Bonds Webster

8/19/2019 Bonds Webster

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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

ayments of rincial andinterest! on seci"c dates! to theholders of the bond#


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Bond markets $rimarily traded in the over-the-counter

%&T'( market#

Most bonds are owned by and tradedamong large "nancial institutions#

)ull information on bond trades in the&T' market is not ublished! but areresentative grou of bonds is listedand traded on the bond division of the*+,#


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Key )eatures of a Bond $ar value . face amount of the bond! whichis aid at maturity %assume /0!111(#

'ouon interest rate . stated interest rate

%generally "2ed( aid by the issuer# Multilyby ar to get dollar ayment of interest#

Maturity date . years until the bond must bereaid#

3ssue date . when the bond was issued# +ield to maturity - rate of return earned on

a bond held until maturity %also called the4romised yield5(#


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6ect of a call rovision Allows issuer to refund the bond

issue if rates decline %hels the

issuer! but hurts the investor(# Borrowers are willing to ay

more! and lenders re7uire more!

for callable bonds# Most bonds have a deferred call

and a declining call remium#


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What is a sinking fund? $rovision to ay o6 a loan over

its life rather than all at maturity# ,imilar to amorti8ation on a term

loan# 9educes risk to investor!

shortens average maturity# But not good for investors if

rates decline after issuance#


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:ow are sinking funds

e2ecuted? 'all 2; of the issue at ar! for sinking

fund uroses#


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The value of "nancial

assets

n

n

=

=

0

0

k(%0') ###

k(%0')

k(%0') Value

+

++

+

+

+

=

0 1 2 n

k

CF1

CFn

CF2

Value

...


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&ther tyes %features( of

bonds 'onvertible bond . may be e2changed for

common stock of the "rm! at the holder>sotion#

Warrant . long-term otion to buy a statednumber of shares of common stock at aseci"ed rice#

$utable bond . allows holder to sell the

bond back to the comany rior to maturity# 3ncome bond . ays interest only when

interest is earned by the "rm# 3nde2ed bond . interest rate aid is based

uon the rate of ination#


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What is the oortunity cost of

debt caital? The discount rate %ki ( is the

oortunity cost of caital! and is

the rate that could be earned onalternative investments of e7ualrisk#

ki @ k 3$ M9$ C9$


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Bond values over time At maturity! the value of any bond must

e7ual its ar value#

3f kd remains constantD The value of a remium bond would

decrease over time! until it reached/0!111#

The value of a discount bond wouldincrease over time! until it reached/0!111#

A value of a ar bond stays at /0!111#


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Ce"nitions

+

==

=

=

'E+

-2ected

'+

-2ected +TMreturntotal-2ected

rice Beginning

ricein'hange %'E+(yieldgains'aital

rice'urrent

ayment couon Annual %'+(eld'urrent yi


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What is reinvestment rate

risk? 9einvestment rate risk is the concern

that kd will fall! and future ')s will

have to be reinvested at lower rates!hence reducing income#

EXAMPLE: Suppose you just won

$500,000 playing the lottery. Youinten to in!est the "oney an

li!e o# the interest.


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9einvestment rate risk

e2amle +ou may invest in either a 01-year bond or

a series of ten 0-year bonds# Both 01-yearand 0-year bonds currently yield 01;#

3f you choose the 0-year bond strategyD After +ear 0! you receive /F1!111 in

income and have /F11!111 to reinvest#But! if 0-year rates fall to G;! your

annual income would fall to /0F!111# 3f you choose the 01-year bond strategyD

+ou can lock in a 01; interest rate! and/F1!111 annual income#


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'onclusions about interest rate

and reinvestment rate risk

'&*'


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Would you refer to buy a 01-year!01; annual couon bond or a 01-

year! 01; semiannual couon bond!all else e7ual?

The semiannual bond>s e6ective rateisD

01#=F; 01; %the annual bond>se6ective rate(! so you would refer thesemiannual bond#

01#=F;0=

1#0100m

i0-));

=m

*om =−

+=−

+=


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Cefault risk

3f an issuer defaults! investorsreceive less than the romised

return# Therefore! the e2ectedreturn on cororate and municialbonds is less than the romisedreturn#

3nuenced by the issuer>s "nancialstrength and the terms of the bondcontract#


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Tyes of bonds

Mortgage bonds

Cebentures

,ubordinated debentures

3nvestment-grade bonds

Lunk bonds


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valuating default riskDBond ratings

Bond ratings are designed to reectthe robability of a bond issue goinginto default#

Investment Grade Jn! "#nds

$##d%&s

Aaa Aa A Baa Ba B 'aa '

' ( P AAA AA A BBB BB B '''C


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)actors a6ecting default risk andbond ratings

)inancial erformance Cebt ratio

T3 ratio

'urrent ratio

Bond contract rovisions ,ecured vs# Hnsecured debt

,enior vs# subordinated debt

Euarantee and sinking fund rovisions

Cebt maturity


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&ther factors a6ecting defaultrisk

arnings stability

9egulatory environment

$otential antitrust or roductliabilities

$ension liabilities

$otential labor roblems

Accounting olicies


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Bankrutcy

Two main chaters of the )ederalBankrutcy ActD 'hater 00! 9eorgani8ation 'hater !


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$riority of claims inli7uidation

0# ,ecured creditors from sales ofsecured assets#

=# Trustee>s costsG# Wages! subNect to limitsO# Ta2es

F# Hnfunded ension liabilities

P# Hnsecured creditors# $referred stock

Q# 'ommon stock


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9eorgani8ation

3n a li7uidation! unsecured creditorsgenerally get 8ero# This makes themmore willing to articiate inreorgani8ation even though their claimsare greatly scaled back#

Various grous of creditors vote on thereorgani8ation lan# 3f both the maNority

of the creditors and the Nudge arove!comany 4emerges5 from bankrutcywith lower debts! reduced interestcharges! and a chance for success#

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Bonds Webster