MBA FM Lec 4 Bonds S22016 Linh

8/16/2019 MBA FM Lec 4 Bonds S22016 Linh

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Financial Management

MBA program – sem 2 (2015-2016)

Lecturer: Dr. Linh Nguyen

Email: [email protected]

Tutor: Mr. Le Ngoc Anh Khoa (MSc)

Email: [email protected]

The International University, VNU-HCMSchool of Business

mailto:[email protected]:[email protected]


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The International University, VNU-HCMSchool of Business

Lecture 4Bond Analysis and

Evaluation

2


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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 term structure of interest rates

and the determinants of bond yields

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DIFFERENCES BETWEENDEBT AND EQUITY

Debt Not an ownership interest Creditors do not have voting

rights Interest is considered a cost

of doing business and is taxdeductible Creditors have legal

recourse if interest orprincipal payments aremissed

Excess debt can lead tofinancial distress andbankruptcy

Equity Ownership interest Common stockholders vote

for the board of directorsand other issues

Dividends are notconsidered a cost of doingbusiness and are not taxdeductible

Dividends are not a liabilityof the firm, and stockholdershave no legal recourse if

dividends are not paid An all equity firm can not go

bankrupt merely due to debtsince it has no debt

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The most common type of fixed-income security

Promises to make a series of interest payments in

fixed amount and to repay the principal amount at

maturity

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• The face value of a bond, which the borrower repaysat maturity.

Par value/face value/principal value

• The date when a bond’s life ends and the borrowermust make the final interest payment and repay theprincipal / par value.

Maturity Date

• A fixed amount of interest that a bond promises topay investors each period.

Coupon payments

• The rate derived by dividing the bond’s annualcoupon payment by its par value.

Coupon interest rate

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• The price that investors need to pay to buy the bond

Asked price

• The price at which an investor who already owns the bond and wishes to sell it would receive

Bid price

• The return to investors if they buy the bond at theasked price and hold it to maturity .

Yield to maturity

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8

CASH FLOWS OF A TYPICAL BOND

Year 2015 2016 2017 2018

- Price

Coupon Coupon

Coupon & Face Value


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9


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THE BOND INDENTURE

Contract between the company and thebondholders that includes

The basic terms of the bonds

The total amount of bonds issued

A description of property used as security, if applicable

Sinking fund provisions:

Sinking fund : an account managed by the bond trustee for early bondredemption

Call provisions

Details of protective covenants

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BOND CLASSIFICATIONS

Registered vs. Bearer Forms

Security: secured versus unsecured

Collateral – secured by financial securities

Mortgage – secured by real property, normally land orbuildings

Debentures – unsecured

Notes – unsecured debt with original maturity less than

10 years Seniority ranking: a bond’s priority of claims to the

issuer’s assets and cash flows

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BOND CHARACTERISTICS AND REQUIRED RETURNS

The coupon rate depends on the risk characteristicsof the bond when issued

Which bonds will have the higher coupon, all else

equal? Secured debt versus a debenture

Subordinated debenture versus senior debt

A bond with a sinking fund versus one without

A callable bond versus a non-callable bond

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BOND RATINGS – INVESTMENT QUALITY

High Grade

Moody’s Aaa and S&P AAA – capacity to pay is extremelystrong

Moody’s Aa and S&P AA – capacity to pay is very strong

Medium Grade

Moody’s A and S&P A – capacity to pay is strong, but moresusceptible to changes in circumstances

Moody’s Baa and S&P BBB – capacity to pay is adequate,adverse conditions will have more impact on the firm’s ability

to pay

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BOND RATINGS - SPECULATIVE

Low Grade Moody’s Ba and B

S&P BB and B

Considered possible that the capacity to pay will degenerate.

