Chapter 7
Bonds and their Valuation
7-1 Who issues bonds?
Bond – long-term contract under which a borrower agrees to make payments of interest and principal on specific dates to
the holder of the bonds; issued by corporations and government agencies that are looking for long-term debt capital
Until 1970s, bonds are engraved pieces of paper. Today, they are represented by electronic data stored in secure
computers.
Classification of bonds based on issuer:
•
Treasury bonds – government bonds; issued by the federal government; no default risk; bond’s prices decline
when interest rates rise so they are not completely riskless
•
Corporate bonds – issued by business firms and are exposed to default risk, its level depending on the issuing
company’s characteristics and the terms of specific bonds; default risk = credit risk
•
Municipal bonds – munis; bonds issued by state and local governments; major advantage: interest earned on
most munis is exempted from federal taxes and from state taxes if the holder is a resident of the issuing state;
market IR is lower than on a corporate of equivalent risk
•
Foreign bonds – issued by a foreign government or a foreign corporation; exposed to default risk, as are some
government bonds; additional risk exists when bonds are denominated in a currency other than that of investor’s
home currency
7-2 Key Characteristics of Bonds
Different bonds can have different contractual features that lead to differences in bonds’ risks, prices, and expected
returns.
Par Value
Stated value of the bond; generally represents the amount of money the firm borrows and promises to repay on
the maturity date
Coupon Payment
Set at the time the bond is issued and remains in force during the bond’s life; typically set at a level that will
induce investors to buy the bond at or near its par value
Coupon interest rate: annual coupon payment is divided by the par value
o Fixed-rate bonds – coupon rate is fixed for the life of the bond
o Floating-rate bonds – a bond’s coupon payment is allowed to vary over time; it is set for an initial period (often
6mos) and adjusted every 6 months; some floaters have upper limits (caps) and lower limits (floors) on how high or
low the rate can go
o Zero coupon bonds – offered at a discount below their par values and hence provide capital appreciation rather
than interest income; other bonds pay some coupon interest but not enough to induce investors to buy them at
par
▪
Original issue discount (OID) bond – any bond originally offered at a price significantly below its par
value
Maturity Date
When the par value of the bonds must be paid; effective maturity declines each year after it has been issued
o Original maturities – maturity at the time the bond is issued; mostly ranging from 10 to 40 years but any maturity
is legally permissible
Call Provisions
Gives the issuer the right to call the bonds for redemption; states that the issuer must pay the bondholders an
amount greater than the par value if they are called
o Call premium – additional sum paid and is often equal to one year’s interest; in most cases, declines over time as
bonds approach maturity
o
Deferred call – bonds that are often not callable until several years after issue, generally 5 to 10 years and are said
to have call protection
Companies are not likely to call bonds unless interest rates have declined significantly since the bonds were
issued:
Refunding operation: a company can sell a new issue of low-yielding securities when interest rates drop and use
the proceeds to retire the high-rate issue to reduce interest expense; IR on a new issue of callable bonds will
exceed that on the company’s new noncallable bonds
Sinking Funds
Facilitates orderly retirement of the bond issue; require the issuer to buy back a specified percentage of the issue
each year; it is a mandatory payment and failure to do so may throw the company into bankruptcy
2 ways in handling sinking fund requirement:
o Call in for redemption at par value; bonds are numbered serially and those called for would be
determined by a lottery administered by trustee
o Buy the required number of bonds on the open market
Least-cost method:
o IR has fallen and the bond will sell for more than its par value – use the call option
o IR has risen and the bond will sell at a price below par – buy from the open market
Detrimental to the bondholders if the bond’s coupon rate is higher than the current market rate
Regarded as being safer than those without such a provision so they have lower coupon rates
Other Features
Other types of bonds:
•
Convertible bonds – exchangeable into shares of common stock at a fixed price at the option of the bondholder;
offer the investors the chance for capital gains if the stock price increases, but that feature enables the issuing
company to set a lower coupon rate
•
Bonds with warrants – give the holder the option to buy stock for a stated price, providing a capital gain if the
stock’s prices rises; also carry lower coupon rate
•
Putable bonds – allow investors to require the company to pay in advance; if IR rises, investors will put the
bonds back to the company and reinvest in higher coupon bonds
•
Income bonds – pay interest only if the issuer has earned enough money to pay the interest; cannot bankrupt a
company but for the investor, they are riskier than regular bonds
•
Indexed/purchasing power bonds – interest rate is based on an inflation index such as the consumer price index
(CPI) so the interest paid rises automatically when the inflation rises, thus protecting bondholders against
inflation
7-3 Bond Valuation
The value of any financial asset is the present value of the cash flows the asset is expected to produce. The cash flows for a
standard coupon-bearing bond consist of interest payments during the bond’s life plus the amount borrowed when the
bond matures.
rd – market rate interest of the bond; discount rate used to calculate the present value of the cash flows which is also the
bond’s price; not the coupon rate but may, at times, be equal to it and is sold at par
N – number of years before the bond matures; decline over time after the bond has been issued
INT – dollars of interest paid each year = Coupon rate x Par value
M – par/maturity value of the bond; amount to be paid at maturity
Since the PV is an outflow to the investor, it is shown with a negative sign in the financial calculator.
