1. 1-1 6-1 CHAPTER 5 Bonds, Bond Valuation, and Interest Rates Omar Al Nasser, Ph.D. FIN 6352 1

2. 1-2 6-2 2 Key Concepts and Skills Know the important bond features and bond types Understand bond values and why they fluctuate Understand bond ratings and what they mean Understand the impact of inflation on interest rates Understand the term structure of interest rates and the determinants of bond yields

3. 1-3 6-3 3 Chapter Outline Bonds and Bond Valuation More on Bond Features Bond Ratings Some Different Types of Bonds Bond Markets Inflation and Interest Rates Determinants of Bond Yields

4. 1-4 6-4 4 Value = + + + FCF 1 FCF 2 FCF ∞ (1 + WACC) 1 (1 + WACC) ∞ (1 + WACC) 2 Free cash flow (FCF) Market interest rates Firm’s business riskMarket risk aversion Firm’s debt/equity mix Cost of debt Cost of equity Weighted average cost of capital (WACC) Net operating profit after taxes Required investments in operating capital − = Determinants of Intrinsic Value: The Cost of Debt...

5. 1-5 6-5 5 Key Features of a Bond A bond is along-term contract under which a borrower agrees to make payments of interest and principal on specific date to the holder of the bond. –For example, if a company borrowed $50 million dollars by issuing $50 millions of bonds. Lets assume that the company sold 50,000 for 1,000 each. Par value: –The face value of the bond. –The par value represents the amount of money the firm borrow and promises to repay on the maturity date. –We generally assume a face value of $1000, although any multiple of $1000 ($5000 or $5m) can be used.

6. 1-6 6-6 6 Key Features of a Bond Coupon interest rate: –The coupon payments represent the periodic interest payments from the bond issuer to the bondholder. The annual coupon payment is calculated by multiplying the coupon rate by the bond's face value. Maturity: –A specified date at which the par value of a bond must be repaid. Yield or Yield to maturity: –The rate required in the market on a bond.

7. 1-7 6-7 7 Zero Coupon Bonds Make no periodic interest payments (coupon rate = 0%) The entire yield to maturity comes from the difference between the purchase price and the par value A bond bought at a price lower than its face value, with the face value repaid at the time of maturity. These bonds pays no annual interest. Thus, these bonds provide capital appreciation rather than interest income. Examples of zero-coupon bonds include U.S. Treasury bills, U.S. savings bonds.

8. 1-8 6-8 8 Bond Valuation Bonds are valued using time value of money concepts (PV of cash flows). Their coupon, or interest, payments are treated like an equal cash flow stream.

9. 1-9 6-9 9  PV= CF 1+r... + 1+r 1n 1 2 2 1 r n. 012n r CF 1 CF n CF 2 Value... ++ + Financial Assets Valuation

10. 1-10 6-10 10 PV of Cash Flows as Rates Change Bond Value = PV of coupons + PV of par Remember, as interest rates increase, the PVs decrease So, as interest rates increase, bond prices decrease and vice versa

11. 1-11 6-11 11 Valuing a Discount Bond with Annual Coupons Consider a bond with a coupon rate of 10% and coupons paid annually. The par value is $1,000 and the bond has 15 years to maturity. The yield to maturity is (rd) 10%. What is the value of the bond?

12. 1-12 6-12 12

13. 1-13 6-13 13 15 10 100 1000 NI/YR PV PMTFV -1,000 INPUTS OUTPUT A bond with a coupon rate of 10% and coupons paid annually. The yield to maturity is (rd) 10%, the par value is $1,000 and the bond has 15 years to maturity. What is the value of the bond? The bond is selling at a price equal to its par value because rd equal the coupon rate.

14. 1-14 6-14 14  When r d rises, above the coupon rate, the bond’s value falls below par, so it sells at a discount.  Discount Bond is a bond that sells below its par value which occurs whenever the required interest is above the coupon rate. 15 13 100 1000 NI/YR PV PMTFV -806.13 INPUTS OUTPUT What would happen if expected inflation rose by 3%, causing r = 13%?

