The Valuation and Characteristics of Bonds

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The Basis of Value

A security’s value is equal to the present value of its expected cash flows.

A security should sell in financial markets for a price close to that value Differences of opinion exist about a security’s price

because of different assumptions about cash flows and interest rates for PV calculations

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The Basis for Value

Investing Using a resource to benefit

the future rather than for current satisfaction Putting money to work to

earn more money Common types of

investments Debt—lending money Equity—buying

ownership in a business

Return

What the investor receives for making an investment

For a 1 year investment the rate of return =

$ received / $ invested

Debt investors receive interest

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The Basis for Value

Rate of return is the interest rate that equates the present value of an investment’s expected future cash flows with its current price

Return is also known as Yield Interest

Debt investments only

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Bond Valuation

Bonds represent a debt relationship in which the issuing company borrows and the buyers lend. A bond issue represents borrowing

from many lenders at one time under a single agreement

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Bond Terminology and Practice

A bond’s term (or maturity) is the time from the present until the principal is returned Bonds mature on the last day of their term A bond’s term gets shorter as it ages

A bond’s face (or par) value represents the amount the firm intends to borrow (the principal) at the coupon rate of interest Bonds are non-amortized debt - the entire principal is

repaid at maturity

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The Coupon Rate

Coupon Rate – the fixed rate of interest paid by a bond Doesn’t change over the bond’s life

In the past, bonds had “coupons” attached, today they are “registered”

Most bonds pay coupon interest semiannual

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Bond Valuation—Basic Ideas

Adjusting to Interest Rate Changes Bonds are originally sold in the primary

market and trade subsequently among investors in the secondary market.

Although bonds have fixed coupons, market interest rates constantly change. What happens to the price of a bond paying a fixed

interest rate in the secondary market when interest rates change?

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Bond Valuation—Basic Ideas

Buy a 20 year, $1000 par bond with a 10% coupon rate for $1,000. It promises 20 years of coupon payments of $100 each, and a principal

repayment of $1,000 after 20 years

Needing cash, you sell it early. Assume interest rates have risen and the market rate of return is 11% Investors can now buy new bonds with an 11% coupon rate for $1,000 so

they will not pay $1000 for your bond – but they will buy it for less than $1,000

Bond prices and interest rates move in opposite directions

Bonds adjust to changing yields by changing price Selling at a Premium – bond price above face value Selling at a Discount – bond price below face value

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Determining the Price of a Bond

0 1 5 10

$100a year for 10 years

$100

$1,000

$1,100

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Q:A bond has 10 years to maturity, a par value of $1,000, and a coupon rate of 10%. What cash flows are expected from the bond?

A:

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Determining the Price of a Bond

The Bond Valuation Formula The price of a bond is the present value of a

stream of interest payments plus the present value of the principal repayment

k,n

Interest payments are annuities--can usethe present value of an annuity form

Principal repayment is a lump sum in ula:

PMT[PVFA

the futur

]

B PV(princiPV(interest payme pal repaymP +nt ) es nt)

k, n

e--can use the future value formula:FV[PVF ]

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Cash Flow Time Line for a Bond Figure 7.1

This is an ordinary annuity. This is a

single sum.

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Determining the Price of a Bond

Two Interest Rates and One More Coupon Rate

Determines the size of the interest payments

k—the current market yield on comparable bonds The discount rate that makes the present value of the payments

equal to the price of the bond in the market AKA yield to maturity (YTM)

Current yield — annual interest payment divided by bond’s current price

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Solving Bond Problems with a Financial Calculator

Financial calculators have five time value of money keys

With a bond problem, all five keys are used n—number of periods until maturity I/Y—market interest rate PV—price of bond FV—face value (par) of bond PMT—coupon interest payment per period

With calculators that have a sign convention the PMT and FV must be of one sign while the PV will be the other sign

The unknown is either interest rate or present value (Price)

Sophisticated calculators have a ‘bond’ mode allowing easy calculations dealing with accrued interest

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Determining the Price of a Bond Example 7.1

Q: The Emory Corporation issued an 8%, 25-year bond 15 years ago. At the time of issue it sold for its par (face) value of $1,000. Comparable bonds are yielding 10% today. What must Emory’s bond sell for in today’s market to yield 10% (YTM) to the buyer? Assume the bond pays interest semiannually. Also calculate the bond’s current yield.

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Bond Example Continued Example 7.1

A: Substituting the correct values into the equation gives us:

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This can also be calculated via a financial calculator:

N

PV

PMT

FV

I/Y

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Maturity Risk Revisited

Relates to term of the debt Longer term bond prices fluctuate more in

response to changes in interest rates than shorter term bonds

AKA price risk and interest rate risk

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Price Changes at Different Terms due to an Interest Rate Increase

from 8% to 10% Table 7.1

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Finding the Yield at a Given Price

Calculate a bond’s yield assuming it is selling at a given price

Trial and error – guess a yield – calculate price – compare to price given

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Finding the Yield at a Given PriceExample 7.3

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Q: The Benson Steel Company issued a 30-year bond 14 years ago with a face value of $1,000 and a coupon rate of 8%. The bond is currently selling for $718. What is the yield to an investor who buys it today at that price? (Assume semiannual interest.)

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Call Provisions

If interest rates fall, a firm may wish to retire old, high interest bonds “Refinance” with new lower interest debt

To ensure their ability to refinance bonds, corporations make bonds ‘callable’ Call provision gives right to pay off the bond early

Investors don’t like calls – lose high interest So issuers and investors Compromise

Call provisions usually have a call premium Call protection means the bond won’t be called for a

certain number of years.

