Chapter 6 Bonds Debt Characteristics and Valuation

Chapter 6 Bonds (Debt) – Characteristics and Valuation Essentials of Managerial Finance by S. Besley & E. Brigham Slide 1 of 22

Background on Bonds • Bonds represents long-term debt securities that are issued by government agencies or corporations • Interest payments occur annually or semiannually • Par value is repaid at maturity • Most bonds have maturities between 10 and 30 years • Bearer bonds require the owner to clip coupons attached to the bonds • Registered bonds require the issuer to maintain records of who owns the bond automatically send coupon payments to the owners 2 Essentials of Managerial Finance by S. Besley & E. Brigham Slide 2 of 22

Background on Bonds (cont’d) • Bond yields – The issuer’s cost of financing is measured by the yield to maturity • The annualized yield that is paid by the issuer over the life of the bond • Equates the future coupon and principal payments to the initial proceeds received • Does not include transaction costs associated with issuing the bond • Earned by an investor who invests in a bond when it is issued and holds it until maturity – The holding period return is used by investors who do not hold a bond to maturity 3 Essentials of Managerial Finance by S. Besley & E. Brigham Slide 3 of 22

Treasury and Federal Agency Bonds • The U. S. Treasury issues Treasury notes or bonds to finance federal government expenditures – Note maturities are usually less than 10 years – Bonds maturities are 10 years or more – An active secondary market exists – The 30 -year bond was discontinued in October 2001 4 Essentials of Managerial Finance by S. Besley & E. Brigham Slide 4 of 22

Treasury and Federal Agency Bonds (cont’d) • Trading Treasury bonds – Bond dealers serve as intermediaries in the secondary market and also take positions in the bonds – 30 primary dealers dominate the trading • Profit from the bid-ask spread • Conduct trading with the Fed during open market operations • Typical daily volume is about $200 billion – Online trading • Treasury. Direct program (http: //www. treasurydirect. gov) 5 Essentials of Managerial Finance by S. Besley & E. Brigham Slide 5 of 22

Treasury and Federal Agency Bonds (cont’d) • Treasury bond quotations – Published in financial newspapers • The Wall Street Journal • Barron’s • Investor’s Business Daily – Bond quotations are organized according to their maturity, with the shortest maturity listed first – Bid and ask prices are quoted per hundreds of dollars of par value – Online quotations at • http: //www. investinginbonds. com • http: //www. federalreserve. gov/releases/H 15/ 6 Essentials of Managerial Finance by S. Besley & E. Brigham Slide 6 of 22

Treasury and Federal Agency Bonds (cont’d) • Savings bonds – – – Issued by the Treasury Have a 30 -year maturity and no secondary market Series EE bonds provide a market-based interest rate Series I bonds provide a rate of interest tied to inflation Interest on savings bonds is not subject to state and local taxes • Federal agency bonds – Ginnie Mae issues bonds and purchases mortgages that are insured by the FHA and the VA – Freddie Mac issues bonds and purchases conventional mortgages – Fannie Mae issues bonds and purchases residential mortgages 7 Essentials of Managerial Finance by S. Besley & E. Brigham Slide 7 of 22

Municipal Bonds • Municipal bonds can be classified as either general obligation bonds or revenue bonds – General obligation bonds are supported by he municipal government’s ability to tax – Revenue bonds are supported by the revenues of the project for which the bonds were issued • Municipal bonds typically pay interest semiannually, with minimum denominations of $5, 000 • Municipal bonds have a secondary market • Most municipal bonds contain a call provision 8 Essentials of Managerial Finance by S. Besley & E. Brigham Slide 8 of 22

Municipal Bonds (cont’d) • Trading and quotations – Investors can buy or sell munis by contacting brokerage firms – Electronic trading has become popular • http: //www. tradingedge. com – Online quotations are available at http: //www. munidirect. com and http: //www. investinginbonds. com 9 Essentials of Managerial Finance by S. Besley & E. Brigham Slide 9 of 22