Very Low Grade Moody’s C (and below) and S&P C (and below)

income bonds with no interest being paid, or

in default with principal and interest in arrears

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GOVERNMENT BONDS

Treasury Securities Federal government debt

T-bills – pure discount bonds with original maturity of oneyear or less

T-notes – coupon debt with original maturity between oneand ten years

T-bonds – coupon debt with original maturity greater thanten years

Municipal Securities

Debt of state and local governments Varying degrees of default risk, rated similar to corporate

debt

Interest received is tax-exempt at the federal level

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CORPORATE BONDS AND THE RISK OF DEFAULT

16

When investing in bonds, there is always the risk that the issuer may

default .

• Default risk: The risk that a bond issuer may default on

his bonds.• Companies compensate investors for bearing this added risk in

the form of higher interest rates on their bonds.

• Default premium: The additional yield on a bond that

investors require for bearing default risk.• Usually the difference between the promised yield on a

corporate bond and the yield on a U.S. Treasury bond with thesame coupon and maturity.


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Assuming annual interest:

17

)r +(1

F +

)r +(1

C +...+

)r +(1

C +

)r +(1

C = P nn210

)r +(1 F

+r r

C = P nn

1

110

Bond Price = PV of coupons + PV of face value/principal

Where :C: annual coupon payment

n: number of years of bond’s life

r: annual interest rate


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18

ExampleWhat is the price of a 5.5 % annual coupon bond, with a $1,000face value, which matures in 3 years? Assume a requiredreturn of 3.5%p.a.

03.056,1$

)035.0.1(

000,1

)035.01(

11

035.0

5533

PV

PV


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Example (continued)What is the price of the bond if the required rate of returnis 5.5%?

Example (continued)What is the price of the bond if the required rate of return is

15 %?

000,1$

)055.0.1(

000,1

)055.01(

11

055.0

55

33

PV

PV

09.783$

)15.0.1(

000,1

)15.01(

11

15.0

5533

PV

PV


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R > Coupon InterestRate

P0 < par value DISCOUNT

20

R< Coupon InterestRate P0 > par value PREMIUM

R = Coupon InterestRate

P0 = par value PAR VALUE

What happens to bond values if the required return is not equal tothe coupon rate?

The bond's price will differ from its par value.


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6% coupon ratefor both

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Bond prices move inversely to yields (interest rates)


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22

880

900

920

940

960

980

1,000

1,020

1,040

1,060

1,080

0 5 10 15 20 25 30

B o n d

P r i c e

Time to Maturity

Price path for PremiumBond

Price path for DiscountBond

TodayMaturity

Bond prices converge to par value (plus final coupon) withpassage of time


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Example:

Determine the price of a 5.5 % annual coupon bond, with a $1,000face value, which matures in 3 years?

What is the price of the bond if the required rate of return is 3.5% AND the coupons are paid semi-annually ?

49.056,1$

)0175.1(

50.027,1

)0175.1(

50.27...)0175.1(

50.27

)0175.1(

50.276521

PV

PV


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Assuming annual interest:

24

)r +(1

F

+ )r +(1 +...+ )r +(1 + )r +(1 = P nn210

000

)r +(1

F = P

n0

Bond Price = PV of coupons + PV of principal

Zero coupon bond: is the bond that does not pay interestsduring the bond’s life.


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YTM is the interest rate for which the presentvalue of the bond’s coupon payments andprincipal equal the bond price.

YTM

Economic meaning: YTM is the rate of returninvestors earn if they buy at P0 and hold ituntil maturity

YTM

nYTM

F C

YTM

C

YTM

C P

)1(

)(....)1()1( 21

0


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Example

What is the YTM of a 5.5 % annual coupon bond, with a

$1,000 face value, which matures in 3 years? The market price

of the bond is $1,056.03.

26

03.056,1$

)1(

000,1

)1(

11

5533

PV

YTM YTM YTM PV

Calculating Yield to Maturity (YTM=r)If you are given the price of a bond (PV) and the coupon

rate, the yield to maturity can be found by solving for r or

YTM.


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The amount obtained by dividing the bond’scoupon by its current market price (which

does not always equal its par value).

Current Yield


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EXAMPLES

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1. Staind, Inc., has 7.5 percent coupon bonds on themarket that have 10 years left to maturity. The bondsmake annual payments. If the YTM on these bonds is8.75 percent, what is the current bond price? Assuming

the par value of Staind, Inc. bonds is $1,000.