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The Refunding Decision

When current interest rates fall below the bond’s coupon rate, a firm must decide whether to call in the issue Compare interest savings to the cost of making

the call: Call premium – extra payment to bond holders Flotation costs – incurred in issuing new bonds,

includes brokerage fees, administrative expenses, printing, etc.

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Dangerous Bonds with Surprising Calls

Bonds can have obscure call features buried in their contract terms.

Most common type – a sinking fund provision – requires an issuer to call in and retire a fixed percentage of the issue each year Usually no call premium Determined by lottery

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Convertible Bonds

Unsecured bonds exchangeable for a fixed number of shares of stock at the bondholder's discretion Bondholders can participate in the stock’s price appreciation

Conversion ratio - the number of shares of stock received for each bond

Conversion price - the implied stock price if bond is converted into a certain number of shares Usually set 15-30% above the stock’s market value when the

bond is issued

Usually issued at lower coupon rates

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Advantages of Convertible Bonds

To Issuing Companies

Convertible features are “sweeteners” enabling a risky firm to pay a lower interest rate

Viewed as a way to sell equity at a price above market

Usually have few or no restrictions

To Buyers

Offer the chance to participate in stock price appreciation

Offer a way to limit risk associated with a stock investment

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Forced Conversion

A firm may want bonds converted eliminates interest payments on bond strengthens balance sheet don’t want conversion at very high stock prices

Convertible bonds are always issued with call features which can be used to force conversion

Issuers generally call convertibles when stock prices rise to 10-15% above conversion prices

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Effect on Earnings Per Share—Diluted EPS

Upon conversion convertible bonds cause dilution in EPS EPS drops due to the increase in the number of

shares of stock

Thus outstanding convertibles represent a potential to dilution of EPS

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Q: Montgomery Inc. is a small manufacturer of men’s clothing with operations in Southern California. It issued 2,000 convertible bonds in 1999 at a coupon rate of 8% and a par value of $1,000. Each bond is convertible into Montgomery’s common stock at $40 per share. Management expected the stock price to rise rapidly after the convertible was issued and lead to a quick conversion of the bond debt into equity. However, a recessionary climate has prevented that from happening, and the bonds are still outstanding. In 2003 Montgomery had net income of $3 million. One million shares of its stock were outstanding for the entire year, and its marginal tax rate is 40%. Calculate Montgomery’s basic and diluted EPS.

A: Basic EPS is the firm’s net income divided by the number of shares outstanding, or $3,000,000 ÷ 1,000,000 = $3.00.

Effect on Earnings Per Share—Diluted EPS

Example 7.7

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Effect on Earnings Per Share—Diluted EPS

Example 7.7

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Diluted EPS assumes all convertible bonds are converted at the beginning of the year. Two adjustments need to be made:

Add the number of newly converted shares to the denominator:

Shares exchanged: Bond’s par ÷ Conversion price = $1,000 ÷ $25 = 40

Since each bond can be converted into 40 shares of stock and there are 2,000 bonds, the newly converted shares totals 80,000, or 40 x 2,000, bringing the total number of shares outstanding to 1,080,000.

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Institutional Characteristics of Bonds

Registration, Transfer Agents, and Owners of Record

Classify bonds as either bearer or registered bonds. Bearer bonds — interest payment is made to the bearer of the

bond Registered bonds — interest payment is made to the holder of

record Owners of registered bonds are recorded with a

transfer agent. Keeps track of bonds for issuing companies Sends payments to owners of record Transfers ownership when bond is sold to another investor

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Kinds of Bonds

Secured bonds and mortgage bonds Backed by the value of specific assets - collateral

Debentures Unsecured bonds issued with higher

interest rates Subordinated debentures

Lower in priority than senior debt Junk bonds

Issued by risky companies and pay high interest rates

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Bond Ratings—Assessing Default Risk

Bonds are assigned quality ratings reflecting their probability of default. Higher ratings mean lower default probability

Bond rating agencies (such as Moody’s, S&P) evaluate bonds (and issuers), and assign a rating Examine the financial and market conditions

of the issuer

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Bond Ratings—Assessing Default Risk

Why Ratings Are Important Ratings are the primary measure of the default

risk associated with bonds The rating determines the rate at which the

firm can borrow A lower quality rating implies a higher borrowing rate A differential exists between the rates required on high

and low quality issues.

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Moody’s and S&P Bond Ratings Table 7.2

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Bond Indentures—Controlling Default Risk

Bond indentures attempt to prevent firms from becoming riskier after bonds are purchased by including restrictive covenants: Preclude entering high risk businesses Limit further borrowing Require certain financial ratios

Safety is also provided by sinking funds Provide money for repayment of bond principal

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The Advantages of Leasing Appendix 7-A

No money down Lenders generally require a down payment lessors usually do not

Restrictions Lenders require covenants/indentures, lessors have few,

if any, restrictions

Easier credit with manufacturers/lessors Equipment manufacturers may lease their own products

and will sometimes lease to marginally creditworthy customers

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The Advantages of Leasing Appendix 7-A

Avoiding the risk obsolescence Short leases transfer this risk to lessors

Tax deducting the cost of land If real estate is leased - the lease payment can be

deducted as an expense If land is owned - it is not depreciable

Increasing liquidity—the sale and leaseback A firm may sell an asset to a financial institution and

lease back the same asset — frees up cash Tax advantages for marginally profitable

companies