Whenever the bond’s market rate is equal to its coupon rate, a fixed-rate bond will sell at its par value. The coupon rate
remains fixed after the bond is issued, but interest rates in the market move up and down. An increase in the market
interest rate causes the price of an outstanding bond to fall, whereas a decrease in the rate causes the bond’s price to rise.
DCMF
Discount bond – whenever the going rate of interest rises above the coupon rate, a fixed-rate bond will fall below its par
value
Premium bond – whenever the going rate of interest falls below the coupon rate, a fixed-rate bond will rise above its par
value
rd = coupon rate, bond sells at par, par bond
rd > coupon rate, bond sells below par, discount bond
rd < coupon rate, bond sells above par, premium bond
7-4 Bond Yields
The bond’s yield varies from day to day depending on current market conditions. To be useful, bond’s yield should give us
an estimate of the rate of return we would earn if we purchased the bond today and held it over its remaining life. If the
bond is callable, its remaining life is its years to maturity. If it is callable, its remaining life is the years of maturity if it is not
called or the years to call if it is called.
Yield to Maturity
Rate of interest an investor will earn on the investment if held until maturity and received the promised interest
and maturity payments
Can also be viewed as the bond’s promised rate of return: return that investors will receive if all the promised
payments are made
YTM equals the expected rate of return only when
o Probability of default is zero
o Bond cannot be called
If there is some default risk or the bond may be called, there is some chance that promised payments to maturity
will not be received in which case YTM will exceed the expected return
Changes whenever IR in the economy changes which is almost daily
An investor who purchases a bond and holds it until matures will receive the YTM that existed on date of
purchase but bond’s calculated YTM will change frequently between purchase date and maturity date
Yield to Call
If you purchase a bond that is callable, and the company calls it, you do not have the option of holding it to
maturity and thus, YTM would not be earned
If current rates are well below an outstanding bond’s coupon rate, a callable bond is likely to be called and
investors will estimate its most likely rate of return as the yield to call
N is the number of years until the company call the bond
Call price is the price the company must pay in order to call the bond and is often set equal to par value plus one
year’s interest
7-5 Changes in Bond Values Over Time
When a coupon bond is issued, the coupon is generally set at a level that causes the bond’s market price to equal its par
value. Investment bankers can judge quite precisely the coupon rate that will cause a bond to sell at its par value.
New issue – a bond that has just been issued; generally, sells at prices very close to par
Outstanding/seasoned issue – bond that has been issued; prices can vary widely far from par
Except for floating-rate bonds, coupon payments are constant; so when economic conditions change, a bond with coupon
that sold at its par value when it was issued will for more or less than its par thereafter.
Investors can have three equally risky issues with the same maturity and thus each has the same market interest rate.
However, the bonds have different prices because of their different coupon rates.
Current yield – coupon interest rate divided by the bond’s prices
Capital gains yield – calculated as the bond’s annual change in price divided by the beginning-of-year price
Bond’s total return – equal to the current yield plus the capital gains yield
In the absence of default risk and assuming market equilibrium, the total return is also equal to YTM and the market
interest rate
The discount bond has a low coupon rate, but it provides a capital gain each year. The premium bond has a high current
yield, but it has an expected capital loss each year.
7-6 Bonds with Semiannual Coupons
Modification on valuation model if interest payments are made semiannually:
1. Divide the annual coupon interest payment by 2 to determine the dollars of interest paid each six months
2. Multiply the years to maturity, N, by 2 to determine the number of semiannual periods
3. Divide the nominal (quoted) interest rate, rd, by 2 to determine the periodic semiannual interest rate
On a time line, there would be twice as many payments, but each would be half as large as with an annual payment bond.
The value with semiannual interest payments is slight larger than the value when interest is paid annually. This higher
value occurs because each interest payment is received somewhat faster under semiannual compounding.
7-7 Assessing a Bond’s Riskiness
There are two factors that impact a bond’s riskiness. Once those factors are identified, we differentiate between them and
discuss how to minimize these risks.
