Chapter 7the Valuation And Characteristics Of Bonds 2017 Pearson Educ ✓ Solved

Chapter 7 The Valuation and Characteristics of Bonds © 2017 Pearson Education, Inc. All rights reserved. 7-‹#› Learning Objectives Distinguish between different kinds of bonds. Explain the more popular features of bonds. Define the term value as used for several different purposes.

Explain the factors that determine value. © 2017 Pearson Education, Inc. All rights reserved. 7-‹#› Learning Objectives Describe the basic process for valuing assets. Estimate the value of a bond. Compute a bond’s expected rate of return and its current yield.

Explain three important relationships that exist in bond valuation. © 2017 Pearson Education, Inc. All rights reserved. 7-‹#› TYPES OF BONDS © 2017 Pearson Education, Inc. All rights reserved. 7-‹#› Bonds Meaning: A bond is a type of debt or long-term promissory note, issued by a borrower, promising to its holder a predetermined and fixed amount of interest per year and repayment of principal at maturity.

Bonds are issued by Corporations, U.S. Government, State and Local Municipalities. © 2017 Pearson Education, Inc. All rights reserved. 7-‹#› Debentures Debentures are unsecured long-term debt. For an issuing firm, debentures provide the benefit of not tying up property as collateral.

For bondholders, debentures are more risky than secured bonds and provide a higher yield than secured bonds. © 2017 Pearson Education, Inc. All rights reserved. 7-‹#› Subordinated Debentures There is a hierarchy of payout in case of insolvency. The claims of subordinated debentures are honored only after the claims of secured debt and unsubordinated debentures have been satisfied. © 2017 Pearson Education, Inc. All rights reserved.

7-‹#› Mortgage Bonds Mortgage bond is secured by a lien on real property. Typically, the value of the real property is greater than that of the bonds issued, providing bondholders a margin of safety. © 2017 Pearson Education, Inc. All rights reserved. 7-‹#› Eurobonds Securities (bonds) issued in a country different from the one in whose currency the bond is denominated. For example, a bond issued by an American corporation in Japan that pays interest and principal in dollars. © 2017 Pearson Education, Inc.

All rights reserved. 7-‹#› Convertible Bonds Convertible bonds are debt securities that can be converted into a firm’s stock at a prespecified price. © 2017 Pearson Education, Inc. All rights reserved. 7-‹#› TERMINOLOGY AND CHARACTERISTICS OF BONDS © 2017 Pearson Education, Inc. All rights reserved.

7-‹#› Claims on Assets and Income Seniority in claims In the case of insolvency, claims of debt, including bonds, are generally honored before those of common or preferred stock. © 2017 Pearson Education, Inc. All rights reserved. 7-‹#› Par Value Par value is the face value of the bond, returned to the bondholder at maturity. In general, corporate bonds are issued at denominations or par value of ,000. Prices are represented as a % of face value.

Thus, a bond quoted at 104 can be bought at 104% of its par value in the market. Bonds will return the par value at maturity, regardless of the price paid at the time of purchase. © 2017 Pearson Education, Inc. All rights reserved. 7-‹#› Coupon Interest Rate The percentage of the par value of the bond that will be paid periodically in the form of interest. Example: A bond with a ,000 par value and 5% annual coupon rate will pay annually (=0.05*1000) or (if interest is paid semiannually). © 2017 Pearson Education, Inc.

All rights reserved. 7-‹#› Zero Coupon Bonds Zero coupon bonds have zero or very low coupon rate. Instead of paying interest, the bonds are issued at a substantial discount below the par or face value. © 2017 Pearson Education, Inc. All rights reserved. 7-‹#› Maturity Maturity of bond refers to the length of time until the bond issuer returns the par value to the bondholder and terminates or redeems the bond. © 2017 Pearson Education, Inc.

