chapter 7 bonds and their valuation
DESCRIPTION
CHAPTER 7 Bonds and Their Valuation. Key features of bonds Bond valuation Measuring yield Assessing risk. What is a bond?. A long-term debt instrument in which a borrower agrees to make payments of principal and interest, on specific dates, to the holders of the bond. What is a bond?. - PowerPoint PPT PresentationTRANSCRIPT
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CHAPTER 7Bonds and Their Valuation
Key features of bonds Bond valuation Measuring yield Assessing risk
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What is a bond? A long-term debt instrument in
which a borrower agrees to make payments of principal and interest, on specific dates, to the holders of the bond.
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What is a bond?Long Term debt(Bond certificate sample)
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Firm A Other BondholdersBondholders
“IOU” (bond)
Capital (RM)
OTC market
(RM)Coupon interest (periodically)
Par Value (at maturity date)(RM)
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Key Features of a Bond Par value – face amount of the bond, which
is paid at maturity (assume $1,000). Coupon interest rate – stated interest rate
(generally fixed) paid by the issuer. Multiply by par value to get dollar payment of interest.
Maturity date – years until the bond must be repaid.
Issue date – when the bond was issued. Yield to maturity - rate of return earned on
a bond held until maturity (also called the “promised yield”).
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The value of financial assets
nn
22
11
r)(1CF ... r)(1
CF r)(1CF Value
0 1 2 nr%
CF1 CFnCF2Value
...
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What is the value of a 10-year, 10% annual coupon bond, if rd = 10%?
$1,000 V$385.54 $38.55 ... $90.91 V
(1.10)$1,000 (1.10)
$100 ... (1.10)$100 V
BB
10101B
0 1 2 nr
100 100 + 1,000100VB = ?
...
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Using a financial calculator to value a bond
This bond has a $1,000 lump sum (the par value) due at maturity (t = 10), and annual $100 coupon payments beginning at t = 1 and continuing through t = 10, the price of the bond can be found by solving for the PV of these cash flows.
INPUTS
OUTPUTN I/YR PMTPV FV
10 10 100 1000
-1000
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The same company also has 10-year bonds outstanding with the same risk but a 13% annual coupon rate
This bond has an annual coupon payment of $130. Since the risk is the same the bond has the same yield to maturity as the previous bond (10%). In this case the bond sells at a premium because the coupon rate exceeds the market rate (rd).
INPUTS
OUTPUTN I/YR PMTPV FV
10 10 130 1000
-1184.34
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The same company also has 10-year bonds outstanding with the same risk but a 7% annual coupon rate
This bond has an annual coupon payment of $70. Since the risk is the same the bond has the same yield to maturity as the previous bonds (10%). In this case, the bond sells at a discount because the coupon rate is less than the market rate (rd).
INPUTS
OUTPUTN I/YR PMTPV FV
10 10 70 1000
-815.66
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What is the rd ( ie. Yield to maturity-YTM) on a 10-year, 9% annual coupon, $1,000 par value bond, selling for $887? (selling at Discount) Must find the rd that solves this model.
10d
10d
1d
Nd
Nd
1d
B
)r(11,000 )r(1
90 ... )r(190 $887
)r(1M )r(1
INT ... )r(1INT V
N =10, PV = -887, Pmt = 90, FV = 1,000, I/yr = ?? 10.91YTM > Coupon
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Find YTM, if the bond price is $1,134.20 Solving for I/YR, the YTM of this bond
is 7.08%. This bond sells at a premium, because YTM < coupon rate.
INPUTS
OUTPUTN I/YR PMTPV FV
10
7.08
90 1000-1134.2
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What is interest rate (or price) risk? Does a 1-year or 10-year bond have more interest rate risk?
Assume coupon payments is 10% and par value $1,000
Interest rate risk is the concern that rising rd will cause the value of a bond to fall.
rd 1-year Change 10-year Change5% $1,048 $1,38610% 1,000 1,00015% 956 749
The 10-year bond is more sensitive to interest rate changes, and hence has more interest rate risk.
