November 24, 2014

Chapter 7. Bond Valuation

. Who issues bonds
. Characteristics of bonds
. Bond valuation
. Important relationships in bond pricing
. Bond rating
. Bond markets

. Who issues bonds

 Bond: a long-term debt

 Treasury bonds: issued by the federal government, no default risk

Municipal bonds (munis): issued by state and local governments with some default risk - tax benefit (returns are tax exempt)

 Corporate bonds: issued by corporations with different levels of default risk

 Mortgage bonds: backed by fixed assets (first vs. second)

 Debenture: not secured by a mortgage on specific property

 Subordinated debenture: have claims on assets after the senior debt has been paid  off

 Zero coupon bonds: no interest payments (coupon rate is zero)

 Junk bonds: high risk, high yield bonds

 Eurobonds: bonds issued outside the U.S. but pay interest and principal in U.S. dollars

 International bonds

. Characteristics of bonds

 Claim on assets and income

 Par value (face value, M): the amount that is returned to the bondholder at maturity, usually it is $1,000

  Maturity date: a specific date on which the bond issuer returns the par value to the bondholder

 Coupon interest rate: the percentage of the par value of the bond paid out annually  to the bondholder in the form of interest

 Coupon payment (INT): annual interest payment

 Fixed rate bonds vs. floating rate bonds

 Zero coupon bond: a bond that pays no interest but sold at a discount below par

Indenture: a legal agreement between the issuing firm and the bondholder

 Call provision: gives the issuer the right to redeem (retire) the bonds under  specified terms prior to the normal maturity date

 Convertible bonds: can be exchanged for common stock at the option of the bondholder

 Putable bonds: allows bondholders to sell the bond back to the company prior to  maturity at a prearranged price

 Income bonds: pay interest only if it is earned

Sinking fund provision: requires the issuer to retire a portion of the bond issue each year

 Indexed bonds: interest payments are based on an inflation index

Required rate of return: minimum return that attracts the investor to buy a bond;

It serves as the discount rate (I/YR) in bond valuation

. Bond valuation

 Market value vs. intrinsic (fair) value

 Market value: the actual market price, determined by the market conditions

 Intrinsic value: the fair or fundamental value

(1) Intrinsic value: present value of expected future cash flows, fair value

 Annual and semiannual coupon payments using a financial calculator

 Discount bond: a bond that sells below its par value

 Premium bond: a bond that sell above its par value

(2) Yield to maturity (YTM): the return from a bond if it is held to maturity

 (3) Yield to call: the return from a bond if it is held until called

(4) Current yield (CY) = annual coupon payment / current market price

. Important relationships in bond pricing

 (1) The value of a bond is inversely related to changes in the investor’s
present required rate of return (current interest rate); or

 As interest rates increase, the value of a bond decreases

 Interest rate risk: the variability in a bond value caused by changing
interest rates

Interest rate price risk: an increase in interest rates causes a decrease in
bond value

 Interest reinvestment risk: a decrease in interest rates leads to a decline in

 reinvestment income from a bond

(2) If the required rate of return (or discount rate) is higher than the coupon
rate, the value of the bond will be less than the par value; and

 If the required rate of return (or discount rate) is less than the coupon rate,
the value of the bond will be higher than the par value

 (3) As the maturity date approaches, the market value of a bond approaches
its par value

 (4) Long-term bonds have greater interest rate risk than short-term bonds

 (5) The sensitivity of a bond’s value to changing interest rates depends not
only on the length of time to maturity, but also on the pattern of cash
flows provided by the bond (or coupon rates)

. Bond rating

 Importance: firm’s credit

 Moody’s and S&P provide bond ratings



 A Investment-grade bonds



 B Junk bonds


 Criteria to consider

 Financial ratios: for example, debt ratio and interest coverage ratio

Qualitative factors: for example, contract terms, subordinated issues, etc.

 Other factors: for example, profitability ratios and firm size

. Bond markets

 OTC markets

 Quotes: quoted as a % of par value of $100

Invoice price (dirty price) = quoted price (clear price) + accrued interest

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