Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Investments: Theory and Applications Mark Hirschey

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Chapter 7 Bond Valuation and Management

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Bond Valuation

7-4 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Economic Characteristics  When an investor purchases a bond, they are lending money to a:  Corporation  Municipality  Federal Agency or  Some other issuer  A bond is simply a debt security, similar to an IOU

7-5 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Economic Characteristics  In return for such a loan, the issuer promises to pay:  A specified rate of interest during the life of the bond and  Repay the face amount of the bond (the principal) when it comes due.

7-6 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Economic Characteristics  Bond types include:  Corporate Bonds  Municipal Bonds  U.S. Government Securities  Mortgage and Asset-backed Securities  Federal Agency Securities  Foreign Government Bonds

7-7 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Economic Characteristics  The following factors determine the:  Value of any bond and  Degree to which it matches the financial objectives of any given investor  Interest payment obligation  Price  Yield  Maturity  Redemption Features  Credit Quality  Market Interest Rate: Prevailing rate of interest on essentially identical securities.

7-8 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Economic Characteristics  Bonds are debt securities that:  Pay a rate of interest  Based on the stated face amount or par value of the bond  The interest rate can be:  Fixed (most common) or  Variable  Bond investors typically receive interest payments twice a year: on a semiannual basis.

7-9 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Economic Characteristics  For Example:  A $1,000 bond sold at par with a 7% interest rate pays interest of ($1,000 x.07) $70 per year, in $35 payments every six months.  When the bond matures, (typically in 10, 20, or 30 years) bond investors will also receive the full face amount of the bond.

7-10 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Economic Characteristics  Variable interest rate bonds adjust on a daily, monthly, annual basis.  The interest rate paid closely tracks market interest rates.  Interest rates on floating-rate bonds are pegged to an underlying benchmark interest: interest rate standard.  (LIBOR, Discount Rate, T-Bill, Treasury Bond rate, etc.)

7-11 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Economic Characteristics  Zero Coupon Bonds: Discount Bonds that pay no coupon interest.  Sold at an original price that’s a substantial discount from their face amount  Make no periodic interest payments.  The bond investor receives a single payment at the time of maturity that equals:  Return of the original purchase price (or principal) plus  The total interest earned

7-12 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Economic Characteristics  Zero Coupon Bond Example:  A bond with a face amount of $1,000, maturing in 30 years, and priced to yield 7% might be purchased for about $131.  At the end of 30 years, the bond investor will receive $1,000.  The difference between $1,000 and $131 represents the interest income to be received, based on an interest rate of roughly 7%, which compounds until the zero coupon bond matures.

7-13 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Economic Characteristics  Popular among issuers because they avoid the need to make periodic interest and principal payments.  Long-term bond investors are attracted to zeros because they eliminate interest reinvestment risk: the chance that a subsequent rise in interest rates will reduce the amount earned on reinvested interest income.

7-14 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Economic Characteristics  The three largest categories of zero coupon securities are offered by:  The U.S. Treasury  Corporations  State and Local Governments  Zero coupon bonds issued by a corporation or the U.S. Treasury generate taxable income even though bondholders receive no periodic cash payments.  The implicit interest is determined by amortizing the loan and is based on the difference in the bond’s value at the beginning of each year.

7-15 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Economic Characteristics  Example: A company issues a $1,000 face value, five-year zero coupon bond. The initial price is set at $497. At this price, the bond yields 15% to maturity. The implicit interest each year is simply the change in the bond’s value for the year. Year one interest: 572 – 497 = 75. Year two interest: 658 – 572 = 86, etc. Beg Year:12345  N =  PV =  FV = 1,  Therefore: I =

7-16 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Present Value of a Bond  Bond prices are conventionally quoted as a percentage of par, where par is typically $1,000.  A bond price of 95 implies a bond market value of $950 ($1,000 x.95 = $950)  A bond price of 98 1/2 implies a bond market value of $985 ($1,000 x.985 = $985)

7-17 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Present Value of a Bond  The initial or par value of a bond is typically set by the issuer at $1,000.  From that point until the time of maturity its price is set by the forces of supply and demand in the marketplace.  Newly issued bonds normally sell at or close to the face value or principal amount.

