1、7-1CHAPTER 7Bonds and Their ValuationnKey features of bondsnBond valuationnMeasuring yieldnAssessing risk7-2What is a bond?nA 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.7-3Bond marketsnPrimarily traded
2、in the over-the-counter(OTC)market.nMost bonds are owned by and traded among large financial institutions.nFull information on bond trades in the OTC market is not published,but a representative group of bonds is listed and traded on the bond division of the NYSE.7-4Key Features of a BondnPar value
3、face amount of the bond,which is paid at maturity(assume$1,000).nCoupon interest rate stated interest rate(generally fixed)paid by the issuer.Multiply by par to get dollar payment of interest.nMaturity date years until the bond must be repaid.nIssue date when the bond was issued.nYield to maturity-r
4、ate of return earned on a bond held until maturity(also called the“promised yield”).7-5Effect of a call provisionnAllows issuer to refund the bond issue if rates decline(helps the issuer,but hurts the investor).nBorrowers are willing to pay more,and lenders require more,for callable bonds.nMost bond
5、s have a deferred call and a declining call premium.7-6What is a sinking fund?nProvision to pay off a loan over its life rather than all at maturity.nSimilar to amortization on a term loan.nReduces risk to investor,shortens average maturity.nBut not good for investors if rates decline after issuance
6、.7-7How are sinking funds executed?nCall x%of the issue at par,for sinking fund purposes.nLikely to be used if kd is below the coupon rate and the bond sells at a premium.nBuy bonds in the open market.nLikely to be used if kd is above the coupon rate and the bond sells at a discount.7-8The value of
7、financial assetsnn2211k)(1CF .k)(1CF k)(1CF Value012nkCF1CFnCF2Value.7-9Other types(features)of bondsnConvertible bond may be exchanged for common stock of the firm,at the holders option.nWarrant long-term option to buy a stated number of shares of common stock at a specified price.nPutable bond all
8、ows holder to sell the bond back to the company prior to maturity.nIncome bond pays interest only when interest is earned by the firm.nIndexed bond interest rate paid is based upon the rate of inflation.7-10What is the opportunity cost of debt capital?nThe discount rate(ki)is the opportunity cost of
9、 capital,and is the rate that could be earned on alternative investments of equal risk.ki=k*+IP+MRP+DRP+LP7-11What is the value of a 10-year,10%annual coupon bond,if kd=10%?$1,000 V$385.54$38.55 .$90.91 V(1.10)$1,000 (1.10)$100 .(1.10)$100 VBB10101B012nk100100+1,000100VB=?.7-12Using a financial calc
10、ulator to value a bondnThis bond has a$1,000 lump sum due at t=10,and annual$100 coupon payments beginning at t=1 and continuing through t=10,the price of the bond can be found by solving for the PV of these cash flows.INPUTSOUTPUTNI/YRPMTPVFV10101001000-10007-13An example:Increasing inflation and k
11、dnSuppose inflation rises by 3%,causing kd=13%.When kd rises above the coupon rate,the bonds value falls below par,and sells at a discount.INPUTSOUTPUTNI/YRPMTPVFV10131001000-837.217-14An example:Decreasing inflation and kdnSuppose inflation falls by 3%,causing kd=7%.When kd falls below the coupon r
12、ate,the bonds value rises above par,and sells at a premium.INPUTSOUTPUTNI/YRPMTPVFV1071001000-1210.717-15The price path of a bondnWhat would happen to the value of this bond if its required rate of return remained at 10%,or at 13%,or at 7%until maturity?Years to Maturity1,3721,2111,0008377753025 20
13、15 10 5 0kd=7%.kd=13%.kd=10%.VB7-16Bond values over timenAt maturity,the value of any bond must equal its par value.nIf kd remains constant:nThe value of a premium bond would decrease over time,until it reached$1,000.nThe value of a discount bond would increase over time,until it reached$1,000.nA va
14、lue of a par bond stays at$1,000.7-17What is the YTM on a 10-year,9%annual coupon,$1,000 par value bond,selling for$887?nMust find the kd that solves this model.10d10d1dNdNd1dB)k(11,000 )k(190 .)k(190$887)k(1M )k(1INT .)k(1INT V7-18Using a financial calculator to find YTMnSolving for I/YR,the YTM of
