BOND VALUATION BOND VALUATION CONCEPTS CONCEPTS

FIN 3403, 3404FIN 3403, 3404

PROF. DIGGLEPROF. DIGGLE

BOND CONCEPTSBOND CONCEPTS

What is a bond?What is a bond? How do corporate bonds differ from other How do corporate bonds differ from other

kinds of bonds?kinds of bonds? Priority of claim pyramidPriority of claim pyramid Characteristics of Corporate bondsCharacteristics of Corporate bonds What is a Municipal bond?What is a Municipal bond? Characteristics of muny bonds.Characteristics of muny bonds.

RISK VS RETURNRISK VS RETURN

KINDS OF RISK--RECAPKINDS OF RISK--RECAP– INFLATION RISKINFLATION RISK– BUSINESS OR DEFAULT RISKBUSINESS OR DEFAULT RISK– MARKET RISKMARKET RISK– LIQUIDITY RISKLIQUIDITY RISK– INTR. RATE RISKINTR. RATE RISK– OTHEROTHER

» CURRENCY RISKCURRENCY RISK» POLITICAL RISKPOLITICAL RISK» ETC.ETC.

BOND CONCEPTS AND BOND CONCEPTS AND TERMS (see lec notes p. 34) TERMS (see lec notes p. 34)

TERMSTERMS PARPAR COUPON RATECOUPON RATE DOLLAR ANNUAL DOLLAR ANNUAL

COUPONCOUPON CURRENT YIELDCURRENT YIELD YIELD TO YIELD TO

MATURITYMATURITY INDENTURE INDENTURE

DEBENTURE DEBENTURE DURATIONDURATION

ACCRUED INTERESTACCRUED INTEREST

CONCEPTSCONCEPTS IF INTEREST RATES IF INTEREST RATES

RISE WHAT RISE WHAT HAPPENS TO BOND HAPPENS TO BOND PRICES?PRICES?

Current yield vs. YTM Current yield vs. YTM

THE BOND TVM TIME LINETHE BOND TVM TIME LINE

COUPONCOUPON COUPONCOUPON COUPONCOUPON

COUPON COUPON ETC ETCCOUPON COUPON ETC ETC

All bonds we will study pay SEMI-All bonds we will study pay SEMI-ANNUALLY (coupon every 6 months)ANNUALLY (coupon every 6 months)

An 8% bond pays two coupons of $40 eachAn 8% bond pays two coupons of $40 each

A 30 year bond has 60 interest coupons.A 30 year bond has 60 interest coupons.

PAR AT MATURITY ($1000)PAR AT MATURITY ($1000)

BOND VALUATIONBOND VALUATIONSEE LEC NOTES PP. 35-38SEE LEC NOTES PP. 35-38

A BOND IS IN TWO A BOND IS IN TWO PARTS:PARTS:– PRINCIPAL ($1000 PRINCIPAL ($1000

PAR) -- PAR) -- LUMP SUMLUMP SUM AT AT MATURITYMATURITY

– INTEREST coupons INTEREST coupons (SEMIANNUAL) (SEMIANNUAL) (ANNUITY)(ANNUITY)

The value of a bond is The value of a bond is the NPV of both the NPV of both elementselements

The price of a bond is, The price of a bond is, therefore, another therefore, another TVM problem.TVM problem.

What is the discount What is the discount rate?rate?– The current MARKET The current MARKET

rate of bonds of similar rate of bonds of similar TYPE, QUALITY and TYPE, QUALITY and MATURITYMATURITY

KINDS OF BONDSKINDS OF BONDS

U.S. GOVERNMENTU.S. GOVERNMENT– U.S. TREASURYU.S. TREASURY

– Treasury series EETreasury series EE

– U.S. AGENCYU.S. AGENCY

– MUNICIPALMUNICIPAL

CORPORATECORPORATE– MortgageMortgage

– DebentureDebenture

FOREIGN GOVT.FOREIGN GOVT.

