Chapter 6

The Valuation and Characteristics of Bonds

VALUATION
A systematic process through which the price at which
a security should sell is established
The security's intrinsic value

THE BASIS OF VALUE

Real assets (houses, cars) have worth due to the services they provide

Financial assets are pieces of paper and depend for value on the present value of future
cash flows

Differences of opinion about the value of securities arise from different assumptions about
future cash flows and the interest rate for taking present values

Stock prices are hardest to pin down because future dividends and prices are never
guaranteed.

INVESTMENTS AND RETURNS

Investing: Using any resource in a way which generates future benefits rather than
immediate satisfaction

Financial Investing:
Investing Putting money to work to earn more money by entrusting it to an
organization which pays the owner for its use

Methods of entrusting money

lending - debt investment - bonds
ownership - equity investment - stock

Return on One Year Investments

Return is what the investor receives
Can be expressed as a dollar amount or as a rate

Rate of return (required rate of return) is what the investor receives divided by what was
invested

6-1
 BONDS
Bonds represent a debt relationship:
The issuing company borrows and the bond buyer lends.

Bonds enable one company to borrow from many investors at once

Firms raise money through L-T securities therefore the value of these securities is
important to the financial manager.

The valuation of these securities is affected by investing, financing, and dividend decisions.

Terminology
Promissory note - Legal evidence of the debt
Term or Maturity - Time until repayment
Par or face value - Loan principal
Non-amortized debt - pays interest only until maturity
New issues, seasoned issues

Characteristics:
Type
(1) Classify by security behind it
Secured Bonds
Backed by the value of specific assets
Mortgage Bonds - Backed by real estate
Debentures
Unsecured bonds
Rely on general creditworthiness
Riskier than secured debt of the same company
Usually issued at higher coupon rates
Subordinated Debentures - Senior Debt
Priority in the event of failure
Junk Bonds:
High risk - High return
Issued by weak or new companies
Often used to finance acquisitions
(2) classify as to whether senior or junior
(3) Equipment Trust Certificates
(4) Collateral Trust Bonds
(5) Income bonds
(6) Pollution Control & Industrial Revolution

6-2
Features
(1) Indenture
(2) Trustee
(3) Call feature
(4) Bond refunding
(5) Sinking fund
(6) Equity Linked Debt
Convertible Bonds
Can be converted into stock
Exercise if the stock's price rises enough to make converted shares
worth more than the bond
"Sweetener"
Warrants
(7) Sizes of issue
(8) Coupon rates
(9) Maturities
(10) Bond ratings
Investment Grade (top 4 ratings)

BOND RATINGS
Ratings assess default risk based on analysis of issuing firm by rating agency
Main agencies: Moody's and S&P

Rating Symbols and Grades

Moody's S&P Implication

Aaa AAA Highest quality,
Aa AA extremely safe
A A Good quality,

Baa BBB "Investment grade"

Ba BB Poor quality,
B B risky

Caa CCC Low quality, very

C D risky

Investment grade: Above Baa/BBB

6-3
 Why Ratings are Important

Investors require higher returns on riskier issues

Ratings measure default risk and are therefore a determinant of the rates investors
demand
A lower rating implies the firm's cost of borrowing is higher

The Significance of
the Investment Grade Rating

Most bonds are purchased by institutional investors

Required by law to make only conservative investments
Can deal only in investment grade bonds
This limits the market for lower rated debt

The Differential Over Time

The rate spread tends to be larger when rates are high

High rates are associated with tough economic times

when marginal companies tend to fail

The risk of default is greater so investors demand bigger differential in bad times

The spread itself is an economic indicator

A high differential is a signal that harder times

are coming

Bond Indentures
Agreements in bond contracts
Control default risk by prohibiting risky activity by the issuing company

Sinking Funds
Ensure funds are available for repayment of principal
Periodic deposits
Random calls
Serial bonds

6-4
Advantages of debt financing
(1) relatively low cost
(2) leverage affect on EPS
(3) owners maintain greater control

