Bonds and Their Valuation
Key features of bonds
Bond valuation
Measuring yield
Assessing risk
7-1
What is a bond?
A 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.
7-2
Bond markets
Primarily traded in the over-the-counter
(OTC) market.
Most bonds are owned by and traded among
large financial institutions.
Full 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.
7-3
Key Features of a Bond
Par value – face amount of the bond, which
is paid at maturity (assume $1,000).
Coupon interest rate – stated interest rate
(generally fixed) paid by the issuer. Multiply by
par to get dollar payment of interest.
Maturity date – years until the bond must be
repaid.
Issue date – when the bond was issued.
Yield to maturity - rate of return earned on
a bond held until maturity (also called the
“promised yield”).
7-4
Effect of a call provision
Allows issuer to refund the bond issue
if rates decline (helps the issuer, but
hurts the investor).
Borrowers are willing to pay more,
and lenders require more, for callable
bonds.
Most bonds have a deferred call and a
declining call premium.
7-5
What is a sinking fund?
Provision to pay off a loan over its life
rather than all at maturity.
Similar to amortization on a term
loan.
Reduces risk to investor, shortens
average maturity.
But not good for investors if rates
decline after issuance.
7-6
How are sinking funds executed?
Call x% of the issue at par, for sinking
fund purposes.
Likely to be used if kd is below the coupon
rate and the bond sells at a premium.
Buy bonds in the open market.
Likely to be used if kd is above the coupon
rate and the bond sells at a discount.
7-7
Other types (features) of bonds
Convertible bond – may be exchanged for
common stock of the firm, at the holder’s option.
Warrant – long-term option to buy a stated
number of shares of common stock at a specified
price.
Putable bond – allows holder to sell the bond
back to the company prior to maturity.
Income bond – pays interest only when interest
is earned by the firm.
Indexed bond – interest rate paid is based upon
the rate of inflation.
7-8
Bond values over time
At maturity, the value of any bond must
equal its par value.
If kd remains constant:
The value of a premium bond would
decrease over time, until it reached
$1,000.
The value of a discount bond would
increase over time, until it reached
$1,000.
A value of a par bond stays at $1,000.
7-9
What is reinvestment rate risk?
Reinvestment rate risk is the concern that kd
will fall, and future CFs will have to be
reinvested at lower rates, hence reducing
income.
EXAMPLE: Suppose you just won
$500,000 playing the lottery. You
intend to invest the money and
live off the interest.
7-10
Reinvestment rate risk example
You may invest in either a 10-year bond or a
series of ten 1-year bonds. Both 10-year and 1-
year bonds currently yield 10%.
If you choose the 1-year bond strategy:
After Year 1, you receive $50,000 in income
and have $500,000 to reinvest. But, if 1-year
rates fall to 3%, your annual income would
fall to $15,000.
If you choose the 10-year bond strategy:
You can lock in a 10% interest rate, and
$50,000 annual income.
7-11
Conclusions about interest rate and
reinvestment rate risk
Short-term AND/OR Long-term AND/OR
High coupon bonds Low coupon bonds
Interest
Low High
rate risk
Reinvestment
High Low
rate risk
CONCLUSION: Nothing is riskless!
7-12
Would you prefer to buy a 10-year, 10%
annual coupon bond or a 10-year, 10%
semiannual coupon bond, all else equal?
The semiannual bond’s effective rate is:
m 2
iNom 0.10
EFF% 1 1 1 1 10.25%
m 2
10.25% > 10% (the annual bond’s
effective rate), so you would prefer the
semiannual bond.
7-13
Default risk
If 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.
Influenced by the issuer’s financial
strength and the terms of the bond
contract.
7-14
Types of bonds
Mortgage bonds
Debentures
Subordinated debentures
Investment-grade bonds
Junk bonds
7-15
Evaluating default risk:
Bond ratings
Investment Grade Junk Bonds
Moody’s Aaa Aa A Baa Ba B Caa C
S&P AAA AA A BBB BB B CCC D
Bond ratings are designed to reflect the
probability of a bond issue going into
default.
7-16
Factors affecting default risk and
bond ratings
Financial performance
Debt ratio
TIE ratio
Current ratio
Bond contract provisions
Secured vs. Unsecured debt
Senior vs. subordinated debt
Guarantee and sinking fund provisions
Debt maturity
7-17
Other factors affecting default risk
Earnings stability
Regulatory environment
Potential antitrust or product liabilities
Pension liabilities
Potential labor problems
Accounting policies
7-18
Priority of claims in liquidation
1. Secured creditors from sales of
secured assets.
2. Trustee’s costs
3. Wages, subject to limits
4. Taxes
5. Unfunded pension liabilities
6. Unsecured creditors
7. Preferred stock
8. Common stock
7-19
Reorganization
In a liquidation, unsecured creditors
generally get zero. This makes them more
willing to participate in reorganization even
though their claims are greatly scaled back.
Various 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.
7-20
