Bonds 1
Long-term Debt Financing,
Bonds and Bond Pricing
Professor Jia Liu
Portsmouth Business School
2020-2021
Topic Summary
Main types of debts
The aim of this lecture is to:
–
introduce the nature and
main types of debts;
–
use valuation principles to
calculate a bond’s value
and/or
its
yield
to
maturity;
–
explain the Term Structure
of interest rates and the
reasons for its existence.
Valuing bonds
- yield to maturity (YTM)
- bond prices and YTM
- duration
The classical theory of interest
- Fisher effect
- the Term Structure and YTM
- Yield Curve
expectation hypothesis
liquidity-preference hypothesis
market-segmentation hypothesis
- allowing for the risk of default
Summary of determinant of YTM
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Long term debt: a review
• Corporate debt can be short-term (maturity
less than one year) or long-term.
• Different from common stock:
– Creditor’s claim on corporation is specified
– Promised cash flows
– Most are callable
• Over half of outstanding bonds are owned by
life insurance companies & pension funds
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Bank borrowing
Borrowing from banks is attractive to companies for the
following reasons:
• Administrative and legal costs are low
• Quick
• Flexibility
• Available to small firms
FACTORS FOR A FIRM TO CONSIDER
• Costs
• Security
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• Repayment
Syndicated loans
Large money-center banks frequently have more demand
for loans than they have supply.
Small regional banks are often in the opposite situation.
As a result, a lager money center bank may arrange a
loan with a firm or country and then sell portions of the
loan to a syndicate of other banks.
A syndicated loan may be publicly traded.
Syndicated loans are always rated investment grade.
However, a leveraged syndicated loan is junk.
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•
•
A few banks each contribute a portion of the overall loan
Lead manager
•
•
Other banks
Co-manage and underwrite the loan
Leasing financing
Sale and leaseback: another popular financing used by
companies.
If a firm owns buildings, land or equipment it may be
possible to sell these to another firm (for example a
bank, insurance company or specialised leasing firm)
and simultaneously agree to lease the property back for
a stated period under specific terms.
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Benefits:
Drawbacks:
• Cash benefit
• Tax benefit
•
•
•
•
•
Ownership
Appreciation
Possible increase in rental
A degree of inflexibility
Complex documentation and
large legal fees
Nature of corporate bonds
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•
Represent a credit instrument where the company
promises to pay some principal amount plus
periodic interest to an investor.
•
Principal and interest payments must be met
before dividends can be paid to either preferred or
common stockholders.
•
Failure to meet interest and principal payment is
an act of default that can lead to bankruptcy and
possible liquidation.
•
Creditors have first claim on the proceeds from
the sales of assets.
The public issue of bonds
• The general procedure is similar to the issuance of stock.
• The indenture is a written agreement between the
borrower and a trust company, and usually lists
–
–
–
–
–
–
–
–
Amount of Issue, Date of Issue, Maturity
Denomination (Par value)
Annual Coupon, Dates of Coupon Payments
A description of property used as security, if applicable
Security
Sinking Funds
Call Provisions
Details of protective covenants
Features that may change over time
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– Rating
– Yield-to-Maturity
– Market price
Bond classifications:
form and seniority
Registered vs. bearer forms
• Registered bond - a bond in which the company's records
show ownership and interest and principal are paid
directly to each owner
• Bearer bonds - the bond holder must send in coupons to
claim interest and must send a certificate to claim the
final payment of principal
Seniority indicates preference in position over other
lenders. The types can be:
• Senior bonds
• Junk bonds
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Bond classifications: security
Secured bonds
– Collateral – secured by financial securities
– Mortgage – long-term secured debt often containing a
claim against a specific building or property
– Asset-backed securities – the sale of cash flows derived
directly from a specific set of bundled assets.
Securitisation involves the pooling and repackaging of
relatively small, homogeneous and illiquid financial
assets into liquid securities.
Unsecured bonds
– Debentures – long-term unsecured issues on debt
– Notes – unsecured debt with original maturity less than
10 years
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Bond classification:
repayment and call provision
Repayment can be made at maturity at the face value, or
made in part or entirely before maturity.
• Sinking fund is an account managed by the bond trustee for
early bond redemption. This can be done by either buying
back some of the bonds or calling in a part of outstanding
bonds, i.e., call provision.
Call provision is an agreement, which allows the borrower to
repurchase or “call” part or all of the bond issue at specific
prices prior to maturity.
• Call premium – the difference between the call price and
bond’s stated value.
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Bond classification:
protective covenants
Protective covenants set the limitations by bondholders
on the actions of the company.
• Positive covenants specifies the actions that the
company agrees to take:
- working capital
- net worth
- provide audited financial statements to the lender
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• Negative covenants limits actions that the company
might take:
- amount of dividends to pay
- new issuance of long-term debts
- merge with others
- sell or lease assets
Summary: bond characteristics
and coupon rates
The coupon rate depends on the
characteristics of the bond when issued.
risk
Which bonds will have the higher coupon, all else
equal?