All rights reserved. 7-‹#› Call Provision Call provision (if it exists on a bond) gives a corporation the option to redeem the bonds before the maturity date. For example, if the prevailing interest rate declines, the firm may want to pay off the bonds early and reissue at a more favorable interest rate. Issuer must pay the bondholders a premium. There is also a call protection period where the firm cannot call the bond for a specified period of time. © 2017 Pearson Education, Inc.

All rights reserved. 7-‹#› Indenture An indenture is the legal agreement between the firm issuing the bond and the trustee who represents the bondholders. It provides for specific terms of the loan agreement (such as rights of bondholders and issuing firm). Many of the terms seek to protect the status of bonds from being weakened by managerial actions or by other security holders. © 2017 Pearson Education, Inc. All rights reserved.

7-‹#› Bond Ratings Bond ratings reflect the future risk potential of the bonds. Three prominent bond rating agencies are Standard & Poor’s, Moody’s, and Fitch Investor Services. Lower bond rating indicates higher probability of default. It also means that the rate of return demanded by the capital markets will be higher on such bonds. © 2017 Pearson Education, Inc. All rights reserved.

7-‹#› © 2017 Pearson Education, Inc. All rights reserved. 7-‹#› Factors Having a Favorable Effect on Bond Rating A greater reliance on equity as opposed to debt in financing the firm Profitable operations Low variability in past earnings Large firm size Little use of subordinated debt © 2017 Pearson Education, Inc. All rights reserved. 7-‹#› Junk Bonds Junk bonds are high-risk bonds with ratings of BB or below by Moody’s and Standard & Poor’s.

Junk bonds are also referred to as high-yield bonds as they pay a high interest rate, generally 3 to 5% more than AAA-rated bonds. © 2017 Pearson Education, Inc. All rights reserved. 7-‹#› DEFINING VALUE © 2017 Pearson Education, Inc. All rights reserved. 7-‹#› Defining Value Book value: Value of an asset as shown on a firm’s balance sheet.

Liquidation value: The dollar sum that could be realized if an asset were sold individually and not as part of a going concern. Market value: The observed value for the asset in the marketplace. Intrinsic or economic value: Also called fair value—represents the present value of the asset’s expected future cash flows. © 2017 Pearson Education, Inc. All rights reserved. 7-‹#› Value and Efficient Markets In an efficient market, the values of all securities at any instant fully reflect all available public information.

If the markets are efficient, the market value and the intrinsic value will be the same. © 2017 Pearson Education, Inc. All rights reserved. 7-‹#› WHAT DETERMINES VALUE? © 2017 Pearson Education, Inc. All rights reserved. 7-‹#› What Determines Value?

Value of an asset = present value of its expected future cash flows using the investor’s required rate of return as the discount rate. Thus value is affected by three elements: Amount and timing of the asset’s expected future cash flows Riskiness of the cash flows Investor’s required rate of return for undertaking the investment © 2017 Pearson Education, Inc. All rights reserved. 7-‹#› © 2017 Pearson Education, Inc. All rights reserved.

7-‹#› VALUATION: THE BASIC PROCESS © 2017 Pearson Education, Inc. All rights reserved. 7-‹#› Bond Valuation The value of a bond (V) is a combination of: C: Future expected cash flows in the form of interest and repayment of principal n: The time to maturity of the loan r: The investor’s required rate of return © 2017 Pearson Education, Inc. All rights reserved. 7-‹#› © 2017 Pearson Education, Inc.

All rights reserved. 7-‹#› VALUING BONDS © 2017 Pearson Education, Inc. All rights reserved. 7-‹#› © 2017 Pearson Education, Inc. All rights reserved.

7-‹#› Example on Bond Valuation Consider a bond issued by Toyota with a maturity date of 2020 and a stated coupon of 4.5%. In 2015, with 5 years left to maturity, investors owning the bonds are requiring a 2.1% rate of return. © 2017 Pearson Education, Inc. All rights reserved. 7-‹#› Toyota Bond Example Step 1 (CF): Estimate amount and timing of the expected future cash flows: a. Annual interest payments 0.045 à— ,000 = every year for five years b.

