The Valuation and Characteristics of Bonds

The Basis of Value

A securitys value is equal to the present value of its expected cash flows.
 A security should sell in financial markets for a price close to that value
 Differences of opinion exist about a securitys price because of different assumptions about cash flows and interest rates for PV calculations

The Basis for Value

Investing Using a resource to benefit the future rather than for current satisfaction  Putting money to work to earn more money  Common types of investments
  Debtlending money Equitybuying ownership in a business

Return What the investor receives for making an investment For a 1 year investment the rate of return = $ received / $ invested Debt investors receive interest

The Basis for Value

 Rate of return is the interest rate that equates the present value of an investments expected future cash flows with its current price  Return is also known as
 Yield  Interest
 Debt investments only

Bond Valuation
 Bonds represent a debt relationship in which the issuing company borrows and the buyers lend.
 A bond issue represents borrowing from many lenders at one time under a single agreement

Bond Terminology and Practice

 A bonds term (or maturity) is the time from the present until the principal is returned
 Bonds mature on the last day of their term  A bonds term gets shorter as it ages

 A bonds face (or par) value represents the amount the firm intends to borrow (the principal) at the coupon rate of interest
 Bonds are non-amortized debt - the entire principal is repaid at maturity

The Coupon Rate

 Coupon Rate the fixed rate of interest paid by a bond
 Doesnt change over the bonds life

 In the past, bonds had coupons attached, today they are registered  Most bonds pay coupon interest semiannual

Bond ValuationBasic Ideas

Adjusting to Interest Rate Changes
 Bonds are originally sold in the primary market and trade subsequently among investors in the secondary market.  Although bonds have fixed coupons, market interest rates constantly change.
 What happens to the price of a bond paying a fixed interest rate in the secondary market when interest rates change?

Bond ValuationBasic Ideas

 Buy a 20 year, $1000 par bond with a 10% coupon rate for $1,000.
 It promises 20 years of coupon payments of $100 each, and a principal repayment of $1,000 after 20 years

Needing cash, you sell it early.

  Assume interest rates have risen and the market rate of return is 11% Investors can now buy new bonds with an 11% coupon rate for $1,000 so they will not pay $1000 for your bond but they will buy it for less than $1,000

 

Bond prices and interest rates move in directions Bonds adjust to changing yields by changing price
  Selling at a Premium bond price above face value Selling at a Discount bond price below face value

opposite

Determining the Price of a Bond

Example

Q:A bond has 10 years to maturity, a par value of $1,000, and a coupon rate of 10%. What cash flows are expected from the bond? A:
0 1 5 10

$100

a year for 10 years

$100 $1,000 $1,100

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Determining the Price of a Bond

The Bond Valuation Formula

 The price of a bond is the present value of a stream of interest payments plus the present value of the principal repayment PB ! PV(interest payments) + PV(principal repayment) 
   
  
Interest payments are annuities--can use the present value of an annuity formula: PMT[PVFA k,n ] Principal repayment is a lump sum in the future--can use the future value formula: FV[PVFk, n ]

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Cash Flow Time Line for a Bond

Figure 7.1

This is an ordinary annuity.

This is a single sum.

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Determining the Price of a Bond

Two Interest Rates and One More

 Coupon Rate
  Determines the size of the interest payments The discount rate that makes the present value of the payments equal to the price of the bond in the market
 AKA yield to maturity (YTM)

 kthe current market yield on comparable bonds

 Current yield annual interest payment divided by bonds current price

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Solving Bond Problems with a Financial Calculator

  Financial calculators have five time value of money keys With a bond problem, all five keys are used
     nnumber of periods until maturity I/Ymarket interest rate PVprice of bond FVface value (par) of bond PMTcoupon interest payment per period
 With calculators that have a sign convention the PMT and FV must be of one sign while the PV will be the other sign

 

The unknown is either interest rate or present value (Price) Sophisticated calculators have a bond mode allowing easy calculations dealing with accrued interest
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Determining the Price of a Bond

Example 7.1
Q: The Emory Corporation issued an 8%, 25-year bond 15 years ago. At the time of issue it sold for its par (face) value of $1,000. Comparable bonds are yielding 10% today. What must Emorys bond sell for in todays market to yield 10% (YTM) to the buyer? Assume the bond pays interest semiannually. Also calculate the bonds current yield.

Example

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Bond Example Continued

Example 7.1

A: Substituting the correct values into the equation gives us:

Example

This can also be calculated via a financial calculator: N PV FV PMT I/Y

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Maturity Risk Revisited

 Relates to term of the debt
 Longer term bond prices fluctuate more in response to changes in interest rates than shorter term bonds  AKA price risk and interest rate risk

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Price Changes at Different Terms due to an Interest Rate Increase from 8% to 10%
Table 7.1

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Finding the Yield at a Given Price

 Calculate a bonds yield assuming it is selling at a given price  Trial and error guess a yield calculate price compare to price given

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Finding the Yield at a Given Price

Example 7.3

Q: The Benson Steel Company issued a 30-year bond 14 years ago with a face value of $1,000 and a coupon rate of 8%. The bond is currently selling for $718. What is the yield to an investor who buys it today at that price? (Assume semiannual interest.)