Disadvantages
(1) increase financial risk
(2) restrictions placed on firm by lenders

Corporate Bonds
most traded on OTC
large issues are traded on listed exchanges
Government Debt
T-bills
T-notes
T-bonds

Price Quotations of bonds (corporate and government):

Percentage of Par

INTERNATIONAL BOND MARKET

Eurobonds--bonds issued by U.S. Corporation denominated in dollars but sold to investors

outside the U.S. (Mainly bearer bonds)

Foreign Bonds--written by investment banking syndicates from a single country

denominated in the currency of the country and issued in another country

6-5
 Bond Valuation
In terms of the time value of money:

Invest PV at rate k and receive future cash flows of

principal = PV, and
interest = kPV

at the end of a year, so

FV1 = PV + kPV

FV1 = PV(1+k)

Think of PV as the price of the security

with future cash flows FV1

Then the rate of return (k) is the interest rate which makes the present value of the future
cash flows equal to the price

The Return on Longer Term Investments

Usually involves a number of cash flows at different times

The concept remains the same

Return is the discount rate which makes the present value of

all future cash flows equal to the price.

Example: If pay $363 for a guarantee of $200 next year and $250 the following year, the
return is (approximately) 15% because:

0 1 2

$200 $250

PV=$363

6-6
 Bond Cash Flows: The Coupon Rate and Payment

The interest rate paid on the bond's face amount ($1000)

Generally fixed for the life of the bond

Coupon payment - dollar amount of interest paid, usually semiannually

BOND VALUATION - BASIC IDEAS

Coupon rates are fixed for bond's life and are

chosen close to market rates at the time of issue.

But market rates change constantly.

In order to be salable among investors after their initial issue, bonds must offer new
investors the market return.

Accomplished by market price changes

E.g.: If market rate goes up, bond's price goes down. Price drop increases a new buyer's
yield because bond's cash flows are fixed

Price drops until yield = new market rate

6-7
Fundamental rule: Bond prices and interest rates move in opposite directions

As interest rates rise, bond prices lower, but this is not 1-1 relationship.

Coupon Rate - YTM Relationship

6-8
Kd < Coupon Rate  Premium
Kd > Coupon Rate  Discount
Kd = Coupon Rate  Par

DETERMINING THE PRICE OF A BOND

PB = PV interest payments + PV principal repayment

Annuity + Single Amount

Two time value problems together

0 1 2 3 n-2 n-1 n

PMT PMT PMT PMT PMT PMT

Annuity FV
(for bonds the par value
or selling price)
Amount

PVA=PMT[PVFAk,n]

PV=FV[PVFk,n]

PB = PMT[PVFAk,n] + FV[PVFk,n]

6-9
 THE BOND PRICING FORMULA

m
Ct
Price of Bond =  t
(1+ i )
t=1

Two Cash Streams

Annuity (interest)

i - nm
1 - (1+ )
m
PV a = A [ ]
i
m

Single Sum

S
PV s =
i nm
(1 + )
m

Interest paid semiannually therefore need to adjust interest rate and period.

Most bonds pay interest semiannually, so periods along the time line are half years

PB = PMT[PVFAk,n] + FV[PVFk,n]

6-10
PMT (the interest payment) is calculated by applying the coupon rate to
the face value and dividing by two

k = market rate divided by two

n = years from now until maturity times two

Bond Interest Rates

Coupon rate determines PMT

Coupon Rate = Interest in dollars

Par Value

The current yield is the annual interest payment divided by the bond's
current price.
Not used in pricing calculations

Current Yield = Interest in dollars

Price of Bond

k = the current market rate the bond must yield k to new investors
Rate at which PV is taken
k = YTM – Yield to Maturity

YTM= Capital gain (loss) + income from interest payments

YTM (Exact)

6-11
 C1 C2 C m + Par
Bond Price = 1
+ 2
+ ....+
(1 + YTM ) (1 + YTM ) (1 + YTM )m
YTM (approximate)

Par - Price
Annual Interest dollars +
number of yrs maturity
YTM app =
Price + Par
2

Solve for Price

The Emory Corporation issued an 8%, 25 year bond 15 years ago at its $1,000 par
value. Comparable bonds are yielding 10% today. What must Emory's bond sell for
to yield 10% (YTM) to the buyer? Interest is paid semiannually.