Price Risk
Interest rates fluctuate over time and when they rise, the value of outstanding bonds decline.
Also called interest rate risk
Risk of a decline in bond values due to an increase in interest rates
Since interest rates can and do rise, rising rates cause losses to bondholders; people or firms who invest in bonds
are exposed to risk from increasing interest rates
Price risk is higher on bonds that have long maturities on bonds that will mature in the near future; the longer
the maturity, the longer before the bond will be paid off and the bondholder can replace it with another bond
with a higher coupon
An increase in interest rates hurts bondholders because it leads to a decline in the current value of a bondholder
Reinvestment Risk
A decrease in interest rates also hurt bondholders: if interest rates fall, long-term investors will suffer a reduction
in income
Risk of an income decline due to a drop in interest rates
Obviously high on callable bonds and on short-term bonds because the shorter the bond’s maturity, the fewer
the years before the relatively high old-coupon bonds will be replaced with new low-coupon bonds
Comparing Price Risk and Reinvestment Risk
Price risk relates to the current market value of the bond portfolio, while reinvestment risk relates to the income the
portfolio produces.
Long-term bonds: significant price risk because the portfolio’s value will decline if IR rises but will not face much
reinvestment risk because income will be stable
Short-term bonds: not exposed to much price risk but will be exposed to a significant reinvestment risk
Bond
Level of Price Risk
Level of Reinvestment Risk
Longer maturity bonds
High
Low
Higher coupon bonds
Low
High
Investment horizon – which type of risk is more relevant to a given investor depends critically on how long the investor
plans to hold the bonds
Short investment horizon: reinvestment risk is of minimal concern
Long investment horizon: considerable amount of price risk; reinvestment risk is inherently relevant
Duration – weighted average of the time it takes to receive each of the bond’s cash flows
Zero-coupon bond – its only cash flow is payment at maturity and thus has a duration equal to its maturity
Investors with specific goals often invest in zero coupon bonds because they will receive a guaranteed payment at maturity
date equal to the bond’s face value and as there are no coupons to reinvest, there is no reinvestment risk.
DCMF
Positive maturity premium – implies that investors, on average, regard long-term bonds as being riskier than shorterbonds and suggests that the average investor is more concerned with price risk
7-8 Default Risk
Potential default is another important risk that bondholders face because if the issuer defaults, investors will receive less
than the promised return. The higher the probability of default, the higher the premium and thus the yield to maturity.
Various Types of Corporate Bonds
Default risk is influenced by the financial strength of the issuer and the terms of the bond contract, including whether
collateral has been pledged to secure the bond.
a. Mortgage bonds – corporation pledges specific assets as security for the bond
i.
First mortgage – bondholders can foreclose on the property and sell it to satisfy their claims in case of
default; also called senior mortgages
ii.
Second mortgage – holders would have a claim against the property but only after the first mortgage
holders had been paid in full; also called junior mortgages
iii.
Indenture – legal document that spells out in detail the rights of bondholders and the corporation;
generally open-ended meaning that new bonds can be issued from time to time under the same
indenture; but new bonds are however limited to a specified percentage of the firm’s total bondable
property
b. Debenture – an unsecured bond and provides no specific collateral as security for the obligation; holders are
general creditors whose claims are protected by property otherwise not pledged; its use depends on the nature
of the firm’s assets and on its general credit strength
c. Subordinated debentures – “below” or inferior to”; in the event of bankruptcy, has a claim on assets only after
senior debt has been paid in full; may me subordinated to designated NP or to all other debt
Bond Ratings
Since the early 1900s, bonds have been assigned quality ratings that reflect their probability of going into default.
3 major rating agencies:
1. Moody’s Investor’s Service
2. Standard & Poor’s Corporation
3. Fitch Investor’s Service
Triple- and double-A – extremely safe
Investment-grade bonds – single-A and triple-B bonds are also strong enough and are the lowest-rated bonds that many
banks and other institutional investors are permitted by law to hold
Speculative/junk bonds – double-B and lower bonds that have a significant probability of going into default
A. Bond Rating Criteria
The framework used by rating agencies examines both qualitative and quantitative factors.
Quantitative factors – relate to financial risk: examining a firm’s financial ratios; published ratios are historical and show
the firm’s condition in the past, whereas bond investors are more interested in the firm’s condition in the future
Qualitative factors – include an analysis of a firm’s business risk, such as its competitiveness within its industry and the
quality of its management
Determinants of bond ratings:
1. Financial ratios – rating agencies’ analysts perform a financial analysis along the lines and forecast future ratios
along the lines
2. Qualitative factors: bond contract terms – every bond is covered by a contract
a. Indenture – contract between issuer and bondholder; spells out all terms related to the bond:
maturity, coupon interest rate, statement of whether the bond is secured by a mortgage on specific
assets, sinking fund provisions, statement of whether bond is guaranteed by some other party with
high credit ranking
b.