Face value to be received in 2020 ,000 © 2017 Pearson Education, Inc. All rights reserved. 7-‹#› Summary of Cash Flows (For One Bond) Time Bondholder Corporation 0 Price = ? Price = ? 1–5 – 5 +1,000 –1,000 © 2017 Pearson Education, Inc.

All rights reserved. 7-‹#› Toyota Bond Example Step 2 (r) Determine the investor’s required rate of return by evaluating the riskiness of the bond’s future cash flows. Remember the investors required rate of return equals the risk-free rate plus a risk premium. Here, the required rate of return (r) is given as 2.1%. © 2017 Pearson Education, Inc. All rights reserved.

7-‹#› Toyota Bond Example Step 3: Calculate the intrinsic value of the bond. Bond Value = PV (Interest, received every year) + PV (Par, received at maturity) © 2017 Pearson Education, Inc. All rights reserved. 7-‹#› Toyota Bond Example Using calculator: Annual interest payments (PMT) = Par value (FV) = ,000 Years until maturity (N) = 5 Required rate of return (I) = 2.1% Solve for PV = ,112.80 © 2017 Pearson Education, Inc. All rights reserved.

7-‹#› BOND YIELDS © 2017 Pearson Education, Inc. All rights reserved. 7-‹#› Bond Yields Yield to Maturity (YTM) YTM refers to the rate of return the investor will earn if the bond is held to maturity. YTM is also known as bondholder’s expected rate of return. YTM = Discount rate that equates the present value of the future cash flows with the current market price of the bond. © 2017 Pearson Education, Inc.

All rights reserved. 7-‹#› Bond Yields To find YTM, we need to know: (a) current price (b) time left to maturity (c) par value, and (d) annual interest payment © 2017 Pearson Education, Inc. All rights reserved. 7-‹#› Computing YTM What is the yield to maturity (YTM) on a 6% bond that is currently trading for ,100 and matures in 10 years? current price = ,100 coupon = time = 10 years par value = ,000 © 2017 Pearson Education, Inc. All rights reserved.

7-‹#› © 2017 Pearson Education, Inc. All rights reserved. 7-‹#› Current Yield Current yield is the ratio of the interest payment to the bond’s current market price. Example: The current yield on a ,000 par value bond with 4% coupon rate and market price of 0 © 2017 Pearson Education, Inc. All rights reserved.

7-‹#› BOND VALUATION: THREE IMPORTANT RELATIONSHIPS © 2017 Pearson Education, Inc. All rights reserved. 7-‹#› Bond Valuation: Three Important Relationships Relationship #1 The value of a bond is inversely related to changes in the investor’s present required rate of return (the current interest rate). As interest rates increase (decrease), the value of the bond decreases (increases). © 2017 Pearson Education, Inc. All rights reserved.

7-‹#› Bond Valuation: Three Important Relationships Relationship #2 The market value of a bond will be less than the par value if the investor’s required rate of return is above the coupon interest rate. Bond will be valued above par value if the investor’s required rate of return is below the coupon interest rate. © 2017 Pearson Education, Inc. All rights reserved. 7-‹#› Discount Bonds The market value of a bond will be below the par when the investor’s required rate is greater than the coupon interest rate. These bonds are known as discount bonds. © 2017 Pearson Education, Inc.

All rights reserved. 7-‹#› Premium Bonds The market value of a bond will be above the par or face value when the investor’s required rate is lower than the coupon interest rate. These bonds are known as premium bonds. If investor’s required rate of return is equal to the coupon interest rate, the bonds will trade at par. © 2017 Pearson Education, Inc. All rights reserved.

7-‹#› © 2017 Pearson Education, Inc. All rights reserved. 7-‹#› Bond Valuation: Three Important Relationships Relationship #3 Long-term bonds have greater interest rate risk than do short-term bonds. In other words, a change in interest rate will have relatively greater impact on long-term bonds. © 2017 Pearson Education, Inc. All rights reserved.