Solution:The price of the bond will be:

= $75 ×1 −

1

1.0875

0.0875 +

$1,000

1.0875 = $918.89


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EXAMPLES

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2. Ashes Divide Corporation has bonds on the market

with 14.5 years to maturity, a YTM of 6.8 percent, and a

current price of $924. The bonds make semiannual

payments. What must the coupon rate be on these

bonds, assuming the par value of Ashes Divide

Corporation bonds is $1,000?


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EXAMPLES

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Ashes Divide Corporation has bonds on the market with 14.5 years tomaturity, a YTM of 6.8 percent, and a current price of $924. The bonds makesemiannual payments. What must the coupon rate be on these bonds,assuming the par value of Ashes Divide Corporation bonds is $1,000?

Solution:We have:

= $924 = ×1 − 1

1.034

0.034 +

$1,000

1.034

Solving for the coupon payment, we get:C = $29.84Since this is the semiannual payment, the annual coupon

payment is:2 × $29.84 = $59.68

And the coupon rate is the annual coupon payment divided bypar value, so:

Coupon rate = $59.68 / $1,000 = 0.0597 or 5.97%


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31

A five-year, 4.50% semiannual coupon payment government bondis priced at 98 per 100 of par value.

a. Calculate the annual yield-to-maturity stated on a semiannualbond basis, rounded to the nearest basis point.

b. Convert that annual yield to: an annual rate that can be usedfor direct comparison with otherwise comparable bonds thatmake quarterly coupon payments

EXAMPLES


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Solution:

EXAMPLES


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• The stated return offered by an investment and havenot adjusted for the effects of inflation.

Nominal return

• Approximately, the difference between an investment’sstated or nominal return and the inflation rate.

Real return

Investment Initial

Changeice IncomeCouponr

Pr

Bonds Rate of Return: total Income per period per dollarinvested


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CLEAN VS. DIRTY PRICES

Clean price (flat price): quoted price Dirty price (full price): price actually paid = quoted price +

accrued interest

Example: Consider a T-bond with a 4% semiannual yield anda clean price of $1,282.50, assuming that the coupon datesare May 15 and Nov.15, the settlement date: July 15. Number of days since last coupon = 61 = 16 + 30 + 15

Number of days in the coupon period = 184 = 16 + 30 + 31 + 31 + 30 +31 + 15

Accrued interest = (61/184)(.04*1000) = $13.26

Dirty price = $1,282.50 + $13.26 = $1,295.76

So, you would actually pay $ 1,295.76 for the bond

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Interest rate risk: the risk of a decline in bond’s value

(bond price) due to an increase in interest rate.

Duration: is used as a measure of a bond’s interest rate

risk or sensitivity of a bond’s full price to a change in itsyield

Was first introduced by Frederick Macaulay Macaulayduration

There are also other measures of interest rate risk:modified duration, effective duration

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Reinvestment rate risk: the risk of decline inincome from a bond portfolio (e.g. Proceeds fromcoupon) due to the decrease in interest rate.

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TERM STRUCTURE OF INTEREST RATES

Term structure is the relationship between time tomaturity and yields, all else equal

It is important to recognize that we pull out the effect ofdefault risk, different coupons, etc.

Yield curve – graphical representation of the termstructure Normal – upward-sloping; long-term yields are higher than short-

term yields

Inverted – downward-sloping; long-term yields are lower thanshort-term yields

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Upward-Sloping Yield Curve

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Downward-Sloping Yield Curve

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FACTORS AFFECTING BOND YIELDS

Defaul t r isk premium –bond ratings

Taxabi l i ty prem ium –municipal versus taxable

Liqu id ity premium – bonds that have more

frequent trading will generally have lowerrequired returns

Anything else that affects the risk of the cashflows to the bondholders will affect the required

returns

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THANK YOU43

Exercises:

Chapter 7 (pp. 226-230) : 3,7,8,10, 18,19, 20,22

MBA FM Lec 4 Bonds S22016 Linh

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