TAX TAX CONSIDERATIONS CONSIDERATIONS – The Tax Equivalent The Tax Equivalent

yieldyield

ZERO COUPON ZERO COUPON BONDSBONDS

STRIPSSTRIPS INFLATION INFLATION

ADJUSTED BONDSADJUSTED BONDS

CORPORATE BONDSCORPORATE BONDSIssued by domestic corporationsIssued by domestic corporations

ALL new corporate ALL new corporate bond issues are subject bond issues are subject to SEC reviewto SEC review– The IndentureThe Indenture

– Role of the Bond Role of the Bond TrusteeTrustee

– How is a bond soldHow is a bond sold

– The “Shelf The “Shelf registration”registration”

What terms are in the What terms are in the Indenture?Indenture?– Collateral and priority of Collateral and priority of

claimclaim– Coupon in percent and Coupon in percent and

dollarsdollars– MaturityMaturity– Call provisionsCall provisions

» sinking fundsinking fund

» redemptionredemption

– TrusteeTrustee

BOND “RATING” SERVICESBOND “RATING” SERVICES

MOODY’S AND MOODY’S AND STANDARD AND STANDARD AND POORPOOR

RATING FROM RATING FROM AAA (best) to BA AAA (best) to BA (lowest “investment” (lowest “investment” grade), to below B grade), to below B (“junk bonds.”(“junk bonds.”

The bond rating is a The bond rating is a measure of business measure of business risk or risk of default risk or risk of default only.only.

Corporations and Corporations and municipalities must pay municipalities must pay a fee to have bonds a fee to have bonds rated. Therefore many rated. Therefore many bonds are NR.bonds are NR.

MUNY BONDSMUNY BONDSBonds issued by states, cities and Bonds issued by states, cities and

local authorities like airportslocal authorities like airports GOGO or General Obligation (supported usually by or General Obligation (supported usually by

real estate taxes)real estate taxes) REVENUEREVENUE AND AND IDRIDR

– HOW DOES A CORPORATION DO AN IDR?HOW DOES A CORPORATION DO AN IDR?

SINGLE, DOUBLE AND TRIPLE TAX FREE SINGLE, DOUBLE AND TRIPLE TAX FREE MUNYSMUNYS

WHY ARE MUNY’S FREE OF FEDERAL WHY ARE MUNY’S FREE OF FEDERAL INCOME TAX?INCOME TAX?

YIELD TO MATURITYYIELD TO MATURITY

YTMYTM is the “Total is the “Total Return” on a bond. This Return” on a bond. This consists of:consists of:– CURRENT YIELDCURRENT YIELD– CAPITAL GAINS CAPITAL GAINS

“YIELD”“YIELD”

If a bond is selling at a If a bond is selling at a PREMIUM (above par), PREMIUM (above par), bondholder will have a bondholder will have a capital loss to maturity.capital loss to maturity.

If a bond is selling at a If a bond is selling at a DISCOUNT, you have a DISCOUNT, you have a guaranteed capital gain guaranteed capital gain to maturity.to maturity.

PREMIUM: CURRENT PREMIUM: CURRENT YIELD > THAN YTM YIELD > THAN YTM WHY?WHY?

DISCOUNTDISCOUNT

CURRENT YIELD < CURRENT YIELD < YTM. WHY?YTM. WHY?

BOND PROELEM USING BOND PROELEM USING YOUR CALCULATORYOUR CALCULATOR

You buy a corporate You buy a corporate bond on 12-1-98bond on 12-1-98

The coupon is 7.5%The coupon is 7.5% The bond matures on The bond matures on

May 15, 2015 May 15, 2015 (Millennium problem (Millennium problem does not affect does not affect calculator)calculator)

The market yield is 6%. The market yield is 6%. Compute PRICECompute PRICE

THIS IS SDTTHIS IS SDT $75 PER YEAR or $75 PER YEAR or

$37.50 per coupon$37.50 per coupon Matures at par. Par is Matures at par. Par is

expressed in % in your expressed in % in your calculator. Therefore calculator. Therefore $1000 par is entered $1000 par is entered as 100 or 100%as 100 or 100%

YLD = 6YLD = 6

TIBA 2+ CALCULATOR TIBA 2+ CALCULATOR BOND WORKSHEETBOND WORKSHEET

SDT enter 12.0198SDT enter 12.0198 CPNCPN enter 7.5enter 7.5 RDT enter 5.1515RDT enter 5.1515 RV = 100% OF PAR OR RV = 100% OF PAR OR

$1000$1000 ACT (for corporates) and ACT (for corporates) and

360 for Treasuries360 for Treasuries 2/Y (semiannual pay)2/Y (semiannual pay)

LEAVE YOUR TI BA2 AT LEAVE YOUR TI BA2 AT ACT AND 2/YACT AND 2/Y

YLD = YLD = market yieldmarket yield on on bonds of similar type, bonds of similar type, quality and maturity = 6quality and maturity = 6

SOLVE FOR PRI (price SOLVE FOR PRI (price -- push CPT)-- push CPT)

MAY ALSO SOLVE MAY ALSO SOLVE FOR YTM where price FOR YTM where price is givenis given

AI = accrued interest AI = accrued interest

WHAT DOES THE BOND WHAT DOES THE BOND WORKSHEET DO?WORKSHEET DO?