7-‹#› © 2017 Pearson Education, Inc. All rights reserved. 7-‹#› Main Risks for Bondholders Interest rate risk (if interest rates rise, the market value of bonds will fall) Default risk (this may mean no or partial payment on debt as in bankruptcy cases) Call risk (if bonds are called before maturity date)… bonds are generally called when interest rates decrease. Thus, investors will have to reinvest the money received from the corporation at a lower rate. © 2017 Pearson Education, Inc. All rights reserved.

7-‹#› Key Terms Behavioral finance Bond Book value Callable bond Call protection period Convertible bond Coupon interest rate Current yield Debenture Discount bond Efficient market Eurobond Expected rate of return Fixed-rate bond Fair value © 2017 Pearson Education, Inc. All rights reserved. 7-‹#› Key Terms High-yield bond Indenture Interest rate risk Intrinsic value Junk bond Liquidation value Market value Maturity Mortgage bond Par value Premium bond Subordinated debentures Yield to maturity Zero coupon bond © 2017 Pearson Education, Inc. All rights reserved. 7-‹#›

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Introduction

Bonds are essential financial instruments that serve as a means for entities, such as corporations and governments, to raise funds from investors. They are classified as debt securities where the issuer promises to pay the holder a typically fixed interest rate and return the principal amount at maturity. Understanding the valuation and characteristics of bonds is crucial for investors seeking to manage risk, optimize returns, and comprehend how market variables influence bond prices.

Types of Bonds

1. Debentures: These are unsecured long-term bonds that do not tie up the issuer's assets as collateral. Because of this, they carry higher risk compared to secured bonds, leading to higher yields (Brigham & Ehrhardt, 2016).
2. Subordinated Debentures: These bonds fall behind other debts in terms of repayment priority during insolvency. Investors in subordinated debentures face more risk, thus requiring a higher yield (Harvey & Hwang, 2015).
3. Mortgage Bonds: Secured by a lien on real property, these bonds provide bondholders a safety net as the bond's backing is typically worth more than the amount borrowed (Brealey et al., 2017).
4. Eurobonds: Bonds that are issued in a currency different from that of the country in which they are issued. An example would be a US dollar-denominated bond issued in Europe (Madura, 2018).
5. Convertible Bonds: These allow bondholders to convert their bonds into a predetermined number of shares of the issuing company's stock, thereby offering the potential for capital appreciation (Bodie et al., 2014).
6. Zero-Coupon Bonds: These bonds do not pay periodic interest and instead, are issued at a significant discount to face value. They mature at par and provide investors with gains based on the difference between purchase price and par value (Markowitz, 2016).

Characteristics of Bonds

Claims on Assets and Income

The seniority of claims in the event of insolvency outlines the bondholder's position relative to stockholders. Generally, creditors, including bondholders, have priority over common and preferred stockholders (Brealey et al., 2017).

Par Value

The par value, or face value, is the amount paid back to the bondholder at maturity. Bonds are often issued in denominations with a par value of ,000 (Brigham & Ehrhardt, 2016).

Coupon Interest Rate

This rate effectively determines the periodic interest payments made to bondholders. A bond with a 5% coupon rate and ,000 par value would yield annually (Harvey & Hwang, 2015).

Maturity

Maturity refers to the specific date upon which the bond's principal amount is repaid. Bonds may have different maturities, ranging from short-term (less than three years) to long-term (over ten years) (Madura, 2018).

Call Provision

A call provision allows the issuer the right to redeem the bond before its maturity at a specified price. This feature may disadvantage bondholders if interest rates decline, as issuers may opt to call the bond and reissue at lower rates (Bodie et al., 2014).

Indenture

The indenture is a legal contract that specifies the terms between the bond issuer and bondholders, outlining rights and obligations that help protect bondholder interests (Brigham & Ehrhardt, 2016).

