1、BOND VALUATION CONCEPTS,FIN 3403, 3404 PROF. DIGGLE,BOND CONCEPTS,What is a bond? How do corporate bonds differ from other kinds of bonds? Priority of claim pyramid Characteristics of Corporate bonds What is a Municipal bond? Characteristics of muny bonds.,RISK VS RETURN,KINDS OF RISK-RECAP INFLATIO
2、N RISK BUSINESS OR DEFAULT RISK MARKET RISK LIQUIDITY RISK INTR. RATE RISK OTHER CURRENCY RISK POLITICAL RISK ETC.,BOND CONCEPTS AND TERMS (see lec notes p. 34),TERMS PAR COUPON RATE DOLLAR ANNUAL COUPON CURRENT YIELD YIELD TO MATURITY INDENTURE,DEBENTURE DURATION ACCRUED INTERESTCONCEPTS IF INTERES
3、T RATES RISE WHAT HAPPENS TO BOND PRICES? Current yield vs. YTM,THE BOND TVM TIME LINE,COUPON COUPON COUPON COUPON COUPON ETC ETCAll bonds we will study pay SEMI-ANNUALLY (coupon every 6 months)An 8% bond pays two coupons of $40 eachA 30 year bond has 60 interest coupons.PAR AT MATURITY ($1000),BOND
4、 VALUATION SEE LEC NOTES PP. 35-38,A BOND IS IN TWO PARTS: PRINCIPAL ($1000 PAR) - LUMP SUM AT MATURITY INTEREST coupons (SEMIANNUAL) (ANNUITY) The value of a bond is the NPV of both elements,The price of a bond is, therefore, another TVM problem. What is the discount rate? The current MARKET rate o
5、f bonds of similar TYPE, QUALITY and MATURITY,KINDS OF BONDS,U.S. GOVERNMENT U.S. TREASURY Treasury series EE U.S. AGENCY MUNICIPAL CORPORATE Mortgage Debenture FOREIGN GOVT.,TAX CONSIDERATIONS The Tax Equivalent yield ZERO COUPON BONDS STRIPS INFLATION ADJUSTED BONDS,CORPORATE BONDS Issued by domes
6、tic corporations,ALL new corporate bond issues are subject to SEC review The Indenture Role of the Bond Trustee How is a bond sold The “Shelf registration”,What terms are in the Indenture? Collateral and priority of claim Coupon in percent and dollars Maturity Call provisions sinking fund redemption
7、 Trustee,BOND “RATING” SERVICES,MOODYS AND STANDARD AND POOR RATING FROM AAA (best) to BA (lowest “investment” grade), to below B (“junk bonds.”,The bond rating is a measure of business risk or risk of default only. Corporations and municipalities must pay a fee to have bonds rated. Therefore many b
8、onds are NR.,MUNY BONDS Bonds issued by states, cities and local authorities like airports,GO or General Obligation (supported usually by real estate taxes) REVENUE AND IDR HOW DOES A CORPORATION DO AN IDR? SINGLE, DOUBLE AND TRIPLE TAX FREE MUNYS WHY ARE MUNYS FREE OF FEDERAL INCOME TAX?,YIELD TO M
9、ATURITY,YTM is the “Total Return” on a bond. This consists of: CURRENT YIELD CAPITAL GAINS “YIELD” If a bond is selling at a PREMIUM (above par), bondholder will have a capital loss to maturity.,If a bond is selling at a DISCOUNT, you have a guaranteed capital gain to maturity. PREMIUM: CURRENT YIEL
10、D THAN YTM WHY? DISCOUNTCURRENT YIELD YTM. WHY?,BOND PROELEM USING YOUR CALCULATOR,You buy a corporate bond on 12-1-98 The coupon is 7.5% The bond matures on May 15, 2015 (Millennium problem does not affect calculator) The market yield is 6%. Compute PRICE,THIS IS SDT $75 PER YEAR or $37.50 per coup
11、on Matures at par. Par is expressed in % in your calculator. Therefore $1000 par is entered as 100 or 100% YLD = 6,TIBA 2+ CALCULATOR BOND WORKSHEET,SDT enter 12.0198 CPN enter 7.5 RDT enter 5.1515 RV = 100% OF PAR OR $1000 ACT (for corporates) and 360 for Treasuries 2/Y (semiannual pay) LEAVE YOUR
12、TI BA2 AT ACT AND 2/Y,YLD = market yield on bonds of similar type, quality and maturity = 6 SOLVE FOR PRI (price - push CPT) MAY ALSO SOLVE FOR YTM where price is given AI = accrued interest,WHAT DOES THE BOND WORKSHEET DO?,THE PRICE OF A BOND IS THE NET PRESENT VALUE OF: THE LUMP SUM OF $1000 PAR R
