1 Bonds (Debt) Characteristics and Valuation What is debt? What are bond ratings? How are bond prices determined? How are bond yields determined? What is the relationship between bond prices and interest rates?

2 Debt Characteristics Principal value, face value, maturity value, and par value Interest payments—coupon rate of interest Maturity date Priority to assets and earnings Control of the firm

3 Types of Debt—Short-Term Treasury bills—U.S. government securities Repurchase agreement—repo Federal funds—loans from one bank to another Banker’s acceptance—a “postdated check”

4 Types of Debt—Short-Term Commercial Paper (CP)—promissory note Certificate of Deposit (CD)—time deposit Eurodollar deposit—dollar-denominated deposits Money market mutual funds—short-term investments

5 Term loans Bank or insurance company Amortized—payment includes principal and interest Bonds Borrower agrees to make payments of interest and principal on specific dates to the bondholder (investor) Types of Debt—Long-Term

6 Common Bonds Government bonds Treasury—notes and bonds State and local governments (municipals) Revenue bonds General obligation bonds Corporate bonds Mortgage bonds—backed by fixed assets Debenture—unsecured bond Subordinated debenture—low priority

7 Other Types of Bonds Income bond—pays interest when the firm’s income is sufficient Putable bond—can be redeemed at the bondholder’s option Indexed (purchasing power) bond—interest payments are based on an inflation index Floating-rate bond—bond’s interest is based on market interest rates Zero (or very low) coupon bond—little or no interest is paid (discounted) Junk bond—high-risk, high-yield bond (low rating)

8 Bond Contract Features Indenture—bond contract Maturity, coupon, etc. are set in the contract Coupon rate of interest—set at prevailing rate when the bond is issued Trustee—represents bondholders’ interests Restrictive covenant—restricts borrower’s a actions Sinking fund—a required annual payment Call provision—issuer can redeem the bonds prior to maturity Refunding—retire (repay) existing debt with proceeds of new debt—that is, refinancing debt Convertible feature—conversion in to stock

9 Bond Ratings Moody’s S&P Aaa AAA Aa AA A Baa BBB Ba BBB Caa CCC CDCD High quality Investment grade SubstandardSpeculativeBa BBB Caa CCC CD Junk Bonds

10 Importance of Bond Ratings Indication of default risk Institutional investors are restricted to investment-grade securities Ratings changes—affect a firm’s ability to borrow and the cost of borrowing

11 Foreign Debt Instruments Foreign debt—sold by a foreign borrower; denominated in the currency of the country in which it is sold Eurodebt Debt sold in a country other than the one in whose currency the debt is denominated LIBOR: London InterBank Offer Rate

12 Basic Valuation From “The Time Value of Money” we know that the value of an asset is based on the present value of the cash flows the asset is expected to produce in the future.

13 Basic Valuation r = required rate of return

14 Valuation of Bonds 1 … 023 N INT PV of INT PV of M Bond Value = V d INT M INT = $ interest paid each period M = maturity, or face, value rdrd r d = investors’ required rate of return

15 Valuation of Bonds

16 Bond Valuation—Example Bond Characteristics: Face (maturity) value, M$1,000 Coupon rate of interest, C5% Annual interest payment, INT$50= $1,000 x 0.05 Years to maturity, N8 Market rate, r d 6% Bond Characteristics: Face (maturity) value, M$1,000 Coupon rate of interest, C5% Annual interest payment, INT$50= $1,000 x 0.05 Years to maturity, N8 Market rate, r d 6% 1,000 = 50( ) + 1,000( ) = Bond Characteristics: Face (maturity) value, M$1,000 Coupon rate of interest, C5% Annual interest payment, INT$50= $1,000 x 0.05 Years to maturity, N8 Market rate, r d 6% 501,000 Bond Characteristics: Face (maturity) value, M$1,000 Coupon rate of interest, C5% Annual interest payment, INT$50= $1,000 x 0.05 Years to maturity, N8 Market rate, r d 6% 50 (1 + r d ) 8 Bond Characteristics: Face (maturity) value, M$1,000 Coupon rate of interest, C5% Annual interest payment, INT$50= $1,000 x 0.05 Years to maturity, N8 Market rate, r d 6% (1.06) 8 1,000501,00050 (1 + r d ) 8 (1.06) 8 Bond Characteristics: Face (maturity) value, M$1,000 Coupon rate of interest, C5% Annual interest payment, INT$50= $1,000 x 0.05 Years to maturity, N8 Market rate, r d 6%