THE PRICE OF A BOND IS THE NET THE PRICE OF A BOND IS THE NET PRESENT VALUE OF:PRESENT VALUE OF:– THE LUMP SUM OF $1000 PAR RECEIVED THE LUMP SUM OF $1000 PAR RECEIVED

AT MATURITYAT MATURITY– THE ANNUITY OF COUPON INTEREST THE ANNUITY OF COUPON INTEREST

RECEIVED SEMIANNUALLY OVER RECEIVED SEMIANNUALLY OVER REMAINING LIFE OF BOND (P/Y = 2)REMAINING LIFE OF BOND (P/Y = 2)

HOW WOULD YOU COMPUTE THE HOW WOULD YOU COMPUTE THE PRICE OF A ZERO COUPON BOND?PRICE OF A ZERO COUPON BOND?

WHAT IS CALL?WHAT IS CALL?

Why would a company Why would a company or municipality call a or municipality call a bond?bond?

Why do investors Why do investors dislike callable bonds?dislike callable bonds?

If a bond is not callable If a bond is not callable for 5 years this is called for 5 years this is called call protection.call protection.

REDEMPTION CALLREDEMPTION CALL SINKING FUND SINKING FUND

CALLCALL CALCULATING CALCULATING

YIELD TO CALL ON YIELD TO CALL ON YOUR CALCULATORYOUR CALCULATOR

ACCRUED INTERESTACCRUED INTEREST

BOND PROBLEMBOND PROBLEM

A. YOU BUY A BOND A. YOU BUY A BOND TODAY MATURING TODAY MATURING IN 30 YEARS.IN 30 YEARS.

YOU PAY 1030 (103% YOU PAY 1030 (103% of par) of par)

THE COUPON IS THE COUPON IS 7.33%7.33%

WHAT IS THE YIELD WHAT IS THE YIELD TO MATURITY?TO MATURITY?

B. YOU BUY A BOND B. YOU BUY A BOND TODAY MATURING TODAY MATURING IN 25 YEARS THAT IN 25 YEARS THAT IS CALLABLE IN 15 IS CALLABLE IN 15 YEARS AT 105YEARS AT 105

ALL FACTS ON LEFT ALL FACTS ON LEFT SIDE ARE THE SIDE ARE THE SAME.SAME.

COMPUTE YIELD TO COMPUTE YIELD TO CALL.CALL.

DURATION VS MATURITYDURATION VS MATURITY

SEE TEXTSEE TEXT MATURITY IS A MATURITY IS A

FIXED DATE IN TIMEFIXED DATE IN TIME DURATION IS A DURATION IS A

MEASURE OF BOND MEASURE OF BOND CASH FLOW CASH FLOW COMBINING COMBINING MATURITY AND MATURITY AND COUPON INCOMECOUPON INCOME

A HIGH COUPON A HIGH COUPON BOND WILL HAVE BOND WILL HAVE A SHORTER A SHORTER DURATION THAN A DURATION THAN A LOWER COUPON LOWER COUPON ISSUE THAT IS ISSUE THAT IS IDENTICAL IN ALL IDENTICAL IN ALL OTHER RESPECTSOTHER RESPECTS

ACCRUED INTERESTACCRUED INTEREST

You buy a bond on You buy a bond on March 10. Coupons are March 10. Coupons are paid on Jan 1 and June paid on Jan 1 and June 30.30.

What is the accrued What is the accrued income? Who pays it income? Who pays it and why?and why?

Accrued income is added Accrued income is added to the amount received to the amount received by the SELLERby the SELLER

Who will receive the Who will receive the June 30 coupon? THE June 30 coupon? THE BUYER.BUYER.

The buyer must pay the The buyer must pay the seller accrued interest seller accrued interest for the time he owned for the time he owned the bond since the last the bond since the last coupon. This is done coupon. This is done on settlement date.on settlement date.

TRADE DATE AND TRADE DATE AND SETTLEMENT DATESETTLEMENT DATE

Corporate securities Corporate securities settle in 3 business days settle in 3 business days after trade date.after trade date.