PB = PMT[PVFAk,n] + FV[PVFk,n]

PMT = (Coupon Rate  Face Value)/2

= (.08  $1,000)/2
= $40.00

n = 10 years  2 = 20
k = 10%/2 = 5%

FV = $1,000

PB = $40[PVFA5,20] + $1,000[PVF5,20]

A-4: PVFA5,20 = 12.4622

A-2: PVF5,20 = .3769

PB = $40[12.4622] + $1,000[.3769]
= $498.49 + $376.90

6-12
 = $875.39

Double Check for reasonableness: Estimate the answer first based on whether the
market rate is above or below the coupon rate.

MATURITY RISK REVISITED

Maturity risk arises from the fact that bond prices vary (inversely)
with interest rates. Also called price risk and interest rate risk.

Longer term bond prices change more in response to interest rate movements than
shorter term bond prices, so maturity risk implies the degree of risk is related to the
maturity (term) of the bond.

Interest Rate Increase from 8% to 10% Assume all bonds were originally priced at
1000 and had an 8% coupon.

Time to Maturity Price Drop from $1,000

2 yrs $964.54 $35.46
5 yrs $922.77 $77.23
10 yrs $875.39 $124.61
20 yrs $828.36 $171.64

AS TIME GOES BY

What would happen to the price of the Emory bond if interest rates didn't change
again for the remainder of its life?

FINDING THE YIELD AT A GIVEN PRICE

PB = PMT[PVFAk,n] + FV[PVFk,n]

PB is given and k is the unknown

Can't solve algebraically - two tables at once

Trial and error (iterative) approach

Approximate formula indicates an approximate yield.

6-13
 -
Annual Interest + [ P m Po ]
YTM = n
Po + Pm
2

Plug approximate YTM into formula and check to see if calculated Po = actual Po
if not:
(1) Try higher rate if a calculated price is greater than actual price or vice versa.
(2) Bracket the actual rate with one calculated higher and one calculated lower
rate than the actual rate, then interpolate.

i.e. Coupon = 7% Po = 840 N = 10 years (Interest paid annually)

1000 - 840
70 +
10
YTM A = = 9.35%
1840
2

.09 = 871.26
x = 840
.10 = 816.15

9.56%

Zero Coupon Bonds

Pay no interest
Price is present value of principal repayment
Interest is taxable even though not received

Zero Coupon Bonds

(Zero, Bullet, Discount)

= P m ( PVIF x%,m )

i.e.
Pm = 1000 Po = 352 m = 10

352 = 1000(PVIFx%,10)
.352 = (PVIFx%,10)

6-14
 11% = x

Console - Perpetual bonds

CALL PROVISIONS (FEATURES)

Allow bond issuing firms to "call in" and pay off bonds
Protects company against a drop in interest rates

Refunding debt
Pay off high interest bond with new low rate borrowing
A call premium (penalty) included to compensate
investors for loss of high interest
Premium usually declines as maturity approaches
In problems, state premium in terms of coupon rate

Bond's early life is usually call protected

THE EFFECT OF A CALL PROVISION ON PRICE

Bonds may appear certain to be called when protected period is over
Usually due to a large drop in interest rates

Traditional bond valuation includes cash flows -

which aren't likely to happen -
after the protected period

Special procedure is required

6-15
 Bond's Life
0 1 2 3 4 5 6 7 8 9 10

PMT PMT PMT PMT PMT PMT PMT PMT PMT PMT
FV
Now End Maturity
of Call
Protect
FV
+ Unlikely
Call Premium to Occur

Valuation
to Call
Valuation to Maturity
Figure 6-5 Valuation of a Bond Subject to Call