17 Bond Valuation Financial Calculator Solution Bond Characteristics: Face (maturity) value, M$1,000 Coupon rate of interest, C5% Annual interest payment, INT$50 Years to maturity, N8 Market rate, r d 6% N I/Y PV PMT FV Bond Characteristics: Face (maturity) value, M$1,000 Coupon rate of interest, C5% Annual interest payment, INT$50 Years to maturity, N8 Market rate, r d 6% 1,000 Bond Characteristics: Face (maturity) value, M$1,000 Coupon rate of interest, C5% Annual interest payment, INT$50 Years to maturity, N8 Market rate, r d 6% 1, Bond Characteristics: Face (maturity) value, M$1,000 Coupon rate of interest, C5% Annual interest payment, INT$50 Years to maturity, N8 Market rate, r d 6% 1, Bond Characteristics: Face (maturity) value, M$1,000 Coupon rate of interest, C5% Annual interest payment, INT$50 Years to maturity, N8 Market rate, r d 6% 1, Bond Characteristics: Face (maturity) value, M$1,000 Coupon rate of interest, C5% Annual interest payment, INT$50 Years to maturity, N8 Market rate, r d 6% 1, ?

18 Bond Valuation—Yield to Maturity, r d Bond Characteristics: Face (maturity) value, M$1,000 Coupon rate of interest, C10% Annual interest payment, INT$100= $1,000 x 0.10 Years to maturity, N5 Market price, V d $1,123 Bond Characteristics: Face (maturity) value, M$1,000 Coupon rate of interest, C10% Annual interest payment, INT$100= $1,000 x 0.10 Years to maturity, N5 Market price, V d $1,123 1,000 Bond Characteristics: Face (maturity) value, M$1,000 Coupon rate of interest, C10% Annual interest payment, INT$100= $1,000 x 0.10 Years to maturity, N5 Market price, V d $1, Bond Characteristics: Face (maturity) value, M$1,000 Coupon rate of interest, C10% Annual interest payment, INT$100= $1,000 x 0.10 Years to maturity, N5 Market price, V d $1, Bond Characteristics: Face (maturity) value, M$1,000 Coupon rate of interest, C10% Annual interest payment, INT$100= $1,000 x 0.10 Years to maturity, N5 Market price, V d $1,123 r d = Yield to maturity, YTM 1,123 Bond Characteristics: Face (maturity) value, M$1,000 Coupon rate of interest, C10% Annual interest payment, INT$100= $1,000 x 0.10 Years to maturity, N5 Market price, V d $1,123 Bond Characteristics: Face (maturity) value, M$1,000 Coupon rate of interest, C10% Annual interest payment, INT$100= $1,000 x 0.10 Years to maturity, N5 Market price, V d $1,123

19 Bond Valuation—Yield to Maturity, r d, Approximation Example: M = $1,000, INT = $100, N = 5, V d = $1,123 = Adj interest Avg investment

