Topics Covered Domestic Bonds and International Bonds Bond Valuation The Bond Contract Security and Seniority Asset-Backed Securities Repayment Provisions Restrictive Covenants Private Placements Innovation in the Bond Market

Bond Terminology Foreign bonds - Bonds that are sold to local investors in another country's bond market. Yankee bond- a bond sold publicly by a foreign company in the United States. Samurai - a bond sold by a foreign firm in Japan. Eurobond market - by European and American multinationals to tap into international markets for capital.

Bond Terminology Indenture or trust deed - the bond agreement between the borrower and a trust company. Registered bond - a bond in which the Company's records show ownership and interest and principal are paid directly to each owner. Bearer bonds - the bond holder must send in coupons to claim interest and must send a certificate to claim the final payment of principle.

Valuation of Bonds and Stock Chapter 5 revisited First Principles: Value of financial securities = PV of expected future cash flows To value bonds and stocks we need to: Estimate future cash flows: size (how much) and timing (when) Discount future cash flows at an appropriate risk-adjusted rate

Pure Discount Bonds Information needed for valuing pure discount bonds: Time to maturity (T) = Maturity date - today’s date Face value (F) Discount rate (r) 0 1 2 … T |------------|---------------|------ …------| F Value of a pure discount bond: PV = F / (1 + r)T

Level-Coupon Bonds Information needed to value level-coupon bonds: Coupon payment dates and Time to maturity (T) Coupon (C) per payment period and Face value (F) Discount rate 0 1 2 … T |----------------|------------------|------- … ------| Coupon Coupon Coupon + F Value of a Level-coupon bond: PV = F / (1 + r)T + C x {1/r - 1 / [r x (1 + r)T]} = PV of face value + PV of coupon payments

Yield to Maturity Example A $1000 treasury bond expires in 5 years. It pays a coupon rate of 10.5%. If the market price of this bond is 107-88, what is the YTM?

YTM, Discount Rate and Bond Value Bond Value and Discount Rate 1800 1600 1400 Bond Value 1200 $1078.80 1000 800 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09 0.1 YTM and Discount Rate

Some Tips on Bond Pricing 1. Bond prices and market interest rates move in opposite directions. 2. When coupon rate = YTM, price = par value. When coupon rate > YTM, price > par value (premium bond) When coupon rate < YTM, price < par value (discount bond) 3. A bond with longer maturity has higher relative (%) price change than one with shorter maturity when interest rate (YTM) changes. All other features are identical. 4. A lower coupon bond has a higher relative (%) price change than a higher coupon bond when interest rate (YTM) changes. All other features are identical.

Term Structure Year Spot Rate - The actual interest rate today (t=0) YTM (r) 1981 1987 & present 1976 Year 1 5 10 20 30 Spot Rate - The actual interest rate today (t=0) Forward Rate - The interest rate, fixed today, on a loan made in the future at a fixed time. Future Rate - The spot rate that is expected in the future. Yield To Maturity (YTM) - The IRR on an interest bearing instrument.

Bond Terminology Accrued interest - the amount of accumulated interest since the last coupon payment Debentures - long-term unsecured issues on debt Mortgage bonds - long-term secured debt often containing a claim against a specific building or property Asset-backed securities - the sale of cash flows derived directly from a specific set of bundled assets

Valuation of Bonds and Stock First Principles: Value of financial securities = PV of expected future cash flows To value bonds and stocks we need to: Estimate future cash flows: size (how much) and timing (when) Discount future cash flows at an appropriate risk-adjusted rate

Pure Discount Bonds Information needed for valuing pure discount bonds: Time to maturity (T) = Maturity date - today’s date Face value (F) Discount rate (r) 0 1 2 … T |------------|---------------|------ …------| F Value of a pure discount bond: PV = F / (1 + r)T

Level-Coupon Bonds Information needed to value level-coupon bonds: Coupon payment dates and Time to maturity (T) Coupon (C) per payment period and Face value (F) Discount rate 0 1 2 … T |----------------|------------------|------- … ------| Coupon Coupon Coupon + F Value of a Level-coupon bond: PV = F / (1 + r)T + C x {1/r - 1 / [r x (1 + r)T]} = PV of face value + PV of coupon payments

Yield to Maturity Example A $1000 treasury bond expires in 5 years. It pays a coupon rate of 10.5%. If the market price of this bond is 107-88, what is the YTM?

YTM, Discount Rate and Bond Value Bond Value and Discount Rate 1800 1600 1400 Bond Value 1200 $1078.80 1000 800 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09 0.1 YTM and Discount Rate

Some Tips on Bond Pricing 1. Bond prices and market interest rates move in opposite directions. 2. When coupon rate = YTM, price = par value. When coupon rate > YTM, price > par value (premium bond) When coupon rate < YTM, price < par value (discount bond) 3. A bond with longer maturity has higher relative (%) price change than one with shorter maturity when interest rate (YTM) changes. All other features are identical. 4. A lower coupon bond has a higher relative (%) price change than a higher coupon bond when interest rate (YTM) changes. All other features are identical.

Term Structure Year Spot Rate - The actual interest rate today (t=0) YTM (r) 1981 1987 & present 1976 Year 1 5 10 20 30 Spot Rate - The actual interest rate today (t=0) Forward Rate - The interest rate, fixed today, on a loan made in the future at a fixed time. Future Rate - The spot rate that is expected in the future. Yield To Maturity (YTM) - The IRR on an interest bearing instrument.

Term Structure What Determines the Shape of the TS? 1 - Unbiased Expectations Theory 2 - Liquidity Premium Theory 3 - Market Segmentation Hypothesis Term Structure & Capital Budgeting CF should be discounted using Term Structure info. Since the spot rate incorporates all forward rates, then you should use the future spot rate that equals the term of your project.

Bond Terminology Sinking fund - a fund established to retired debt before maturity. Callable bond - a bond that may be repurchased by a the firm before maturity at a specified call price. Defeasance - a method of retiring corporate debt involving the creation of a trust funded with treasury bonds.

Straight Bond vs. Callable Bond Value of Straight bond bond 100 bond callable at 100 75 50 25 Value of straight bond 25 50 75 100 125 150

Bond Terminology Restrictive covenants - Limitations set by bondholders on the actions of the Corporation. Positive or Negative Pledge Clause - the processing of giving unsecured debentures protection to prevent bankruptcy Pay in kind (PIK) - a bond that makes regular interest payments, but in the early years of the bonds life the issuer can choose to pay interest in the form of either cash or more bonds with an equivalent face value.

Covenants Debt ratios: Security: Dividends Event risk Senior debt limits senior borrowing Junior debt limits senior & junior borrowing Security: Negative pledge Dividends Event risk Positive covenants: Working capital Net worth