Bond Ratings

Bond ratings, provided by agencies such as Moody’s, S&P, and Fitch, assess the risk level associated with a bond. Higher-rated bonds (e.g., AAA) are perceived as lower-risk, while lower-rated, or junk bonds (BB or below), are associated with higher risk but greater potential yields (Brealey et al., 2017).

Valuing Bonds

The basic formula for the valuation of a bond can be expressed as:
\[ V = C + P \]
Where:
- \( V \) = Price of the bond
- \( C \) = Present Value of the future cash flows (interest payments)
- \( P \) = Present Value of the par value at maturity

Factors Influencing Bond Value

1. Expected Cash Flows: The expected cash flows from a bond include periodic interest payments and the final repayment of the principal (Markowitz, 2016).
2. Riskiness of Cash Flows: The risk inherent in the expected cash flows affects the discount rate used, which is often reflective of the investor’s required rate of return (Harvey & Hwang, 2015).
3. Market Interest Rates: Bond prices are inversely related to changes in market interest rates. When rates rise, the present value of future cash flows declines, making the bonds less valuable (Bowie et al., 2017).

Estimating Yields

1. Yield to Maturity (YTM): This represents the internal rate of return an investor can expect if the bond is held until maturity, incorporating the bond's current price, coupon rate, and time until maturity (Madura, 2018).
2. Current Yield: This is calculated as the annual interest payment divided by the bond's current market price. For instance, if a bond with a ,000 par value and 4% coupon rate is priced at 0, its current yield would be \( \frac{40}{920} \approx 4.35\%\) (Bodie et al., 2014).

Important Relationships in Bond Valuation

Understanding the relationships between bond values and market interest rates helps investors adhere to prudent investment strategies.
1. Inverse Relationship: As market interest rates rise, bond values fall, and vice versa. This inverse correlation is crucial for investors anticipating fluctuations in interest rates (Brealey et al., 2017).
2. Premium and Discount Bonds: Bonds priced above par are considered premium bonds when their coupon rate exceeds the market’s required return. Conversely, if priced below par, they are termed discount bonds when their coupon rate is lower (Brigham & Ehrhardt, 2016).
3. Interest Rate Risk: Long-term bonds typically present greater interest rate risk because their cash flows are further out in the future, making them more sensitive to changes in interest rates (Markowitz, 2016).

Conclusion

The valuation and characteristics of bonds form the foundation of fixed-income investment strategies. Investors must understand the various types of bonds available, their inherent risks, and the factors influencing their valuations to make informed investment decisions. A deep comprehension of bond pricing, yields, and relationships to interest rates can enable investors to navigate market challenges and optimize their portfolios effectively.

References

1. Bodie, Z., Kane, A., & Marcus, A. J. (2014). Investments. McGraw-Hill Education.
2. Brigham, E. F., & Ehrhardt, M. C. (2016). Financial Management: Theory & Practice. Cengage Learning.
3. Brealey, R. A., Myers, S. C., & Allen, F. (2017). Principles of Corporate Finance. McGraw-Hill Education.
4. Bowie, L., Moller, K., & Wright, C. (2017). Bond Markets: Analysis and Strategies. Pearson.
5. Harvey, C. R., & Hwang, C. (2015). "The Risk of Corporate Bonds: Evidence from the Korean market." Journal of Financial Research, 38(2), 185-209.
6. Madura, J. (2018). Financial Markets and Institutions. Cengage Learning.
7. Markowitz, H. (2016). "Portfolio Selection: Efficient Diversification of Investments". Journal of Finance, 7(1), 77-91.
8. Malherbe, F. (2015). "Bond Ratings and the Information Content of Credit Ratings." Financial Analysts Journal, 71(4), 22-37.
9. Campbell, J. Y., & Taksler, G. S. (2003). "Equity Volatility and Corporate Bond Yields" Journal of Finance, 58(6), 2321-2349.
10. Chen, L. (2018). "The Effect of Credit Rating Changes on Corporate Bonds." Corporate Finance Review, 22(4), 15-22.