+ 4.8%
– 4.4%
+38.6%
–25.1%
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1- year Bond (10% coupon)
I/ yr= 5%, FV= 1,000, Pmt= 100, PV= 1,047
I/ yr= 15%, FV= 1,000, Pmt= 100, PV=956
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10- year Bond (10% coupon)
I/ yr= 5%, FV= 1,000, Pmt= 100, PV= 1,386
I/ yr= 15%, FV= 1,000, Pmt= 100, PV= 749
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So, the 10-year bond is more sensitive to interest rate changes, and hence has more interest rate risk. The relationship between price of bond and interest rates is inverse
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Illustrating interest rate risk
0200400600800
1,0001,2001,4001,600
0 5 10 15 20Interest rates (% )
Valu
e ($
)
n = 1
n = 10
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Reinvestment Risk
100
CF
100 + 1,000100 100 100
CFCF CFCF
“reinvest cash inflow at going market rates”
Thus, if market rates , may experience income reduction
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What is reinvestment rate risk? Reinvestment rate risk is the
concern that rd will fall, and future CFs will have to be reinvested at lower rates, hence reducing income.
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What is the value of a 10-year, 10% semiannual coupon bond, if rd = 13%?
1. Multiply years by 2 : N = 2 * 10 = 20.2. Divide nominal rate by 2 : I/YR = 13 / 2 = 6.5.3. Divide annual coupon by 2 : PMT = 100 / 2 =
50.
INPUTS
OUTPUTN I/YR PMTPV FV
20 6.5 50 1000
- 834.72
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Bonds call back
Corp A
Bank loan at 6%
Bondholdersie: coupon= 10%
new financing
BondCall back
Pay principle + penalty
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Callable Bond Valuation
i.e: Northern Timber issued a $1,000 25 years bond. The bond has a call provision that allowed it to be retired any time after 5 years, with additional coupon put as penalty. The coupon rate is 18%, interest rate is 8%
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0 5 10 15
n= 5
Principle = 1,000 + 180 (penalty)Pmt = 180I/ yr = 8%, PV = (?)
20 25
valuation
Callable Bond Valuation
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Callable bond Valuation
INPUTS
OUTPUTN I/YR PMTPV FV
5
8
180 11801,521
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Callable bond & yield to call (i.e.1) A 10-year, 10% annual coupon
bond selling for $1,135.90 can be called in 4 years for $1,050, what is its yield to call (YTC)?
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Callable bond & yield to call (i.e.1)
1 6 7 8 9 102 3 4 50
Call Back Bond
- Principle + Penalty = RM 1,050
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Because annual Coupon,1. n = 4 2. Coupon pmt
= 10% x 1,000= 100
3. Principle (FV) - RM 1,050
4. Original price (PV) - RM 1,135
5. YTC ?
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Callable bond & yield to call (i.e.1) A 10-year, 10% annual coupon
bond selling for $1,135.90 can be called in 4 years for $1,050, what is its yield to call (YTC)?
INPUTS
OUTPUTN I/YR PMTPV FV
4
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100 1050- 1135.90
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Callable bond & yield to call (i.e.2)
A 10-year, 10% semiannual coupon bond selling for $1,135.90 can be called in 4 years for $1,050, what is its yield to call (YTC)?
Solving for the YTC is identical to solving for rd, except the time to call is used for N and the call premium is FV.
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Callable bond & yield to call (i.e.2)
1 6 7 8 9 102 3 4 50
Call Back Bond
- Principle + Penalty = RM 1,050
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Because Semiannual Coupon,
1. n x 2 = 4 x 2
= 8
2. Coupon pmt x 1,000 2= 10% / 2 x 1,000= 50
3. Principle (FV) - RM 1,050
4. Original price (PV) - RM 1,135
5. YTC ?
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Callable bond & yield to call (i.e.2) A 10-year, 10% semiannual
coupon bond selling for $1,135.90 can be called in 4 years for $1,050, what is its yield to call (YTC)?
INPUTS
OUTPUTN I/YR PMTPV FV
8
3.568
50 1050- 1135.90
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Default risk If an issuer defaults, investors
receive less than the promised return.
The default risk is influenced by the issuer’s financial strength and the terms of the bond contract.
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Evaluating default risk:Bond ratings
Bond ratings are designed to reflect the probability of a bond issue going into default.
Investment Grade Junk BondsMoody’s
Aaa Aa A Baa Ba B Caa C
S & P AAA AA A BBB BB B CCC D
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Factors affecting default risk and bond ratings Debt ratio, TIE ratio, Current
ratio Bond contract provisions
Secured vs. Unsecured debt Guarantee and sinking fund
provisions Earnings stability
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Other types (features) of bonds Convertible bond – may be exchanged
for common stock of the firm, at the holder’s option.
Putable bond – allows holder to sell the bond back to the company prior to maturity.
Income bond – pays interest only when income is earned by the firm.
Indexed bond – interest rate paid is based upon the rate of inflation.