BOND VALUATION CONCEPTS

1
BOND VALUATION CONCEPTS

• FIN 3403, 3404
• PROF. DIGGLE

2
BOND CONCEPTS

• What is a bond?
• How do corporate bonds differ from other kinds of
  bonds?
• Priority of claim pyramid
• Characteristics of Corporate bonds
• What is a Municipal bond?
• Characteristics of muny bonds.

3
RISK VS RETURN

• KINDS OF RISK--RECAP
• INFLATION RISK
• BUSINESS OR DEFAULT RISK
• MARKET RISK
• LIQUIDITY RISK
• INTR. RATE RISK
• OTHER
• CURRENCY RISK
• POLITICAL RISK
• ETC.

4
BOND CONCEPTS AND TERMS (see lec notes p. 34)

• TERMS
• PAR
• COUPON RATE
• DOLLAR ANNUAL COUPON
• CURRENT YIELD
• YIELD TO MATURITY
• INDENTURE

• DEBENTURE DURATION
• ACCRUED INTEREST
• CONCEPTS
• IF INTEREST RATES RISE WHAT HAPPENS TO BOND
  PRICES?
• Current yield vs. YTM

5
THE BOND TVM TIME LINE

• COUPON COUPON COUPON
• COUPON COUPON ETC ETC
• All bonds we will study pay SEMI-ANNUALLY
  (coupon every 6 months)
• An 8 bond pays two coupons of 40 each
• A 30 year bond has 60 interest coupons.
• PAR AT MATURITY (1000)

6
BOND VALUATIONSEE LEC NOTES PP. 35-38

• A BOND IS IN TWO PARTS
• PRINCIPAL (1000 PAR) -- LUMP SUM AT MATURITY
• INTEREST coupons (SEMIANNUAL) (ANNUITY)
• The value of a bond is the NPV of both elements

• The price of a bond is, therefore, another TVM
  problem.
• What is the discount rate?
• The current MARKET rate of bonds of similar TYPE,
  QUALITY and MATURITY

7
KINDS OF BONDS

• U.S. GOVERNMENT
• U.S. TREASURY
• Treasury series EE
• U.S. AGENCY
• MUNICIPAL
• CORPORATE
• Mortgage
• Debenture
• FOREIGN GOVT.

• TAX CONSIDERATIONS
• The Tax Equivalent yield
• ZERO COUPON BONDS
• STRIPS
• INFLATION ADJUSTED BONDS

8
CORPORATE BONDSIssued by domestic corporations

• ALL new corporate bond issues are subject to SEC
  review
• The Indenture
• Role of the Bond Trustee
• How is a bond sold
• The Shelf registration

• What terms are in the Indenture?
• Collateral and priority of claim
• Coupon in percent and dollars
• Maturity
• Call provisions
• sinking fund
• redemption
• Trustee

9
BOND RATING SERVICES

• MOODYS AND STANDARD AND POOR
• RATING FROM AAA (best) to BA (lowest investment
  grade), to below B (junk bonds.

• The bond rating is a measure of business risk or
  risk of default only.
• Corporations and municipalities must pay a fee to
  have bonds rated. Therefore many bonds are NR.

10
MUNY BONDSBonds issued by states, cities and
local authorities like airports

• GO or General Obligation (supported usually by
  real estate taxes)
• REVENUE AND IDR
• HOW DOES A CORPORATION DO AN IDR?
• SINGLE, DOUBLE AND TRIPLE TAX FREE MUNYS
• WHY ARE MUNYS FREE OF FEDERAL INCOME TAX?

11
YIELD TO MATURITY

• YTM is the Total Return on a bond. This
  consists of
• CURRENT YIELD
• CAPITAL GAINS YIELD
• If a bond is selling at a PREMIUM (above par),
  bondholder will have a capital loss to maturity.

• If a bond is selling at a DISCOUNT, you have a
  guaranteed capital gain to maturity.
• PREMIUM CURRENT YIELD THAN YTM WHY?
• DISCOUNT
• CURRENT YIELD

12
BOND PROELEM USING YOUR CALCULATOR

• You buy a corporate bond on 12-1-98
• The coupon is 7.5
• The bond matures on May 15, 2015 (Millennium
  problem does not affect calculator)
• The market yield is 6. Compute PRICE

• THIS IS SDT
• 75 PER YEAR or 37.50 per coupon
• Matures at par. Par is expressed in in your
  calculator. Therefore 1000 par is entered as
  100 or 100
• YLD 6

13
TIBA 2 CALCULATOR BOND WORKSHEET

• SDT enter 12.0198
• CPN enter 7.5
• RDT enter 5.1515
• RV 100 OF PAR OR 1000
• ACT (for corporates) and 360 for Treasuries
• 2/Y (semiannual pay)
• LEAVE YOUR TI BA2 AT ACT AND 2/Y