TM 6-10 Slide 2 of 3

6-16
 Valuing The Sure-To-Be-Called Bond

Solve for YTC

Rate Maturity Bid Ask Bid Chg

Yld
81/4s 2000-05* May 105:25 106:1 +4
7.53*

* May 2000-05 Bond matures on 2005 but is callable starting in 2000

** Yld
For callable bonds the YTM is calculated in one of two ways
a. to first call date when the asked price is above par
b. to maturity date when the asked price is equal to or below par

YTC
1. Substitute the Call Price for Par
2. Substitute the number of years to first call for maturity years

Use a Modified Formula

PB(call) = PMT[PVFAk,m] +CP[PVFk,m]

where

m = number of periods to call

CP = Call Price
= Face Value + Call Premium

6-17
 Example 6-4
Northern Timber issued a callable, $1,000, 25-year bond five years ago at an
18% coupon rate. Call protected for first 10 years; Call premium is one
year's interest at coupon rate; Market rate is now 8%. What is bond's price
with and without the call?

Solution: Normal valuation to maturity

n = 20yrs  2 = 40

Now FV = $1,000

0 10 20 30 40 50 Semiannual
Periods
Now Call

CP = FV + Call Prem = $1,180

Valuation to call
m = 5yrs  2 = 10

TM 6-11 Slide 1 of 3

Without call:

PB = PMT[PVFAk,n] + FV[PVFk,n]
PMT = (.18  $1,000)/2 = $90
n = 20  2 = 40, k = 8%/2 = 4%
FV = $1,000

PB = $90[PVFA4,40] + $1,000[PVF4,40]
= $90[19.7928] + $1,000[.2083]
= $1,781.35 + $208.30
= $1989.65

The price represents the present value of the issuer's cash flow commitment if the
bond isn't called.

6-18
 With call:

PB(call) = PMT[PVFAk,m] + CP[PVFk,m]

PMT = .18  $1,000 / 2 = $90

m = 5  2 = 10, k = 8% / 2 = 4%
CP = $1,000 + .18($1,000) = $1,180

PB(call) = $90[PVFA4,10] + $1,180[PVF4,10]

= $90[8.1109] +$1,180[.6756]
= $729.98 + $797.21
= $1,527.19

The Refunding Decision

Compare the interest savings from calling with the cost of making the call and
issuing a new bond

Dangerous Bonds With Surprising Calls

Obscure call features buried in contract terms,
e.g., sinking funds

Risky Issues
Sometimes bonds sell for prices far below those indicated by valuation techniques
Implies the company that issued the bond is in financial trouble

THE INSTITUTIONAL CHARACTERISTICS OF BONDS

Bearer bonds or registered bonds
Transfer agent
Owners of record

6-19
 Treasury Bill Yields

Money market instruments sold on a discount basis are sensitive to changes in interest
rates but not to the same degree as bonds with coupon payments.

360 100 - P
Discount Yield = [ ]
n 100

Treasury Bill Yields

365 100 - P
Equivalent Yield = [ ]
n P

i.e. Discount yield on bill 8.6% with 80 days till maturity.

360 100 - Price

.086 =
80 100
8.6 = 4.5 [ 100 - Price ]
4.5 [Price] = 447.4
P = 98.48

Equivalent Yield = 8.6%

6-20
 365 100 - Price
.086 =
80 Price
.0188 = 100 - Price
Price
1.0188 [Price] = 100
Price = 98.15

6-21
 Factors Affecting Overall Interest Rates and Bond Prices
Strong economic growth tends to place upward pressure on interest rates (drop in bond
prices)
Weak economic growth tends to place downward pressure on interest rates (increase in
bond prices)

Money supply increase (demand not affected) downward pressure on rates

Money supply increase (demand increases for funds) upward pressure--inflation

Oil prices have major impact upon prices

drop in oil prices--lower interest rates

Weaker dollar (everything else constant) increase inflationary expectations (prices of

imports increase); thus increase in rates

6-22