Key Features of Bonds Bond Valuation Measuring Yield Assessing Risk Chapter 7 What is a bond A longterm debt instrument in which a borrower bond issuer agrees to make payments of principal and interest on specific dates to the lender bondholders ID: 232907
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Slide1
Bonds and Their Valuation
Key Features of BondsBond ValuationMeasuring YieldAssessing Risk
Chapter 7Slide2
What is a bond?
A long-term debt instrument in which a borrower (bond issuer) agrees to make payments of principal and interest, on specific dates, to the lender (bondholders)
They are issued by government agencies and corporations that are looking for long-term debt capital.
A bond that has just been issued
new issue
A bond that has been issued outstanding bond or seasonal issue. Slide3
Key Features of a Bond
Par value:
face amount of the bond, which is paid at maturity (assume $1,000).
Coupon interest rate
: stated interest rate paid by the issuer.
Multiply it by par value to get dollar payment of interest.
Coupon payments can be fixed rates or floating rates
Some bond pay no coupons at all (called zero coupon bonds). However, they are offered at a discount (below the par value)
they offer capital gain not interest income
Maturity date:
years until the bond must be repaid.
Effective maturity date declines each year passes after the issue date
Issue date (settlement date):
when the bond was issued.Slide4
Key Features of a Bond
Call Provision
Allows issuer to refund (Call) the bond issue if rates decline.
Helps the issuer (lower interest expenses), but hurts the investor (reinvestment risk).
Borrowers (bond issuers) are willing to pay more than par value if want to call bond (call premium).
Cost of borrowing at the lower rate < Cost they will pay to retire high-interest rate bonds
Investor (lender) require more return on callable bonds than on non-callable with same risk
To compensate them for the reinvestment riskSlide5
Key Features of a Bond
Convertible bonds
Bonds that are exchangeable into shares of common stock at fixed price at the option of the holder.
It offer lenders (B/H) the chance to benefit from the increase in the stock price.
Buy stock with less than what it is worth in the market.
Because of this feature, borrows (firms) are willing to pay less interest (coupon rate) than on a non-convertible bond with similar risks. Slide6
How to determine the bond’s valueSlide7
The Value Bonds
INT: interest payments (par value x coupon rates).
M:
The par value (bond face value)
N:
Is the time until the bonds matures.
0
1
2
N
rd%
INT
1
INT
N
+ M
INT
2
Value
...Slide8
The Value Bonds
rd: Market interest rates on the bond or discount rate (
the cost a borrower must pay for borrowing funds
) or (
required rate of return that B/H requires
)
It is the minimum acceptable return that B/H require to hold that bond.
0
1
2
N
rd%
INT
1
INT
N
+ M
INT
2
Value
...Slide9
Note on rd (the market interest rate)
If the minimum acceptable return (rd) is equal to the return B/H expected to get from holding the bond until maturity, then rd is called
Yield to Maturity
YTM
T
he compounding rate of return earned on a bond if it was held to maturity. It accounts for both:
Interest payment represented in (Current Yield CY)
CY = Interest/current price
Capital gains/loss: appreciation or depreciation of the bond price
CG = % change in the bond price
YTM
= CY + CG
If the bond is
callable
, then rd is equal to minimum acceptable return B/H expected to get from holding the bond until it is
called
. It is called
Yield to Call
YTC
When the bond is called, investors
have no choice of holding the bond to maturity.
YTM could not be earned. Slide10
Important Bond Theorems
Coupon rate = yield to maturity
V
B
= M
Bond is selling at par
Coupon rate > yield to maturity
V
B
> M
Bond is selling at premium
Coupon rate < yield to maturity
VB
< M Bond is selling at discount
M is the par value at maturity Slide11
Default Risk
If an issuer defaults, investors receive less than the promised return.
Therefore, the required rate of return (rd) that B/H require on corporate bonds
is higher
than that on T-bond
that have the same maturity (
MRP
) and marketability (LP)
(probability of default is higher than that in T-bonds).
DR is influenced by the issuer’s financial strength and the terms of the bond contract.
And many agencies use such info to rate these issuers based on the default probability Slide12
Evaluating Default Risk:
Bond Ratings
Investment Grade
Junk Bonds
Moody’s
Aaa Aa A Baa
Ba B Caa C
S & P
AAA AA A BBB
BB B CCC C
Bond ratings are designed to reflect the probability of a bond issue going into default.
AAA bonds provide lower return (rd) than
Aa
, A, BBB…etc
because they are considered more safer (less default risk)
There is an inverse relationship between rating and required rate of return (rd).