BOND VALUATION CONCEPTS FIN 3403, 3404 FIN 3403, 3404 PROF. DIGGLE

BOND CONCEPTS n What is a bond? n How do corporate bonds differ from other kinds of bonds? n Priority of claim pyramid n Characteristics of Corporate bonds n What is a Municipal bond? n Characteristics of muny bonds.

RISK VS RETURN n KINDS OF RISK--RECAP –INFLATION RISK –BUSINESS OR DEFAULT RISK –MARKET RISK –LIQUIDITY RISK –INTR. RATE RISK –OTHER »CURRENCY RISK »POLITICAL RISK »ETC.

BOND CONCEPTS AND TERMS (see lec notes p. 34) TERMS n PAR n COUPON RATE n DOLLAR ANNUAL COUPON n CURRENT YIELD n YIELD TO MATURITY n INDENTURE n DEBENTURE DURATION n ACCRUED INTEREST CONCEPTS n IF INTEREST RATES RISE WHAT HAPPENS TO BOND PRICES? n Current yield vs. YTM

THE BOND TVM TIME LINE COUPONCOUPONCOUPON COUPON COUPON ETC ETC All bonds we will study pay SEMI- ANNUALLY (coupon every 6 months) An 8% bond pays two coupons of $40 each A 30 year bond has 60 interest coupons. PAR AT MATURITY ($1000)

BOND VALUATION SEE LEC NOTES PP n A BOND IS IN TWO PARTS: –PRINCIPAL ($1000 PAR) -- LUMP SUM AT MATURITY –INTEREST coupons (SEMIANNUAL) (ANNUITY) n The value of a bond is the NPV of both elements n The price of a bond is, therefore, another TVM problem. n What is the discount rate? –The current MARKET rate of bonds of similar TYPE, QUALITY and MATURITY

KINDS OF BONDS n U.S. GOVERNMENT –U.S. TREASURY –Treasury series EE –U.S. AGENCY –MUNICIPAL n CORPORATE –Mortgage –Debenture n FOREIGN GOVT. n TAX CONSIDERATIONS –The Tax Equivalent yield n ZERO COUPON BONDS n STRIPS n INFLATION ADJUSTED BONDS

CORPORATE BONDS Issued by domestic corporations n ALL new corporate bond issues are subject to SEC review –The Indenture –Role of the Bond Trustee –How is a bond sold –The “Shelf registration” n What terms are in the Indenture? –Collateral and priority of claim –Coupon in percent and dollars –Maturity –Call provisions »sinking fund »redemption –Trustee

BOND “RATING” SERVICES n MOODY’S AND STANDARD AND POOR n RATING FROM AAA (best) to BA (lowest “investment” grade), to below B (“junk bonds.” n The bond rating is a measure of business risk or risk of default only. n Corporations and municipalities must pay a fee to have bonds rated. Therefore many bonds are NR.

MUNY BONDS Bonds issued by states, cities and local authorities like airports n GO or General Obligation (supported usually by real estate taxes) n REVENUE AND IDR –HOW DOES A CORPORATION DO AN IDR? n SINGLE, DOUBLE AND TRIPLE TAX FREE MUNYS n WHY ARE MUNY’S FREE OF FEDERAL INCOME TAX?

YIELD TO MATURITY n YTM is the “Total Return” on a bond. This consists of: –CURRENT YIELD –CAPITAL GAINS “YIELD” n If a bond is selling at a PREMIUM (above par), bondholder will have a capital loss to maturity. n If a bond is selling at a DISCOUNT, you have a guaranteed capital gain to maturity. n PREMIUM: CURRENT YIELD > THAN YTM WHY? n DISCOUNT CURRENT YIELD < YTM. WHY?

BOND PROELEM USING YOUR CALCULATOR n You buy a corporate bond on n The coupon is 7.5% n The bond matures on May 15, 2015 (Millennium problem does not affect calculator) n The market yield is 6%. Compute PRICE n THIS IS SDT n $75 PER YEAR or $37.50 per coupon n Matures at par. Par is expressed in % in your calculator. Therefore $1000 par is entered as 100 or 100% n YLD = 6

TIBA 2+ CALCULATOR BOND WORKSHEET n SDT enter n CPNenter 7.5 n RDT enter n RV = 100% OF PAR OR $1000 n ACT (for corporates) and 360 for Treasuries n 2/Y (semiannual pay) LEAVE YOUR TI BA2 AT ACT AND 2/Y n YLD = market yield on bonds of similar type, quality and maturity = 6 n SOLVE FOR PRI (price -- push CPT) n MAY ALSO SOLVE FOR YTM where price is given n AI = accrued interest

WHAT DOES THE BOND WORKSHEET DO? n THE PRICE OF A BOND IS THE NET PRESENT VALUE OF: –THE LUMP SUM OF $1000 PAR RECEIVED AT MATURITY –THE ANNUITY OF COUPON INTEREST RECEIVED SEMIANNUALLY OVER REMAINING LIFE OF BOND (P/Y = 2) n HOW WOULD YOU COMPUTE THE PRICE OF A ZERO COUPON BOND?