15、 this bond is 10.91%.This bond sells at a discount,because YTM coupon rate.INPUTSOUTPUTNI/YRPMTPVFV1010.91901000-8877-19Find YTM,if the bond price was$1,134.20.nSolving for I/YR,the YTM of this bond is 7.08%.This bond sells at a premium,because YTM 10%(the annual bonds effective rate),so you would p
16、refer the semiannual bond.10.25%120.1011mi1EFF%2mNom7-30If the proper price for this semiannual bond is$1,000,what would be the proper price for the annual coupon bond?nThe semiannual coupon bond has an effective rate of 10.25%,and the annual coupon bond should earn the same EAR.At these prices,the
17、annual and semiannual coupon bonds are in equilibrium,as they earn the same effective return.INPUTSOUTPUTNI/YRPMTPVFV1010.251001000-984.807-31A 10-year,10%semiannual coupon bond selling for$1,135.90 can be called in 4 years for$1,050,what is its yield to call(YTC)?nThe bonds yield to maturity can be
18、 determined to be 8%.Solving for the YTC is identical to solving for YTM,except the time to call is used for N and the call premium is FV.INPUTSOUTPUTNI/YRPMTPVFV83.568501050-1135.907-32Yield to calln3.568%represents the periodic semiannual yield to call.nYTCNOM=kNOM=3.568%x 2=7.137%is the rate that
19、 a broker would quote.nThe effective yield to call can be calculatednYTCEFF=(1.03568)2 1=7.26%7-33If you bought these callable bonds,would you be more likely to earn the YTM or YTC?nThe coupon rate=10%compared to YTC=7.137%.The firm could raise money by selling new bonds which pay 7.137%.nCould repl
20、ace bonds paying$100 per year with bonds paying only$71.37 per year.nInvestors should expect a call,and to earn the YTC of 7.137%,rather than the YTM of 8%.7-34When is a call more likely to occur?nIn general,if a bond sells at a premium,then(1)coupon kd,so(2)a call is more likely.nSo,expect to earn:
21、nYTC on premium bonds.nYTM on par&discount bonds.7-35Default risknIf an issuer defaults,investors receive less than the promised return.Therefore,the expected return on corporate and municipal bonds is less than the promised return.nInfluenced by the issuers financial strength and the terms of the b
22、ond contract.7-36Types of bondsnMortgage bondsnDebenturesnSubordinated debenturesnInvestment-grade bondsnJunk bonds7-37Evaluating default risk:Bond ratingsnBond ratings are designed to reflect the probability of a bond issue going into default.Investment GradeJunk BondsMoodysAaa Aa A BaaBa B Caa CS&
23、PAAA AA A BBBBB B CCC D7-38Factors affecting default risk and bond ratingsnFinancial performancenDebt rationTIE rationCurrent rationBond contract provisionsnSecured vs.Unsecured debtnSenior vs.subordinated debtnGuarantee and sinking fund provisionsnDebt maturity7-39Other factors affecting default ri
24、sknEarnings stabilitynRegulatory environmentnPotential antitrust or product liabilitiesnPension liabilitiesnPotential labor problemsnAccounting policies7-40BankruptcynTwo main chapters of the Federal Bankruptcy Act:nChapter 11,ReorganizationnChapter 7,LiquidationnTypically,a company wants Chapter 11
25、,while creditors may prefer Chapter 7.7-41Chapter 11 BankruptcynIf company cant meet its obligations nIt files under Chapter 11 to stop creditors from foreclosing,taking assets,and closing the business.nHas 120 days to file a reorganization plan.nCourt appoints a“trustee”to supervise reorganization.
26、nManagement usually stays in control.nCompany must demonstrate in its reorganization plan that it is“worth more alive than dead”.nIf not,judge will order liquidation under Chapter 7.7-42Priority of claims in liquidation1.Secured creditors from sales of secured assets.2.Trustees costs3.Wages,subject
27、to limits4.Taxes5.Unfunded pension liabilities6.Unsecured creditors7.Preferred stock8.Common stock7-43ReorganizationnIn a liquidation,unsecured creditors generally get zero.This makes them more willing to participate in reorganization even though their claims are greatly scaled back.nVarious 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.