Corporate Bonds • Corporations issue corporate bonds to borrow for long-term periods • Corporate bonds have a minimum denomination of $1, 000 • Larger bonds offerings are achieved through public offerings registered with the SEC • Secondary market activity varies • Financial and nonfinancial institutions as well as individuals are common purchasers • Most corporate bonds have maturities between 10 and 30 years • Interest paid by corporations is tax-deductible, which reduces the corporate cost of financing with bonds 10 Essentials of Managerial Finance by S. Besley & E. Brigham Slide 10 of 22

Corporate Bonds (cont’d) • Corporate bond yields and risk – Interest income earned on corporate represents ordinary income – Yield curve • Affected by interest rate expectations, a liquidity premium, and maturity preferences of corporations • Similar shape as the municipal bond yield curve – Default rate • Depends on economic conditions • Less than 1 percent in the late 1990 s • Exceeded 3 percent in 2002 11 Essentials of Managerial Finance by S. Besley & E. Brigham Slide 11 of 22

Corporate Bonds (cont’d) • Corporate bond yields and risk (cont’d) – Investor assessment of risk • Investors may only consider purchasing corporate bonds after assessing the issuing firm’s financial condition and ability to cover its debt payments • Investors may rely heavily on financial statements created by the issuing firm, which may be misleading – Bond ratings • Bonds with higher ratings have lower yields • Corporations seek investment-grade ratings, since commercial banks will only invest in bonds with that status • Rating agencies will not necessarily detect any misleading information contained in financial statements 12 Essentials of Managerial Finance by S. Besley & E. Brigham Slide 12 of 22

Corporate Bonds (cont’d) • Corporate bond characteristics (cont’d) – Call provisions: • Require the firm to pay a price above par value when it calls its bonds – The difference between the call price and par value is the call premium • Are used to: – Issue bonds with a lower interest rate – Retire bonds as required by a sinking-fund provision • Are a disadvantage to bondholders 13 Essentials of Managerial Finance by S. Besley & E. Brigham Slide 13 of 22

Corporate Bonds (cont’d) • Trading corporate bonds – Bonds are traded through brokers, who communicate orders to bond dealers – A market order transaction occurs at the prevailing market price – A limit order transaction will occur only if the price reaches a specified limit – Bonds listed on the NYSE are traded through the automated Bond System (ABS) – Online trading is possible at: • http: //www. schwab. com • http: //www. etrade. com 14 Essentials of Managerial Finance by S. Besley & E. Brigham Slide 14 of 22

Corporate Bonds (cont’d) • Corporate bond quotations – More than 2, 000 bonds are traded on the NYSE with a market value of more than $2 trillion – Corporate bond prices are reported in eighths – Corporate bond quotations normally include the volume of trading and the yield to maturity 15 Essentials of Managerial Finance by S. Besley & E. Brigham Slide 15 of 22

Corporate Bonds (cont’d) • Junk bonds – Junk bonds have a high degree of credit risk – About two-thirds of junk bonds are used to finance takeovers – Size of the junk bond market • Currently about 3, 700 junk bond offerings exist with a market value of $80 billion – Participation in the junk bond market • 70 large issuers of junk bonds each have more than $1 billion in debt outstanding • Primary investors in junk bonds are mutual funds, life insurance companies, and pension funds • The junk bond secondary market consists of 20 bond traders 16 Essentials of Managerial Finance by S. Besley & E. Brigham Slide 16 of 22

Basic Valuation • The (market) value of any investment asset is simply the present value of expected cash flows. • The interest rate that these cash flows are discounted at is called the asset’s required return. • The higher expected cash flows, the greater the asset’s value. • It makes sense that an investor is willing to pay (invest) some amount today to receive future benefits (cash flows). Essentials of Managerial Finance by S. Besley & E. Brigham Slide 17 of 22