7-18 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Present Value of a Bond  Seasoned Bonds: Bonds traded from one investor to another.  Seasoned Bond prices can fluctuate widely depending on a number of factures:  Prevailing market interest rates  The supply and demand for similar types of bonds  Credit Quality  The term-to-maturity  Tax Status of individual bonds

7-19 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Present Value of a Bond  If a bond is trading for more than the face amount (usually $1,000), it is trading at a premium.  A bond trading for $1,400 is trading at a premium of $400  The investor receives a yield-to-maturity less than the one stated on the face of the bond.  A bond trading at $700 is trading at a $300 discount.  The investor will earn a higher yield-to-maturity than the amount stated on the face of the bond.  Remember: the face amount or par value of a bond represents the dollar repayment obligation at maturity on the part of the issuer.

7-20 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Present Value of a Bond  In general economic terms: the economic value of a bond equals the present value of all expected interest and principal payments.  In general, the value of a bond will:  Fall with a rise in prevailing market interest rates  Rise with a decline in prevailing market interest rates.

7-21 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Present Value of a Bond Economic value of a bond = PV of all expected interest and principal payments. N: number of years until maturity Yield: market interest rate on economically similar securities

7-22 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. QUICK QUIZ Bond Price & Interest Rates Holding all else equal, the value of a bond will _______ with a rise in market interest rates. a.fall b.rise c.stay the same d.equal the face amount or par value of the bond a.fall b.rise c.stay the same d.equal the face amount or par value of the bond

7-23 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Bond Pricing  Settlement date: Date when buyer takes effective possession of security  For an initial public offering, the settlement date is the day after the issue date  In most instances, bond transactions are governed by a one- day settlement period.  Maturity date: date when the security expires or ceases to accrue interest  The time remaining until maturity is the simple difference between the maturity date the the settlement date.

7-24 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Bond Pricing  Bond Coupon Rate: Bond interest rate expressed as a percentage of par value  Often differs from the security’s yield-to-maturity which is closely determined by prevailing market interest rates.  Bond Redemption Value: amount to be received from issuer on maturity date  Usually equal to par value, which is typically $1,000  Semiannual Interest: interest paid in two equal installments per year.

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Yield-to-Maturity

7-26 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Common Maturities  Short-term notes have initial maturities of up to five years.  Medium-term notes or bonds have initial maturities of five to 12 years.  Long-term bonds generally have initial maturities of 12 or more years.

7-27 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Common Maturities  Some bonds, especially mortgage-backed securities, are typically priced and traded on the basis of the bond’s expected average life: typical period before refunding, rather than on the basis of any stated term-to maturity.  When mortgage rates decline, homeowners often move quickly to prepay their mortgage.  This may reduce the expected average life of the bondholder’s investment.  When mortgage rates rise, the reverse tends to be true.

7-28 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Common Maturities  The investor’s choice of a preferred term-to- maturity depends on:  When principal repayment is required  The investment return sought  The investor’s risk tolerance.

7-29 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Common Maturities  Many bond investors prefer short-term bonds for their comparative stability of:  Principal  Interest payments  Such investors are willing to accept the typically lower rates or return offered on short-term bonds.  Bond investors seeking greater overall returns tend to favor long term securities despite the fact that such bonds are are more vulnerable to:  Interest rate fluctuations  Other market risks.

7-30 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Call Provisions  Most bonds have Call Provisions: Contractual authority that allows the issuer to redeem bonds prior to scheduled maturity.  The issuer may repay investor principal at a specified date and price prior to scheduled maturity.  Entail no “obligation” on the part of the issuer  Represent a refinancing opportunity.  Bonds are commonly called by issuers:  Following a significant drop in prevailing interest rates or a rise in the issuer’s credit quality  New bonds can be issued a lower interest rates.  Following a rise in government agency’s tax receipts

7-31 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Call Provisions  Call Protection: Amount of time before a newly issued bond is callable.  Must be explicitly detailed in the bond offering circular.  Should be fully considered by investors and fully reflected in market prices.  Bonds with limited call protection usually have a higher expected return to compensate for the risk that the bonds might be called for early redemption.