20 Bond Valuation—YTM Financial Calculator Solution Bond Characteristics: Face (maturity) value, M$1,000 Coupon rate of interest, C10% Annual interest payment, INT$100 Years to maturity, N5 Market price, V d $1,123 N I/Y PV PMT FV Bond Characteristics: Face (maturity) value, M$1,000 Coupon rate of interest, C10% Annual interest payment, INT$100 Years to maturity, N5 Market price, V d $1,123 1,000 Bond Characteristics: Face (maturity) value, M$1,000 Coupon rate of interest, C10% Annual interest payment, INT$100 Years to maturity, N5 Market price, V d $1,123 1, Bond Characteristics: Face (maturity) value, M$1,000 Coupon rate of interest, C10% Annual interest payment, INT$100 Years to maturity, N5 Market price, V d $1,123 1, Bond Characteristics: Face (maturity) value, M$1,000 Coupon rate of interest, C10% Annual interest payment, INT$100 Years to maturity, N5 Market price, V d $1,123 1, ,123 ? Bond Characteristics: Face (maturity) value, M$1,000 Coupon rate of interest, C10% Annual interest payment, INT$100 Years to maturity, N5 Market price, V d $1,123 1, ,123

21 Bond Valuation—Yield to Call Bond Characteristics: Face (maturity) value, M$1,000 Call price$1,060 Coupon rate of interest, C10% Annual interest payment, INT$100 Years to maturity, N5 Date to first call3 Market price, V d $1,123 N I/Y PV PMT FV 3?-1, ,

22 Bond Valuation Semiannual Payment of Interest Most bonds pay interest semiannually Adjustments to computations N = # years x m; m = # of interest payments per year r = r d /m INT = interest payment per period = Annual INT/m Example: M = $1,000, C = 5%, Yrs to maturity = 8, r d = 6% N I/Y PV PMT FV ,000? ,

23 Changes in Bond Values Over Time Whenever the going rate of interest, r d, equals the coupon rate, a bond will sell at its par value An increase (decrease) in interest rates will cause the price of an outstanding bond to fall (rise). The market value of a bond will always approach its par value as its maturity date approaches, provided the firm does not go bankrupt.

24 Bond Valuation Relationship of YTM, Coupon, and Price Example: N = 10 yrs; C = 6%; M = 1,000 Relationship of rates Market Price, V d Market rate, k d =Coupon rate, C par; V d = M Market rate, k d >Coupon rate, C discount; V d < M Market rate, k d <Coupon rate, C premium V d > M Example: N = 10 yrs; C = 6%; M = 1,000 Relationship of rates Market Price, V d Market rate, r d =Coupon rate, C par; V d = M Market rate, r d >Coupon rate, C discount; V d < M Market rate, r d <Coupon rate, C premium V d > M Example: N = 10 yrs; C = 6%; M = 1,000 Relationship of rates Market Price, V d If r d =V d = Market rate, r d =Coupon rate, C par; V d = M Market rate, r d >Coupon rate, C discount; V d < M Market rate, r d <Coupon rate, C premium V d > M Example: N = 10 yrs; C = 6%; M = 1,000 Relationship of rates Market Price, V d If r d =V d = Market rate, r d =Coupon rate, C par; V d = M 6% Market rate, r d >Coupon rate, C discount; V d < M Market rate, r d <Coupon rate, C premium V d > M Example: N = 10 yrs; C = 6%; M = 1,000 Relationship of rates Market Price, V d If r d =V d = Market rate, r d =Coupon rate, C par; V d = M 6%$1, Market rate, r d >Coupon rate, C discount; V d < M Market rate, r d <Coupon rate, C premium V d > M Example: N = 10 yrs; C = 6%; M = 1,000 Relationship of rates Market Price, V d If r d =V d = Market rate, r d =Coupon rate, C par; V d = M 6%$1, Market rate, r d >Coupon rate, C discount; V d < M Market rate, r d <Coupon rate, C premium V d > M Example: N = 10 yrs; C = 6%; M = 1,000 Relationship of rates Market Price, V d If r d =V d = Market rate, r d =Coupon rate, C par; V d = M 6%$1, Market rate, r d >Coupon rate, C discount; V d < M 10% Market rate, r d <Coupon rate, C premium V d > M Example: N = 10 yrs; C = 6%; M = 1,000 Relationship of rates Market Price, V d If r d =V d = Market rate, r d =Coupon rate, C par; V d = M 6%$1, Market rate, r d >Coupon rate, C discount; V d < M 10%$ Market rate, r d <Coupon rate, C premium V d > M Example: N = 10 yrs; C = 6%; M = 1,000 Relationship of rates Market Price, V d If r d =V d = Market rate, r d =Coupon rate, C par; V d = M 6%$1, Market rate, r d >Coupon rate, C discount; V d < M 10%$ Market rate, r d <Coupon rate, C premium V d > M Example: N = 10 yrs; C = 6%; M = 1,000 Relationship of rates Market Price, V d If r d =V d = Market rate, r d =Coupon rate, C par; V d = M 6%$1, Market rate, r d >Coupon rate, C discount; V d < M 10%$ Market rate, r d <Coupon rate, C premium V d > M 4% Example: N = 10 yrs; C = 6%; M = 1,000 Relationship of rates Market Price, V d If r d =V d = Market rate, r d =Coupon rate, C par; V d = M 6%$1, Market rate, r d >Coupon rate, C discount; V d < M 10%$ Market rate, r d <Coupon rate, C premium V d > M 4%$1, Example: N = 10 yrs; C = 6%; M = 1,000 Relationship of rates Market Price, V d If r d =V d = Market rate, r d =Coupon rate, C par; V d = M 6%$1, Market rate, r d >Coupon rate, C discount; V d < M 10%$ Market rate, r d <Coupon rate, C premium V d > M 4%$1,162.22

