Bonds & Valuation

Cost of Money

Cost of debt = Interest Rate

Cost of Equity = Required Rate of Return = Dividend
+ Capital Gain

Factors Affecting Cost of Money

Production opportunities

Time preferences for consumption

Risk

Inflation

Financial Management - Reza Masri 2

Determinants of Interest Rates
r = r* + IP + DRP + LP + MRP

r = rate of interest on a debt security.

r* = real risk-free rate of interest.
IP = inflation premium.
DRP = default risk premium.
LP = liquidity premium.
MRP= maturity risk premium.

Financial Management - Reza Masri 3

Term Structure of Interest Rates
Term structure: the relationship between interest
rates (or yields) and maturities
Yield curve: graph depicting the term structure.
Corporate and Treasury
Interest Rate Yield Curves

12% (%) BBB-rated bond

10%
8% AA-rated bond

6% Treasury Bond
4%
2%
0%
10 20 30
Years to Maturity
Financial Management - Reza Masri 4
What is a bond?

A long-term debt instrument in which a

borrower agrees to make payments of
principal and interest, on specific dates,
to the holders of the bond.
Bond markets
Traded in exchanges and private markets.
Most bonds are owned by and traded among
large financial institutions.
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
(generally fixed) paid by the issuer. Multiply by par to
get dollar payment of interest.
Maturity date years until the bond must be repaid.
Issue date when the bond was issued.
Yield to maturity (YTM)- rate of return earned on
a bond held until maturity (also called the promised
yield).
Yield to call (YTC) - rate of return earned on a bond
held until the call date.
Effect of a call provision

Allows issuer to refund the bond issue if

rates decline (helps the issuer, but hurts
the investor).
Borrowers are willing to pay more, and
lenders require more, for callable bonds.
Other types (features) of
bonds
Convertible bond may be exchanged for
common stock of the firm, at the holders
option.
Bond issued with Warrant long-term option to
buy a stated number of shares of common
stock at a specified price.
Putable bond allows holder to sell the bond
back to the company prior to maturity.
What is the opportunity cost of
debt capital?
The discount rate (ri ) is the opportunity
cost of capital, and is the rate that could
be earned on alternative investments of
equal risk.

ri = r* + IP + MRP + DRP + LP
 The value of financial assets
0 1 2 n
r ...
Value CF1 CF2 CFn

CF1 CF2 CFn

Value ...
(1 r) (1 r)
1 2
(1 r) n
What is the value of a 10-year, 10%
annual coupon bond, if rd = 10%?
0 1 2 n
r ...
VB = ? 100 100 100 + 1,000

$100 $100 $1,000

VB 1
... 10
10
(1.10) (1.10) (1.10)
VB $90.91 ... $38.55 $385.54
VB $1,000
 The price path of a bond
What would happen to the value of this bond if
its required rate of return remained at 10%, or
VB
at 13%, or at 7% until maturity?

1,372 rd = 7%.
1,211
rd = 10%.
1,000
837
775 rd = 13%.
Years
to Maturity
30 25 20 15 10 5 0
Bond values over time

At maturity, the value of any bond must

equal its par value.
If rd remains constant:
The value of a premium bond would
decrease over time, until it reached $1,000.
The value of a discount bond would increase
over time, until it reached $1,000.
A value of a par bond stays at $1,000.
 What is the YTM on a 10-year, 9%
annual coupon, $1,000 par value
bond, selling for $887?
Must find the rd that solves this model.

INT INT M
VB ...
(1 rd )1
(1 rd ) N
(1 rd ) N
90 90 1,000
$887 ...
(1 rd )1
(1 rd )10
(1 rd )10

rd = 10.91%
What is the YTC on a 9-year, 10% annual
coupon, $1,000 par value, $1,100 call price
bond, selling for $1,495?

INT INT M
VB ...
(1 ytc )1
(1 ytc) N
(1 ytc ) N
100 100 1,100
$1,495 ...
(1 ytc)1
(1 ytc) 9
(1 ytc )9

ytc = 4.21%
Definitions

Annual coupon payment

Current yield (CY)
Current price

Change in price
Capital gains yield (CGY)
Beginning price

Expected Expected
Expected total return YTM
CY CGY
An example:
Current and capital gains yield

Find the current yield and the capital gains

yield for a 10-year, 9% annual coupon
bond that sells for $887, and has a face
value of $1,000.

Current yield = $90 / $887

= 0.1015 = 10.15%
Calculating capital gains yield
YTM = Current yield + Capital gains yield

CGY = YTM CY
= 10.91% - 10.15%
= 0.76%

Could also find the expected price one year from

now and divide the change in price by the
beginning price, which gives the same answer.
What is interest rate (or price)
risk?

Interest rate risk is the concern that rising rd will

cause the value of a bond to fall.