15. 1-15 6-15 15 What would happen if inflation fell, and r d declined to 7%?  If coupon rate > r d, price rises above par, and bond sells at a premium.  Premium Bond is a bond that sells above its par value which occurs whenever the required interest is below the coupon rate. 15 7 100 1000 NI/YR PV PMTFV -1,273.24 INPUTS OUTPUT

16. 1-16 6-16 16 Valuing a Premium Bond with Annual Coupons Suppose you are looking at a bond that has a 10% annual coupon and a face value of $1,000. There are 20 years to maturity and the yield to maturity is 8%. What is the price of this bond? –Using the formula: B = PV of annuity + PV of lump sum B = $100[1 – 1/(1.08) 20 ] /.08 + $1,000 / (1.08) 20 B = $981.81 + 214.55 = $1,196.36 –Using the calculator: N = 20; I/Y = 8; PMT = 100; FV = 1,000 CPT PV = -1,196.36

17. 1-17 6-17 17 M 1,372 1,211 1,000 837 775 02 4 6 8 10 12 14 r d = 7%. r d = 13%. r d = 10%. Bond Value ($) vs Years remaining to Maturity

18. 1-18 6-18 18 At maturity, the value of any bond must equal its par value. The value of a premium bond would decrease to $1,000. The value of a discount bond would increase to $1,000. A par bond stays at $1,000 if r d remains constant.

19. 1-19 6-19 19 Bond Prices: Relationship Between Coupon and Yield If YTM = coupon rate, then par value = bond price If YTM > coupon rate, then par value > bond price –Price below par = “discount” bond If YTM < coupon rate, then par value < bond price –Price above par = “premium” bond

20. 1-20 6-20 20 Computing Yield to Maturity Yield to maturity is the rate implied by the current bond price YTM is the rate of return earned on a bond held to maturity. Also called “promised yield.” If you have a financial calculator, enter N, PV, PMT and FV, remembering the sign convention (PMT and FV need to have the same sign; PV the opposite sign)

21. 1-21 6-21 21 Suppose you were offered a 10-years, 9% annual coupon, $1,000 par value bond at a price of $887. What rate of interest would you earn in your investment if you held the bond to maturity? 90 01910 r d =? 1,000 PV 1. PV 10 PV M 887 Find r d that “works”!... Computing Yield to Maturity

22. 1-22 6-22 22 10 -887 90 1000 NI/YR PV PMTFV 10.91  V INT r M r B d N d N  11 1... + INT 1 + r d  887 90 1 1,000 1 110  rr dd + 90 1+r d + + + + + + + + INPUTS OUTPUT... Find r d

23. 1-23 6-23 23 Find YTM if price were $1,134.20. Sells at a premium. Because coupon = 9% > r d = 7.08%, bond’s value > par. 10 -1134.2 90 1000 NI/YR PV PMTFV 7.08 INPUTS OUTPUT

24. 1-24 6-24 24 YTM with Annual Coupons Consider a bond with a 10% annual coupon rate, 15 years to maturity, and a par value of $1,000. The current price is $928.09.  Will the yield be more or less than 10%?  N = 15; PV = -928.09; FV = 1,000; PMT = 100  CPT I/Y = 11%

25. 1-25 6-25 25 Semiannual Bonds 1. Multiply years to maturity, N, by 2 to determine the number of semiannual periods. N = 2n. 2. Divide nominal rate, rd, by 2 to determine the semiannual interest rate. I/Y= rd/2. 3. Divide the annual coupon interest payment (INT) by 2 to determine the dollars of interest paid each 6 months. PMT = INT/2. 2n r d /2 OK INT/2OK NI/YR PV PMTFV INPUTS OUTPUT

26. 1-26 6-26 26 2(15) 5/2 100/2 30 2.5 50 1000 NI/YR PV PMTFV -1523.26 INPUTS OUTPUT Value of 15-year, 10% coupon, semiannual bond if rd = 5%.

27. 1-27 6-27 27 YTM with Semiannual Coupons Suppose a bond with a 10% coupon rate and semiannual coupons, has a face value of $1,000, 20 years to maturity and is selling for $1,197.93.  Is the YTM more or less than 10%?  What is the semiannual coupon payment?  How many periods are there?  N = 40; PV = -1,197.93; PMT = 50; FV = 1,000; CPT I/Y = 4% (Is this the YTM?)  YTM = 4%*2 = 8%

28. 1-28 6-28 28 Current Yield  The current yield refers to the yield of the bond at the current moment. It does not reflect the total return over the life of the bond. Current yield = Annual coupon pmt Current price

29. 1-29 6-29 29 Current Yield Current yield= = 0.1015 = 10.15% $90 $887 Suppose you were offered a 10-years, 9% annual coupon, $1,000 par value bond at a price of $887. What is the current yield?  This measure looks at the current price of a bond instead of its face value. It represents the amount of cash income that a bond will generate in a given year.