Example

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Call Provisions
 If interest rates fall, a firm may wish to retire old, high interest bonds  Refinance with new lower interest debt  To ensure their ability to refinance bonds, corporations make bonds callable
 Call provision gives right to pay off the bond early

 Investors dont like calls lose high interest  So issuers and investors Compromise
 Call provisions usually have a call premium  Call protection means the bond wont be called for a certain number of years.
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The Refunding Decision

When current interest rates fall below the bonds coupon rate, a firm must decide whether to call in the issue
 Compare interest savings to the cost of making the call:
 Call premium extra payment to bond holders  Flotation costs incurred in issuing new bonds, includes brokerage fees, administrative expenses, printing, etc.
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Dangerous Bonds with Surprising Calls

Bonds can have obscure call features buried in their contract terms.
 Most common type a sinking fund provision requires an issuer call in and retire a fixed percentage of the issue each year
 Usually no call premium  Determined by lottery
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to

Convertible Bonds
 Unsecured bonds exchangeable for a fixed number of shares of stock at the bondholder's discretion
 Bondholders can participate in the stocks price appreciation

 

Conversion ratio - the number of shares of stock received for each bond Conversion price - the implied stock price if bond is converted into a certain number of shares
 Usually set 15-30% above the stocks market value when the bond is issued

Usually issued at lower coupon rates

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Advantages of Convertible Bonds

To Issuing Companies  Convertible features are sweeteners enabling a risky firm to pay a lower interest rate Viewed as a way to sell equity at a price above market Usually have few or no restrictions To Buyers Offer the chance to participate in stock price appreciation Offer a way to limit risk associated with a stock investment

 

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Forced Conversion
 A firm may want bonds converted
 eliminates interest payments on bond  strengthens balance sheet  dont want conversion at very high stock prices

 Convertible bonds are always issued with call features which can be used to force conversion  Issuers generally call convertibles when stock prices rise to 10-15% above conversion prices

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Effect on Earnings Per ShareDiluted EPS

 Upon conversion convertible bonds cause dilution in EPS
 EPS drops due to the increase in the number of shares of stock

 Thus outstanding convertibles represent a potential to dilution of EPS

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Effect on Earnings Per ShareDiluted EPS

Example 7.7

Q: Montgomery Inc. is a small manufacturer of mens clothing with operations in Southern California. It issued 2,000 convertible bonds in 1999 at a coupon rate of 8% and a par value of $1,000. Each bond is convertible into Montgomerys common stock at $40 per share. Management expected the stock price to rise rapidly after the convertible was issued and lead to a quick conversion of the bond debt into equity. However, a recessionary climate has prevented that from happening, and the bonds are still outstanding. In 2003 Montgomery had net income of $3 million. One million shares of its stock were outstanding for the entire year, and its marginal tax rate is 40%. Calculate Montgomerys basic and diluted EPS. A: Basic EPS is the firms net income divided by the number of shares outstanding, or $3,000,000 1,000,000 = $3.00.
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Example

Effect on Earnings Per ShareDiluted EPS

Example 7.7

Diluted EPS assumes all convertible bonds are converted at the beginning of the year. Two adjustments need to be made:
 Add Example

the number of newly converted shares to the denominator:

 Shares 

exchanged: Bonds par Conversion price = $1,000 $25 = 40

 Since

each bond can be converted into 40 shares of stock and there are 2,000 bonds, the newly converted shares totals 80,000, or 40 x 2,000, bringing the total number of shares outstanding to 1,080,000.

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Institutional Characteristics of Bonds

Registration, Transfer Agents, and Owners of Record  Classify bonds as either bearer or registered bonds.
  Bearer bonds interest payment is made to the bearer of the bond Registered bonds interest payment is made to the holder of record

Owners of registered bonds are recorded with a transfer agent.

   Keeps track of bonds for issuing companies Sends payments to owners of record Transfers ownership when bond is sold to another investor

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Kinds of Bonds
 Secured bonds and mortgage bonds
 Backed by the value of specific assets - collateral

 Debentures
 Unsecured bonds issued with interest rates higher

 Subordinated debentures
 Lower in priority than senior debt

 Junk bonds
 Issued by risky companies and pay high interest rates

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Bond RatingsAssessing Default Risk

 Bonds are assigned quality ratings reflecting their probability of default.
 Higher ratings mean lower default probability

 Bond rating agencies (such as Moodys, S&P) evaluate bonds (and issuers), and assign a rating
 Examine the financial and market conditions of the issuer

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Bond RatingsAssessing Default Risk

 Why Ratings Are Important
 Ratings are the primary measure of the default risk associated with bonds  The rating determines the rate at which the firm can borrow
  A lower quality rating implies a higher borrowing rate A differential exists between the rates required on high and low quality issues.

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Moodys and S&P Bond Ratings

Table 7.2

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Bond IndenturesControlling Default Risk

 Bond indentures attempt to prevent firms from becoming riskier after bonds are purchased by including restrictive covenants:
 Preclude entering high risk businesses  Limit further borrowing  Require certain financial ratios

 Safety is also provided by sinking funds

 Provide money for repayment of bond principal

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The Advantages of Leasing

Appendix 7-A

 No money down
 Lenders generally require a down payment  lessors usually do not

 Restrictions
 Lenders require covenants/indentures, lessors have few, if any, restrictions

 Easier credit with manufacturers/lessors

 Equipment manufacturers may lease their own products and will sometimes lease to marginally creditworthy customers
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The Advantages of Leasing

Appendix 7-A

 Avoiding the risk obsolescence

 Short leases transfer this risk to lessors

 Tax deducting the cost of land

 If real estate is leased - the lease payment can be deducted as an expense  If land is owned - it is not depreciable

 Increasing liquiditythe sale and leaseback

 A firm may sell an asset to a financial institution and lease back the same asset frees up cash

 Tax advantages for marginally profitable companies

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