• YLD market yield on bonds of similar type,
  quality and maturity 6
• SOLVE FOR PRI (price -- push CPT)
• MAY ALSO SOLVE FOR YTM where price is given
• AI accrued interest

14
WHAT DOES THE BOND WORKSHEET DO?

• THE PRICE OF A BOND IS THE NET PRESENT VALUE OF
• THE LUMP SUM OF 1000 PAR RECEIVED AT MATURITY
• THE ANNUITY OF COUPON INTEREST RECEIVED
  SEMIANNUALLY OVER REMAINING LIFE OF BOND (P/Y
  2)
• HOW WOULD YOU COMPUTE THE PRICE OF A ZERO COUPON
  BOND?

15
WHAT IS CALL?

• Why would a company or municipality call a bond?
• Why do investors dislike callable bonds?
• If a bond is not callable for 5 years this is
  called call protection.

• REDEMPTION CALL
• SINKING FUND CALL
• CALCULATING YIELD TO CALL ON YOUR CALCULATOR
• ACCRUED INTEREST

16
BOND PROBLEM

• A. YOU BUY A BOND TODAY MATURING IN 30 YEARS.
• YOU PAY 1030 (103 of par)
• THE COUPON IS 7.33
• WHAT IS THE YIELD TO MATURITY?

• B. YOU BUY A BOND TODAY MATURING IN 25 YEARS
  THAT IS CALLABLE IN 15 YEARS AT 105
• ALL FACTS ON LEFT SIDE ARE THE SAME.
• COMPUTE YIELD TO CALL.

17
DURATION VS MATURITY

• SEE TEXT
• MATURITY IS A FIXED DATE IN TIME
• DURATION IS A MEASURE OF BOND CASH FLOW COMBINING
  MATURITY AND COUPON INCOME

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

18
ACCRUED INTEREST

• You buy a bond on March 10. Coupons are paid on
  Jan 1 and June 30.
• What is the accrued income? Who pays it and why?
• Accrued income is added to the amount received by
  the SELLER

• Who will receive the June 30 coupon? THE BUYER.
• The buyer must pay the seller accrued interest
  for the time he owned the bond since the last
  coupon. This is done on settlement date.

19
TRADE DATE AND SETTLEMENT DATE

• Corporate securities settle in 3 business days
  after trade date.
• You buy a bond on Friday. Monday is a Holiday.
  When is corporate settlement? This is when good
  funds must be available to pay for bond or stock.

• Government (TREASURY) bonds are next day
  settlement (next business day).
• SDT on your financial calculator is settlement
  date.
• RDT (redemption date) is maturity or call date.

20
CONVERTS ZEROS FIN 3404--FIN 3404 STUDENTS
not responsible

• A convert is a bond with additional contractual
  provisions in the indenture providing for
  conversion of the bond into common stock.
• A convert is Quasi Equity. It behaves like
  common stock.

• TERMINOLOGY
• CONVERSION PRICE
• CONVERSION RATIO
• THEORETICAL VALUE
• PREMIUM OVER THEORETICAL VALUE

21
CONVERTS CONTD.

• Why would a company include convertibility as a
  sweetener in the indenture?
• What happens if a convertible bond is called by
  the company?
• 2 situations

• Are converts a good investment? Why or why not?
• Should you buy a callable convert selling above
  call price? Why or why not?

22
CONVERT PROBLEM

• A convert is convertible into 20 shares of
  common. This is the conversion ratio.
• This means the conversion price is 50 (1000
  par / 20)

• When a convert is issued, the conversion price is
  usually 15 or so below common price. Why?
• Assume the common price is 40 when the bond is
  floated.

23
CONVERT PROBLEM CONTD

• Assume now it is 3 years later and the common is
  selling for 65 per share.
• What is the theoretical value of the convert?
• Conv ratio number of common shares per bond X
  stock price

• TV 20 x 65 1300
• Assume the call price set in the indenture is 103
  (1030). What happens if this bond is called?

24
CONVERTS CONTD

• Why do most converts sell at a PREMIUM over
  conversion or theoretical value?
• Priority of claim
• Current yield on bond vs dividend yield on stock

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

25
WHAT ARE ZERO COUPON BONDS?

• Bond in which coupons have been stripped off.
• Price is simply the NPV of the par value (1000)
  at maturity.

• What reasons can you think of for investors to
  own zero coupon treasuries?
• Compute the price of a Treasury maturing in 30
  years when the yield on coupon conds of similar
  type and quality is 6.4