25 Interest-Rate Risk Bond Characteristics: M = $1, INT= $60.00 N = 5 yrs Annual Interest Rate, r d Value, V d 4%$1, Rate, r d Value, V d 4%$1, , Rate, r d Value, V d 4%$1, , Rate, r d Value, V d 4%$1, , Rate, r d Value, V d 4%$1, , Rate, r d Value, V d 4%$1, , Rate, r d Value, V d 4%$1, , When market rates change, bondholders are affected in two ways: bond prices change in an opposite direction—price risk the rates investors earn change—reinvestment risk When market rates change, bondholders are affected in two ways: bond prices change in an opposite direction—price risk the rates investors earn change—reinvestment risk When market rates change, bondholders are affected in two ways: bond prices change in an opposite direction—price risk the rates investors earn change—reinvestment risk Rate, r d Value, V d 4%$1, ,

26 Bond Return + = Rate of return Current yield =+ Capital gains yield rdrd V d0 INTV d1 – V d0 V d0 Return on investment Income yield =+ Capital gains yield

27 Bond Valuation—Change in Value Over Time Bond Characteristics: M = $1,000.00, INT = $60.00, r d = 8% Years to Maturity End of Year Value, V d Capital Gain = (V d1 -V d0 )/V d0 Current Yield = INT/V d0 Total Return , %6.52%8.00% %6.52%8.00% % % % %

28 Bond Valuation—Change in Value Over Time , , , Years to Maturity Market Value ($), V d if r d = 8% > C = 6% M = 1,000 Discount bond, V d < M Par bond, V d = M; r d = C = 6% Premium bond, V d > M 1, if r d = 4% < C = 6% INT= $60 (C = 6%) N = 5 yrs

29 Long-Term versus Short-Term Bonds $1, , , % bond Interest rate r d 15-year1-yearCurrent market Value of Coupon = 10% $1, , ,

30 Long-Term versus Short-Term Bonds 15-Year Bond

31 What is debt? Debt represents a loan What are bond ratings? Ratings give an indication of the default risk associated with a bond How are bond prices determined? Value = PV of the cash flows the bond is expected to pay during its life Bonds (Debt) Characteristics and Valuation

32 How are bond yields determined? YTM is the average annual rate of return that an investor will earn if he or she buys the bond at the current market price and holds it until it matures YTC is the average annual rate of return that an investor will earn if he or she buys the bond at the current market price and holds it until the first date the bond can be called What is the relationship between bond prices and interest rates? When interest rates increase, bond prices decrease, and vice versa Bonds (Debt) Characteristics and Valuation