13、ECEIVED AT MATURITY THE ANNUITY OF COUPON INTEREST RECEIVED SEMIANNUALLY OVER REMAINING LIFE OF BOND (P/Y = 2) HOW WOULD YOU COMPUTE THE PRICE OF A ZERO COUPON BOND?,WHAT IS CALL?,Why would a company or municipality call a bond? Why do investors dislike callable bonds? If a bond is not callable for
14、5 years this is called call protection.,REDEMPTION CALL SINKING FUND CALL CALCULATING YIELD TO CALL ON YOUR CALCULATOR ACCRUED INTEREST,BOND PROBLEM,A. YOU BUY A BOND TODAY MATURING IN 30 YEARS. YOU PAY 1030 (103% of par) THE COUPON IS 7.33% WHAT IS THE YIELD TO MATURITY?,B. YOU BUY A BOND TODAY MAT
15、URING IN 25 YEARS THAT IS CALLABLE IN 15 YEARS AT 105 ALL FACTS ON LEFT SIDE ARE THE SAME. COMPUTE YIELD TO CALL.,DURATION VS MATURITY,SEE TEXT MATURITY IS A FIXED DATE IN TIME DURATION IS A MEASURE OF BOND CASH FLOW COMBINING MATURITY AND COUPON INCOME,A HIGH COUPON BOND WILL HAVE A SHORTER DURATIO
16、N THAN A LOWER COUPON ISSUE THAT IS IDENTICAL IN ALL OTHER RESPECTS,ACCRUED INTEREST,You buy a bond on March 10. Coupons are paid on Jan 1 and June 30. What is the accrued income? Who pays it and why? Accrued income is added to the amount received by the SELLER,Who will receive the June 30 coupon? T
17、HE BUYER. The buyer must pay the seller accrued interest for the time he owned the bond since the last coupon. This is done on settlement date.,TRADE DATE AND SETTLEMENT DATE,Corporate securities settle in 3 business days after trade date. You buy a bond on Friday. Monday is a Holiday. When is corpo
18、rate settlement? This is when good funds must be available to pay for bond or stock.,Government (TREASURY) bonds are next day settlement (next business day). SDT on your financial calculator is settlement date. RDT (redemption date) is maturity or call date.,CONVERTS & ZEROS: FIN 3404-FIN 3404 STUDE
19、NTS not responsible,A convert is a bond with additional contractual provisions in the indenture providing for conversion of the bond into common stock. A convert is “Quasi Equity.” It behaves like common stock.,TERMINOLOGY CONVERSION PRICE CONVERSION RATIO THEORETICAL VALUE PREMIUM OVER THEORETICAL
20、VALUE,CONVERTS CONTD.,Why would a company include convertibility as a “sweetener” in the indenture? What happens if a convertible bond is called by the company?2 situations,Are converts a good investment? Why or why not? Should you buy a callable convert selling above call price? Why or why not?,CON
21、VERT PROBLEM,A convert is convertible into 20 shares of common. This is the conversion ratio. This means the conversion price is $50 ($1000 par / 20),When a convert is issued, the conversion price is usually 15% or so below common price. Why? Assume the common price is $40 when the bond is floated.,
22、CONVERT PROBLEM CONTD,Assume now it is 3 years later and the common is selling for $65 per share. What is the theoretical value of the convert?Conv ratio = number of common shares per bond X stock price,TV = 20 x $65 = $1300 Assume the call price set in the indenture is 103 ($1030). What happens if
23、this bond is called?,CONVERTS CONTD,Why do most converts sell at a PREMIUM over conversion or theoretical value? Priority of claim Current yield on bond vs dividend yield on stock,Say the bond we are looking at carried a coupon of 8%. The burrent yield at a price of $1300 = 6.15%. Assume the common
24、dividend is $2.00. The dividend yield is 2/65 or 3.1%. Which would you rather own?,WHAT ARE ZERO COUPON BONDS?,Bond in which coupons have been stripped off. Price is simply the NPV of the par value ($1000) at maturity.,What reasons can you think of for investors to own zero coupon treasuries? Compute the price of a Treasury maturing in 30 years when the yield on coupon conds of similar type and quality is 6.4%,