Basic Valuation Model V 0 = CF 1 + (1 + k)1 CF 2 + … + (1 + k)2 CFn (1 + k)n Where: V 0 = value of the asset at time zero CFt = cash flow expected at the end of year t k = appropriate required return (discount rate) n = relevant time period Essentials of Managerial Finance by S. Besley & E. Brigham Slide 18 of 22

The basic bond valuation model B 0 = I 1 + (1+k)1 I 2 + … + (1+k)2 (In + Mn) (1+k)n Using the above model, find the (market) price of a 10% coupon bond, 3 years to maturity if market interest rates are currently 10%(par value= 100). B 0 = € 10 + (1+. 10)1 € 10 + (1+. 10)2 (€ 10 + € 100) (1+. 10)3 It can also be calculated by finding the present value of the annuity B 0 = 10 * (1 - [1/(1+. 10)3]) + 100 * [1/(1+. 10)3] =. 10 Essentials of Managerial Finance by S. Besley & E. Brigham Slide 19 of 22

Valuation of a bond using Excel For example, find the price of a 10% coupon bond with three years to maturity if market interest rates are currently 10%. Note: the equation for calculating price is =PV(rate, nper, pmt, fv) Essentials of Managerial Finance by S. Besley & E. Brigham Slide 20 of 22

Changes in bond values over time In the previous example, what would happen to the bond’s price if interest rates drop from 10% to 8%? When interest rate falls below the coupon rate, then the bond would sell at a premium When the interest rate goes down, the bond price will always go up Essentials of Managerial Finance by S. Besley & E. Brigham Slide 21 of 22

Changes in bond values over time In the previous example, what would happen to the bond’s price if interest rates increase from 10% to 12%? When interest rate increases above the coupon rate, then the bond would sell at a discount When the interest rate goes up, the bond price will always go down Essentials of Managerial Finance by S. Besley & E. Brigham Slide 22 of 22

Bond value–interest rate relationship Essentials of Managerial Finance by S. Besley & E. Brigham Slide 23 of 22

Bond Return kd Rate of return = INT Vd = Current yield Essentials of Managerial Finance by S. Besley & E. Brigham + Vd 1 – Vd 0 + Capital gains yield Slide 24 of 22

Bond Valuation – Change in value over time Bond Characteristics: M = € 1, 000. 00, INT = € 60. 00, kd = 8% Years to End of Year Maturity Value, Vd Capital Gain = (Vd 1 -Vd 0)/Vd 0 Current Yield = INT/Vd 0 Total Return 5 € 920. 15 4 933. 76 1. 48% 6. 52% 8. 00% 3 2 948. 46 964. 33 1. 57 1. 67 6. 43 6. 33 8. 00 1 981. 48 1. 78 6. 22 8. 00 0 1, 000. 00 1. 89 6. 11 8. 00 Essentials of Managerial Finance by S. Besley & E. Brigham Slide 25 of 22

Market value converges at par value to maturity Essentials of Managerial Finance by S. Besley & E. Brigham Slide 26 of 22

Finding the Yield to Maturity on a Bond • The yield to maturity measures the compound annual return to an investor and considers all bond cash flows. PV = I 1 (1+k)1 + I 2 + … + (1+k)2 (In + Mn) (1+k)n Note that this is the same equation of the Basic Valuation Model. The only difference now is that we know the market price but are solving for return. Essentials of Managerial Finance by S. Besley & E. Brigham Slide 27 of 22

Valuation with semi-annual compounding Example: M = € 1, 000, C = 5%, Yrs to maturity = 8, kd = 6% 16 3 ? 25 PMT N I PV FV 1000 • Adjustments to -931, 23 computations – N = # years x m; m = # of interest payments per year – i = kd/m – INT = interest payment period = Annual INT/m Essentials of Managerial Finance by S. Besley & E. Brigham Slide 28 of 22