You buy a bond on You buy a bond on Friday. Monday is a Friday. Monday is a Holiday. When is Holiday. When is corporate settlement? corporate settlement? This is when good funds This is when good funds must be available to pay must be available to pay for bond or stock.for bond or stock.

Government Government (TREASURY) bonds (TREASURY) bonds are next day settlement are next day settlement (next (next businessbusiness day). day).

SDT on your financial SDT on your financial calculator is settlement calculator is settlement date.date.

RDT (redemption date) RDT (redemption date) is maturity or call date.is maturity or call date.

CONVERTS & ZEROS: CONVERTS & ZEROS: FIN 3404--FIN 3404 FIN 3404--FIN 3404

STUDENTS not responsibleSTUDENTS not responsible A convert is a bond with A convert is a bond with

additional contractual additional contractual provisions in the provisions in the indenture providing for indenture providing for conversion of the bond conversion of the bond into common stock.into common stock.

A convert is “Quasi A convert is “Quasi Equity.” It behaves Equity.” It behaves like common stock.like common stock.

TERMINOLOGYTERMINOLOGY– CONVERSION CONVERSION

PRICEPRICE

– CONVERSION CONVERSION RATIORATIO

– THEORETICAL THEORETICAL VALUEVALUE

– PREMIUM OVER PREMIUM OVER THEORETICAL THEORETICAL VALUEVALUE

CONVERTS CONTD.CONVERTS CONTD.

Why would a company Why would a company include convertibility as include convertibility as a “sweetener” in the a “sweetener” in the indenture?indenture?

What happens if a What happens if a convertible bond is convertible bond is called by the company?called by the company?– 2 situations2 situations

Are converts a good Are converts a good investment? Why or investment? Why or why not?why not?

Should you buy a Should you buy a callable convert callable convert selling above call selling above call price? Why or why price? Why or why not?not?

CONVERT PROBLEMCONVERT PROBLEM

A convert is A convert is convertible into 20 convertible into 20 shares of common. shares of common. This is the conversion This is the conversion ratio.ratio.

This means the This means the conversion price is conversion price is $50 ($1000 par / 20)$50 ($1000 par / 20)

When a convert is When a convert is issued, the conversion issued, the conversion price is usually 15% or price is usually 15% or so below common so below common price. Why? price. Why?

Assume the common Assume the common price is $40 when the price is $40 when the bond is floated.bond is floated.

CONVERT PROBLEM CONTDCONVERT PROBLEM CONTD

Assume now it is 3 Assume now it is 3 years later and the years later and the common is selling for common is selling for $65 per share.$65 per share.

What is the theoretical What is the theoretical value of the convert?value of the convert?

Conv ratio = number Conv ratio = number of common shares per of common shares per bond X stock pricebond X stock price

TV = 20 x $65 = TV = 20 x $65 = $1300$1300

Assume the call price Assume the call price set in the indenture is set in the indenture is 103 ($1030). What 103 ($1030). What happens if this bond is happens if this bond is called?called?

CONVERTS CONTDCONVERTS CONTD

Why do most converts Why do most converts sell at a PREMIUM sell at a PREMIUM over conversion or over conversion or theoretical value?theoretical value?

Priority of claimPriority of claim Current yield on bond Current yield on bond

vs dividend yield on vs dividend yield on stockstock

Say the bond we are Say the bond we are looking at carried a looking at carried a coupon of 8%. The coupon of 8%. The burrent yield at a price burrent yield at a price of $1300 = 6.15%. of $1300 = 6.15%. Assume the common Assume the common dividend is $2.00. The dividend is $2.00. The dividend yield is 2/65 dividend yield is 2/65 or 3.1%. Which would or 3.1%. Which would you rather own?you rather own?

WHAT ARE ZERO COUPON WHAT ARE ZERO COUPON BONDS?BONDS?

Bond in which Bond in which coupons have been coupons have been stripped off.stripped off.

Price is simply the Price is simply the NPV of the par value NPV of the par value ($1000) at maturity.($1000) at maturity.

What reasons can you What reasons can you think of for investors to think of for investors to own zero coupon own zero coupon treasuries?treasuries?

Compute the price of a Compute the price of a Treasury maturing in Treasury maturing in 30 years when the yield 30 years when the yield on coupon conds of on coupon conds of similar type and quality similar type and quality is 6.4%is 6.4%