockCommon StockMore

Risk

LessRisk

Priority of ClaimHigher Lower


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The Yield Spread

The yield spread is the extra return (increased yield to maturity) thatinvestors demand for buying a bond with a lower credit rating (andhigher risk).

Yield spreads are often quoted in basis points over Treasurynotes and bonds (risk free rate bonds). That is,

Suppose we see a 5-year Aaa/AAA yield spread equal to 59.

This means the YTM on this bond is 59 basis points (0.59%)greater than 5-year U.S. Treasury notes.

One basis point is .01% or .0001

So if treasury note is 1% then the corporate note would have tobe 1.59%

A bonds credit rating helps determine itsyieldspread.

Decision Makers


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Times interestearned ratio =

Net income + interest + taxesInterest

Decision Makers

PerspectiveLong-term debt impacts several key

financial ratios.

Debt toequity ratio Total liabilitiesShareholders equity=

Rate of return onshareholders equity

Net incomeShareholders equity

=


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Features of Preferred Stock

A hybrid security with both debt andequity characteristics.

Has priority over common stock in receiptof dividends and in liquidation.

Dividends are fixed as a percentage of parvalue.

Only participating preferred stock (whichis rare) shares in the residual income withthe common stockholders.


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Investors in Preferred Stock

Corporations can generally exclude fromtaxable income 70% of dividend incomereceived on preferred stock issued by another

corporation. e.g. Company X owns Company Y preferred

stock that pays 12% dividends. If CompanyXs marginal tax rate = 40%, the after tax

yield on this investmentAT yield = 12%[1-(.3x.4)] = 10.56%

Compare to 12% on fully taxable investment:

AT yield = 12%(1-.4) = 7.2%


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Types of Bond Risk

Interest Rate Risk

Reinvestment Rate risk

Credit or Default Risk

Liquidity Risk


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Interest Rate Risk

Interest Rate Risk- changes in prevailingmarket rates. Also known as market risk.

Inverse Relationship between Price andInterest Rate.

This is not a concern if the investor held thebond to maturity. If you dont hold bond till

maturity and needed to sell the bond, ratesmight have risen which could cause thebond price to go down. You would beselling at a loss.


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Reinvestment Rate Risk

From the perspective of the owner of the bond(creditor), cash flows or coupon payments areusually reinvested; these additional income

generated off of the these cash flows can also becalled interest on interest.

When these coupon payments are reinvested, therisk is that if prevailing rates have fallen, then the

investor would earn a lower rate of interest off ofthese coupon payments. This is a low concern ifthe investor uses the income.


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Interest Rate Risk

Price Risk

Change in price due to changes in interest rates

Reinvestment Rate Risk

Uncertainty concerning rates at which cash flows can bereinvested

High coupon rate bonds have more reinvestment rate riskthan low coupon rate bonds


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Credit or Default Risk

Definition- risk that the issuer of thebond will be unable to make the

principal and interest payments(i.e. default)


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Term Structure of Interest Rates

Term structure is the relationship betweentime to maturity and yields, all else equal.

Yield curve graphical representation of theterm structure Normal upward-sloping, short term rates are

lower than long-term rates

Inverted downward-sloping, short term ratesare higher than long term rates


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Upward Sloping YieldCurve


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Downward Sloping YieldCurve

li h li d


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Flight to quality = SpreadWidening

Aflight to quality is the act ofmoving capital away from "risky"

investments and toward "safer"investments during a time ofuncertainty.

For Example, Slower-than-expectedeconomic growth, corporate scandals,wars and higher oil prices.


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Flight to quality = SpreadWidening

This time of uncertainty motivates investorsto sell their aggressive, higher-riskinvestments and buy investments than canweather the potentially rough times ahead.

Although a flight to quality can affect allinvestment sectors, it might occur in just one

market sector, such as the bond market(where investors would sell lower grade bondsand invest in Treasuries or higher gradecorporate bonds)


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Historical look at CreditSpreads


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Historical look at CreditSpreads

F g t to ua ty= Y e spreaid i


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g y pwideningTreasury notes outperforming Baa

Corporate notes and economy going intorecession

Fli ht f Q lit S d


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Flight from Quality= SpreadNarrowing Baa Corporate notes

outperforming Treasury notes

bonds masters in financial engineering spring 2012

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