–
–
–
–
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Secured debt versus a debenture
Subordinated debenture versus senior debt
A bond with a sinking fund versus one without
A callable bond versus a non-callable bond
Bond credit ratings
Bond ratings represent a credit agency’s assessment of a
firm’s ability to meet its debt obligations. The main credit
rating agencies are Moody’s and Standard and Poor’s. In
coming up with their ratings, agencies consider many
factors including earnings stability, leverage, interest and
fixed charge coverage, and asset protection. The
assessment of management quality is also an important
intangible aspect of the rating process.
The rating depends on:
• The likelihood of payments of interest and/or capital
not being made (that is, default)
• The extent to which the lender is protected in the event
of a default by the loan contract
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Investment grade
vs. junk bonds
• Bonds rated Baa or better by Moody’s or BBB by
Standard and Poor’s are considered investment
grade. Banks and other financial institutions can only
hold investment grade bonds.
• Bonds not considered investment grade are referred
to as junk, or high-yield bonds.
- below investment credit ratings
- more risky
- fallen angels
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• In the 1980s, start-up companies who could not get
bank accommodation, issued these bonds to finance
growth.
Bond ratings –
investment quality
• High Grade
– Moody’s Aaa and S&P AAA – capacity to pay is
extremely strong
– Moody’s Aa and S&P AA – capacity to pay is very
strong
• Medium Grade
– Moody’s A and S&P A – capacity to pay is strong, but
more susceptible to changes in circumstances
– Moody’s Baa and S&P BBB – capacity to pay is
adequate, adverse conditions will have more impact
on the firm’s ability to pay
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Bond ratings - speculative
• Low Grade
– Moody’s Ba, B, Caa and Ca
– S&P BB, B, CCC, CC
– Considered speculative with respect to capacity to
pay. The “B” ratings are the lowest degree of
speculation.
• Very Low Grade
– Moody’s C and S&P C – income bonds with no
interest being paid
– Moody’s D and S&P D – in default with principal and
interest in arrears
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Credit rating
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Bond valuation
• Valuing principles:
– Value of financial securities = PV of expected
future cash flows
• To value bonds, we need to:
– Estimate future cash flows
• Size (how much) and
• Timing (when)
– Discount future cash flows at an appropriate rate
• The rate should be appropriate to the risk
presented by the security.
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Bond valuation
The value of the bond is the present value of the
coupon interest payments plus the face value at
maturity, discounted at the bond’s required rate of
return.
P
C1
1  k d 

C2
1  k d 
2
 ... 
Cn
1  k d 
n

M
1  k d 
n
Where:
P = the price (or value) of the bond
C = the periodic interest payments in pounds
n = the number of years to maturity
M = the maturity (par) value of the bond
kd = the required rate of return
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Bond valuation: example
Suppose that BT issued a bond with a par value of $1000 in
February 2003, redeemable in February 2010 at par. The
coupon is 7% payable annually in September.
Question 1
What is the price investors will pay for this bond at the time
of issue if the market rate of interest for a security in this risk
class is 6.5 percent?
Question 2:
What is the bond’s value in the secondary market in
February 2010 if the interest rates rise by 100 basis points
between 2003 and 2010?
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Bond valuation: solution
Period
1-7
7
Cash
flow
$70
$1,000
Present value
Factor Factor
@7.5% @6.5%
Present value
of cash flow
@7.5%
@6.5%
5.2966
0.6028
$370.76
$383.92
$602.80
$643.50
5.4845
0.6435
Values of bond
P=$973.56 P=$1,027.42
What implications can you summarise from this example?
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Yield to maturity
A bond’s yield to maturity (YTM) is the discount rate
that equates the present value of coupon interest
payments plus the principal at maturity with the
bond’s current price.
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Bond price, coupon
interest rate and YTM
The BT bond examples above illustrate an important
aspect of bond pricing; namely, that
- there is an inverse relationship between bond price and
YTM;
- if the coupon rate (=7%) is below the YTM (=7.5%) in
case 1, a bond will sell at a discount than its face value;
In our illustration, the BT bond is said to be selling at a
2.64% discount from face;
- alternatively, if the YTM (=6.5%) on BT bond is less than
its coupon interest rate (=7%) in case 2, the bond will sell
at a premium from its face;
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- a bond will only sell at face if its coupon rate and YTM are
the same. (Could you demonstrate this yourself?)
Bond price, coupon
interest rate and YTM
Bond Value
This relationship can be illustrated graphically below:
When the YTM < coupon rate,
the bond trades at a premium.
1300
1200
When YTM = coupon rate,
the bond trades at par.
1050
1000
950
0
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0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09
0.1
YTM
7%
When the YTM > coupon rate,
the bond trades at a discount.
Reading
Chapter 11, Arnold.
Chapters 24, Principles, Brealey and Myers
www.moodys.com
http://www2.standardandpoors.com
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