7-32 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Call Provisions  If interest rates fall or credit quality improves, bonds are apt to be called prior to scheduled maturity.  This denies bond investors the upward revaluation in bond prices  If interest rates rise or credit quality deteriorates, bond prices tumble, and call provisions are “not” apt to be exercised.  Bond investors are likely to have the opportunity to keep bonds to scheduled maturity only in the event of adverse influences on bond prices.

7-33 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Call Provisions  Call Provisions facilitate debt refinancing on terms favorable to the issuing corporation or entity.  Other refinancing options do exist for the issuing entity.  For lightly traded issues, the company might make a formal bond tender offer at a slight premium to the current market price.  Bond Tender Offer: Offer to buy an entire outstanding class of securities.  All the issue or  Part of the issue (first-come-first-served basis)

7-34 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Call Provisions  The company would then probably sell a new bond issue to repay bondholders for the bonds the company was buying back.  Refunding: Retirement of seasoned securities with proceeds from a new issue.  Designed to reduce financing costs or improve financial flexibility.

7-35 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Expected Yield Calculation  Bond yield is the bond investor’s expected rate of return based on:  the price paid for the bond plus  the anticipated amount and timing of interest and principal payments.

7-36 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Expected Yield Calculation  Yield-to-Maturity (YTM): Investor return from settlement day until security expiration.  All interest payments received from the time of purchase until the point of maturity plus any capital gain resulting from the purchase of a bond at a discount from par, or face, value.

7-37 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Expected Yield Calculation  YTM will be more than current yield for bonds purchased at a discount.  YTM is less than current yield for bonds purchased at a premium.  Bond prices and bond yields are inversely related.  As bond prices fall, yield-to-maturity increases.  As bond prices rise, yield-to-maturity decreases.

7-38 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Expected Yield Calculation  Yield-to-Call: Investor return from settlement day until repurchased by company.  The total rate of return expected if the bond is bought and held until the issuer exercises the Call Provision.

7-39 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Expected Yield Calculation  Call provisions are especially important for bonds trading in the secondary market at a significant premium  They have a significant chance of being called  Call provisions are much less important for bonds trading in the secondary market at a significant discount  Not likely to be called by the issuer  The issuer would conduct open-market purchases at a discount vs. redemption at par.

7-40 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Put Provisions  While Call provisions give bond issuers the option to refinance at favorable interest rates  Put provisions give investors the option to require issuers to repurchase bonds at a specified time and price prior to scheduled maturity

7-41 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Put Provisions  Bond Put Provision: An investor’s option to sell a bond back to issuer.  Bond investors typically exercise put options when:  Interest rates have risen  Credit quality of the issuer has deteriorated  A serious threat of credit quality deterioration is present.

7-42 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Put Provisions  Bondholders might exercise a put option in the event of an important:  Divestiture  Merger  Takeover that requires the issuance of a significant amount of new debt financing.  Bond Issuers might attempt to appease these bondholders through:  A change in bond covenant provisions  An increase in interest rates

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Interest Rate Risk

7-44 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Changing Market Conditions  From the time a bond is originally issued until the time it matures, its price in the secondary market fluctuates according to changes in:  General credit market conditions  Issuer-specific changes in credit quality  Interest-Rate-Risk: Chance of bondholder loss due to market-wide fluctuation in interest rates.

7-45 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Changing Market Conditions  When prevailing interest rates rise:  Newly issued bonds offer a promise to pay interest that is higher than that offered on older seasoned bonds.  Market prices for outstanding bonds fall to bring the yield-to-maturity for new buyers of seasoned bonds in line with higher-yield new issues.

7-46 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Changing Market Conditions  When prevailing interest rates fall:  Newly issued bonds offer a promise to pay interest that is lower than that offered on older seasoned bonds.  Market prices for outstanding bonds rise to bring the yield-to-maturity for new buyers of seasoned bonds in line with lower-yield new issues.

7-47 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Changing Market Conditions  Bond prices fluctuate on a day-to-day basis.  Sell of a previously purchased bond prior to maturity can lead to either capital gains or losses.  If market interest rates have risen – typically a capital loss.  If market interest rates have fallen – typically a capital gain.