Restrictive covenant – requirements that the firm not let its debt ratio exceed the a stated level and
that it keep its time-interest-earned ratio
3. Miscellaneous qualitative factors – included are issues like the sensitivity of the firm’s earnings to the strength
of the economy, the way is affected by inflation, a statement of whether it is having or likely to have labor
problems, the extent of its international operations, potential environmental problems, and potential antitrust
problems; today’s most important factor is exposure to subprime loans, including the difficulty to determine the
extent of this exposure as a result of the complexity of the assets backed by such loans
The rating process is dynamic. At times, one factor is of primary importance; at other times, some other factor is key.
Companies with lower business risk, lower debt ratios, higher cash flow to debt, and lower debt to EBITDA typically have
higher bond ratings.
B. Importance of Bond Ratings
1. A bond’s rating is an indicator of its default risk, the rating has a direct, measurable influence on the bond’s
interest rate and the firm’s cost of debt.
2. Most bonds are purchased by institutional investors rather than individuals and many institutions are restricted
to investment-grade securities. If a firm’s bonds fall below BBB, it will have a difficult time selling new bonds
many potential purchasers will not be allowed to buy them.
Lower-grade bonds have higher required rates of returns than high-grade bonds. Gaps between yields vary over time,
indicating that the cost differentials, or yield spreads, fluctuate from year to year. (Figure 7.4, page 243)
C. Changes in Ratings
Changes in a firm’s bond rating affect its ability to borrow funds capital and its cost of capital. Rating agencies review
outstanding bonds on a periodic basis, occasionally upgrading or downgrading a bond as a result of its issuer’s changed
circumstances. Over the long run, rating agencies have done a reasonably good job of measuring the average credit risk of
bonds and of changing ratings whenever there is a significant change in credit quality. However, it is important to
understand that ratings do not adjust immediately; and in some cases, there can be a considerable lag between a change
in credit quality and a change in rating. Many worry that rating agencies don’t have the proper incentives to measure risk
because they are paid for by the issuing firms so many have called for Congress and SEC to reform the agencies.
Bankruptcy and Reorganization
Insolvent – doesn’t have enough cash to meet its interest and principal payments.
In these cases, a decision must be made whether to dissolve the firm through liquidation or to permit it to reorganize and
thus continue to operate. This depends on whether the value of the organized business is likely to be greater than the
value of its assets if they were sold off piecemeal.
•
In reorganization, the firm’s creditors negotiate with management on the terms of a potential reorganization. A
trustee may be appointed by the court to oversee the reorganization, but the existing management generally is
allowed to retain control.
o Restructuring the debt – interest rate may be reduced, term to maturity lengthened, or some may be
exchanged for equity; aims to reduce the financial charges to level that is supportable by the firm’s
projected cash flows
o Common stockholders also have to “take a haircut” – they generally see their position diluted as a
result of additional shares being given to debt holders in exchange for the restructure
•
Liquidation occurs if the company is deemed to be worth more “dead” than “alive”. If the bankruptcy court
orders a liquidation, assets are auctioned off and the cash obtained is distributed.
o Federal bankruptcy statutes govern reorganization and liquidation
o Bankruptcies occur frequently
o Priority of the specified claims must be followed when the assets of a liquidated firm are distributed
o Bondholders’ treatment depends on term of the bonds
o Stockholders generally receive little in reorganizations and nothing in liquidations because the assets
are usually worth less than the amount of outstanding debt
DCMF
7-9 Bond Markets
Corporate bonds are traded primarily in the over-the-counter market. Most bonds are owned by and traded among large
financial institutions, and it is relatively easy for the OTC bond dealers to arrange the transfer of large blocks of bonds
among the relatively few holders of the bond. It would be more difficult to conduct similar operations in the stock market
among millions of large and small stockholders, so a higher percentage of stock trades occur on the exchanges.
High-yield bonds have much higher YTM because of higher default risk and convertible bonds have much lower yields
because investors are willing to accept in return for the option to convert their bonds to common stock and may even be
negative. Bonds with a YTM above the coupon rate trade at a discount, whereas bonds with a yield below the coupon rate
trade at a premium. When bonds with similar ratings are compared, bonds with longer maturities tend to have higher
yields, which is consistent with the upsloping yield curve during this time period.
DCMF