Bond Values

1
Bond Values
2
Objectives

• Define the term value.
• Distinguish between different kinds of bonds.
• Describe the basic process for valuing assets.
• Explain the key features of bonds.
• Estimate the value of a bond.
• Compute a bondholders expected rate of return.
• Explain important relationships that exist in
  bond valuation
• Study the concept of duration.

3
Bond Types

• Debentures
• A certificate issued by a corporation that states
  the amount of a loan, the interest to be paid and
  the time for repayment. It is backed only by the
  corporation's reputation and good word, but not
  by collateral.
• Subordinated Debenture
• A debt security that will be paid off after the
  issuer first pays off debt to senior creditors in
  the event of insolvency.
• Mortgage Bonds
• Debt issues secured by a mortgage on the issuer's
  property, such as buildings or equipment.

4
Bond Types

• Zero Coupon Bonds
• A bond sold at a deep discount. It does not pay
  periodic interest payments to investors
  instead, investors receive their return on
  investment at maturity. The return is equal to
  the difference between the bond's price at
  issuance and its face value.
• Junk Bonds
• These are high-yield bonds that credit-rating
  agencies consider speculative. The bonds
  typically offer higher yields and carry higher
  risk than bonds with investment-grade ratings.
  See Standard Poors or Moodys for rating
  information.
• Eurobonds
• Bonds issued by a borrower outside its own
  country. The bonds are denominated in a currency
  foreign to the borrower or the purchaser or both.

5
Bond Types

• Inflation Indexed Bonds
• These are bonds designed to provide a stream of
  payments with a constant purchasing power.
• Calculator
• 100 Year Bonds
• Convexity and risk
• Much Ado About Nothing?

6
Examples

• Equity Analytics, Ltd. has an excellent primer on
  corporate bonds. Also see the bond directory.
• Briefing.com provides intraday trading
  information on bonds.

7
Basic Valuation Model

• where ct cash flow at date tp the price of
  the asset r the investors required rate of
  return

8
What is a Bond?

• A bond is a long-term promissory note that
  commits the firm to pay the bondholder a fixed
  amount of interest each year until maturity and
  the principal at maturity.

9
Bond Terminology

• A bond's Par Value is the amount that will be
  repaid by the firm when the bond matures.
• The bond has a Maturity Date, at which time the
  borrowing firm is committed to repay the loan
  principal.
• The bonds contractual agreement specifies a
  Coupon Rate that is expressed either as a
  percent of the par value or as a flat amount of
  interest which the borrowing firm promises to pay
  the bondholder each year.

10
Bond Valuation

• The value of a bond with semi-annual interest
  payments is the present value of the interest
  payment stream plus the present value of the face
  value. Letting It rc FV be the interest
  payment per period, T be the maturity, FV be the
  face value (par value) and rb be the rate of
  interest, the bond value B may be expressed
  as
• Examples
• Century Bonds
• Problems

11
Relationships in Bond Valuation

• A decrease in interest rates will cause the value
  of a bond to increase an interest rate increase
  will cause a decrease in value. The change in
  value caused by changing interest rates is called
  interest rate risk.
• If the bondholder's required rate of return
  (current interest rate) equals the coupon
  interest rate, the bond will sell at par, or
  maturity value.
• If the current interest rate exceeds the bond's
  coupon rate, the bond will sell below par value,
  or at a discount.
• If the current interest rate is less than the
  bond's coupon rate, the bond will sell above par
  value, or at a premium.

12
Relationships in Bond Valuation

• Regardless of whether a bond is selling below or
  above par value, the value of the bond will
  gradually approach par value as the bond matures.
• A bondholder owning a long-term bond is exposed
  to greater interest rate risk than when owning a
  short-term bond.
• In understanding a bond's sensitivity to interest
  rate changes, we must consider not only the time
  to maturity, but also the time pattern of interim
  cash flows, or its duration.

13
Interest Rate Risk

• Consider the value of a coupon bearing bond at
  various dates t?as the interest rate changes from
  5 to 15. Suppose the coupon rate is 10 and
  the maturity initially is 30 years.

14
Interest Rate Risk

• Consider the value of a zero coupon bond with an
  initial maturity of 30 years as the interest rate
  changes from 1 to 15

15
Duration

• The duration of an asset or liability is simply a
  measure of the responsiveness of its price to a
  change in interest rateswhere V is the
  present value of the asset or liability.
• Macaulay Duration