7-48 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Changing Market Conditions  During periods of volatile change in interest rates, gains and losses experienced by bond investors can be substantial.  Short-term bonds issued by highly creditworthy institutions involve little or no risk  Long-term bonds issued by even the highest-quality issuers involve substantial risk  Bond prices can be extremely sensitive to changes in market conditions.  The reaction of seasoned bond prices to changing interest rates becomes severe for long-term (30 year) bonds.

7-49 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Changing Market Conditions  Changes in bond yields are quoted in terms of Basis Points:  One basis point = 1/100 th of 1%  50 basis points =.5%  A 1.25% rise in rates translates into a rise of 125 basis points in yield  A 0.30% fall in yield represents a 30-basis point decline in rates

7-50 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Factors That Change Prevailing Interest Rates  The most important cause of fluctuations in the bond market is a change in prevailing interest rates.  Interest rates change in response to changes in:  Supply and demand for credit  Federal Reserve policy  Fiscal policy  Exchange rates  Economic conditions  Market psychology  Changes in expectations about inflation

7-51 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Factors That Change Prevailing Interest Rates  The bond market acts as a barometer for inflationary expectations. An increase in inflation is feared by bond investors:  reduces the buying power of future interest and principal payments.  tends to increase the market rate of interest and lowers the value of outstanding bonds.  Any economic report that raises the possibility of higher future inflation, raises interest rates and lowers bond prices.

7-52 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Factors That Change Prevailing Interest Rates  “Bad” economic news (higher unemployment or weak economic growth) tends to reduce inflationary expectations and is “good” for bonds.  Not as much demand for credit  Interest rates go down  Bond market prices rise  “Good” economic news (lower unemployment or higher retail sales) is “bad” for bonds and tends to weaken bond market prices.  More demand for credit  Interest rates go up  Bond market prices fall

7-53 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Factors That Change Prevailing Interest Rates  Remember: Bond prices and yields move in opposite directions.  Because bond yields tend to move up during “good” economic conditions, a booming economy can be “bad” for bond prices.  Because bond yields tend to move down during “bad” economic conditions, a poor economic environment can actually be “good” for bond prices.

7-54 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Factors That Change Prevailing Interest Rates  Changes in interest rates do not affect all bonds the same.  Generally, the longer it takes for a bond to mature, the greater the risk of price fluctuation in the period prior to maturity.  The value of interest and principal repayments to be received at some distant point in the future fluctuates widely depending on changes in prevailing interest rates.

7-55 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Factors That Change Prevailing Interest Rates  Modest changes in interest rates can dramatically affect zero coupon bond prices.  Similarly, the present value of any stream of interest and principal to be received over a significant time period varies with change in prevailing interest rates.

7-56 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Term Structure of Interest Rates  The 30-year Treasury bond is regarded as the “bellwether” of the bond market and watched carefully by bond investors.  Just as the DJIA is closely followed by stock market investors.

7-57 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Term Structure of Interest Rates  Bond investors expect to be compensated for taking on the higher degree of interest-rate risk tied to investments in long-term bonds.  For bonds of the same risk class, there is typically a direct positive relation between:  Term-to-maturity (in years) and  Yield-to-maturity (in percent)

7-58 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Term Structure of Interest Rates  This link can be seen by drawing the yield curve: a line between the yields offered on similar-risk bonds of different maturities, from shortest to longest.  Figure 7.2, page 257 illustrates the typically upward- sloping yield curve for Treasury Securities.  By watching changes in the yield curve over time, bond investors gain a sense of where the market perceives interest rates are headed.

7-59 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Term Structure of Interest Rates  The yield curve reflects the fact that:  longer-term bonds are exposed to relatively greater interest-rate risk  bond investors typically require an interest-rate premium to invest in long-term bonds.  The yield curve describes the term structure of interest rates: Interest-rate relation among bonds with the same credit quality but different maturities.

7-60 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Term Structure of Interest Rates  When yields on short-term bonds are higher than those on longer-term bonds, the yield curve is said to be “inverted.”  Suggests that bond investors expect interest rates to decline  Sometimes considered a precursor to economic recession.

7-61 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Term Structure of Interest Rates  Liquidity Preference Hypothesis: Theory that rising yield curves give long-term bond investors a holding-period risk premium.