% change 1 yr rd 10yr % change

+4.8% $1,048 5% $1,386 +38.6%
$1,000 10% $1,000
-4.4% $956 15% $749 -25.1%

The 10-year bond is more sensitive to interest

rate changes, and hence has more interest rate
risk.
What is reinvestment rate
risk?

Reinvestment rate risk is the concern that rd

will fall, and future CFs will have to be
reinvested at lower rates, hence reducing
income.

EXAMPLE: Suppose you just won

$500,000 playing the lottery. You
intend to invest the money and
live off the interest.
Reinvestment rate risk
example

You may invest in either a 10-year bond or a

series of ten 1-year bonds. Both 10-year and
1-year bonds currently yield 10%.
If you choose the 1-year bond strategy:
After Year 1, you receive $50,000 in income
and have $500,000 to reinvest. But, if 1-
year rates fall to 3%, your annual income
would fall to $15,000.
If you choose the 10-year bond strategy:
You can lock in a 10% interest rate, and
$50,000 annual income.
 Conclusions about interest rate
and reinvestment rate risk
Short-term bonds Long-term bonds

Interest
Low High
rate risk
Reinvestment
High Low
rate risk

CONCLUSION: Nothing is riskless!

10-year, 10% annual coupon
bond vs. a 10-year, 10%
semiannual coupon bond?

The semiannual bonds effective rate is:

m 2
iNom 0.10
EFF% 1 1 1 1 10.25%
m 2

10.25% > 10% (the annual bonds effective

rate), so you would prefer the semiannual
bond.
Default risk

If an issuer defaults, investors receive

less than the promised return.
Therefore, the expected return on bonds
is less than the promised return.
Influenced by the issuers financial
strength and the terms of the bond
contract.
Bond Spreads, the DRP, and
the LP
A bond spread is often calculated as the
difference between a corporate bonds yield and a
Treasury securitys yield of the same maturity.
Therefore:

Spread = DRP + LP.

26
Evaluating default risk:
Bond ratings
Investment Grade Junk Bonds

Moodys Aaa Aa A Baa Ba B Caa C

S&P AAA AA A BBB BB B CCC D

Bond ratings are designed to reflect the

probability of a bond issue going into
default.
 Bond Ratings % defaulting within:
S&P and Fitch Moodys 1 yr. 5 yrs.
Investment grade bonds:
AAA Aaa 0.0 0.0
AA Aa 0.0 0.1
A A 0.1 0.6
BBB Baa 0.3 2.9
Junk bonds:
BB Ba 1.4 8.2
B B 1.8 9.2
CCC Caa 22.3 36.9
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Source: Fitch Ratings
Bond Ratings and Bond
Spreads (YahooFinance, March 2009)
Long-term Bonds Yield (%) Spread (%)
10-Year T-bond 2.68
AAA 5.50 2.82
AA 5.62 2.94
A 5.79 3.11
BBB 7.53 4.85
BB 11.62 8.94
B 13.70 11.02
CCC 26.30 23.62 29
Factors affecting default risk and
bond ratings
Financial performance
Debt ratio
Coverage ratios
Profitability ratios
Current ratios

Bond contract provisions

Secured versus unsecured debt
Senior versus subordinated debt
Guarantee provisions
Sinking fund provisions
Debt maturity
Bond Ratings Median Ratios
(S&P)

Interest Return on Debt to

coverage capital capital
AAA 23.8 27.6% 12.4%
AA 19.5 27.0% 28.3%
A 8.0 17.5% 37.5%
BBB 4.7 13.4% 42.5%
BB 2.5 11.3% 53.7%
B 1.2 8.7% 75.9%
CCC 0.4 3.2% 113.5% 31
The Maturity Risk Premium
Long-term bonds: High interest rate risk, low
reinvestment rate risk.
Short-term bonds: Low interest rate risk, high
reinvestment rate risk.
Nothing is riskless!
Yields on longer term bonds usually are greater
than on shorter term bonds, so the MRP is more
affected by interest rate risk than by
reinvestment rate risk.

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Bankruptcy

Bankruptcy alternatives::
Reorganization
Liquidation
Typically, a company wants Reorganization,
while creditors may prefer Liquidation.
Priority of claims in liquidation
Secured creditors from sales of secured assets.
Trustees costs
Expenses incurred after bankruptcy filing
Wages and unpaid benefit contributions, subject
to limits
Unsecured customer deposits, subject to limits
Taxes
Unfunded pension liabilities
Unsecured creditors
Preferred stock
Common stock
Reorganization

In a liquidation, unsecured creditors

generally get zero. This makes them
more willing to participate in
reorganization even though their claims
are greatly scaled back.
Various groups of creditors vote on the
reorganization plan. If both the majority
of the creditors and the judge approve,
company emerges from bankruptcy with
lower debts, reduced interest charges,
and a chance for success.