WHAT IS CALL? n Why would a company or municipality call a bond? n Why do investors dislike callable bonds? n If a bond is not callable for 5 years this is called call protection. n REDEMPTION CALL n SINKING FUND CALL n CALCULATING YIELD TO CALL ON YOUR CALCULATOR n ACCRUED INTEREST

BOND PROBLEM A. YOU BUY A BOND TODAY MATURING IN 30 YEARS. n YOU PAY 1030 (103% of par) n THE COUPON IS 7.33% n WHAT IS THE YIELD TO MATURITY? B. YOU BUY A BOND TODAY MATURING IN 25 YEARS THAT IS CALLABLE IN 15 YEARS AT 105 n ALL FACTS ON LEFT SIDE ARE THE SAME. n COMPUTE YIELD TO CALL.

DURATION VS MATURITY n SEE TEXT n MATURITY IS A FIXED DATE IN TIME n DURATION IS A MEASURE OF BOND CASH FLOW COMBINING MATURITY AND COUPON INCOME n A HIGH COUPON BOND WILL HAVE A SHORTER DURATION THAN A LOWER COUPON ISSUE THAT IS IDENTICAL IN ALL OTHER RESPECTS

ACCRUED INTEREST n You buy a bond on March 10. Coupons are paid on Jan 1 and June 30. n What is the accrued income? Who pays it and why? n Accrued income is added to the amount received by the SELLER n Who will receive the June 30 coupon? THE BUYER. n The buyer must pay the seller accrued interest for the time he owned the bond since the last coupon. This is done on settlement date.

TRADE DATE AND SETTLEMENT DATE n Corporate securities settle in 3 business days after trade date. n You buy a bond on Friday. Monday is a Holiday. When is corporate settlement? This is when good funds must be available to pay for bond or stock. n Government (TREASURY) bonds are next day settlement (next business day). n SDT on your financial calculator is settlement date. n RDT (redemption date) is maturity or call date.

CONVERTS & ZEROS: FIN FIN 3404 STUDENTS not responsible n A convert is a bond with additional contractual provisions in the indenture providing for conversion of the bond into common stock. n A convert is “Quasi Equity.” It behaves like common stock. n TERMINOLOGY –CONVERSION PRICE –CONVERSION RATIO –THEORETICAL VALUE –PREMIUM OVER THEORETICAL VALUE

CONVERTS CONTD. n Why would a company include convertibility as a “sweetener” in the indenture? n What happens if a convertible bond is called by the company? – 2 situations n Are converts a good investment? Why or why not? n Should you buy a callable convert selling above call price? Why or why not?

CONVERT PROBLEM n A convert is convertible into 20 shares of common. This is the conversion ratio. n This means the conversion price is $50 ($1000 par / 20) n When a convert is issued, the conversion price is usually 15% or so below common price. Why? n Assume the common price is $40 when the bond is floated.

CONVERT PROBLEM CONTD n Assume now it is 3 years later and the common is selling for $65 per share. n What is the theoretical value of the convert? Conv ratio = number of common shares per bond X stock price n TV = 20 x $65 = $1300 n Assume the call price set in the indenture is 103 ($1030). What happens if this bond is called?

CONVERTS CONTD n Why do most converts sell at a PREMIUM over conversion or theoretical value? n Priority of claim n Current yield on bond vs dividend yield on stock n Say the bond we are looking at carried a coupon of 8%. The burrent yield at a price of $1300 = 6.15%. Assume the common dividend is $2.00. The dividend yield is 2/65 or 3.1%. Which would you rather own?

WHAT ARE ZERO COUPON BONDS? n Bond in which coupons have been stripped off. n Price is simply the NPV of the par value ($1000) at maturity. n What reasons can you think of for investors to own zero coupon treasuries? n Compute the price of a Treasury maturing in 30 years when the yield on coupon conds of similar type and quality is 6.4%