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Valuing Bonds

Valuing Bonds. Chapter 6 Fin 325, Section 04 - Spring 2010 Washington State University. Overview. The U.S. bond market is over twice the size of the U.S. stock market Total outstanding debt in 2007: $29.2 trillion Total market value of common stock: $14.2 trillion

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Valuing Bonds

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  1. Valuing Bonds Chapter 6 Fin 325, Section 04 - Spring 2010 Washington State University

  2. Overview • The U.S. bond market is over twice the size of the U.S. stock market • Total outstanding debt in 2007: $29.2 trillion • Total market value of common stock: $14.2 trillion • In general, bonds are less risky than stocks • But, like all assets, high-yield bonds have higher risk

  3. Bond Characteristics • Bonds are debt obligations • Corporations • Federal government and federal agencies • States and local governments • Bonds are also known as fixed-income securities • Amount and timing of cash flows are known • For the issuer, the bond is a loan that requires regular interest payments and repayment of the borrowed principal

  4. Bond Terms • The precise terms of a bond issue are outlined in the indenture • Maturity date • Par value (also called face value), usually $1,000 • Interest rate • Any property pledged as collateral • Steps the bondholder can take in event of default

  5. Coupon Rate • The bond’s interest rate • The name “coupon” is an artifact of history • Now, bond owners are registered with the company. Interest payments are wired to the owner’s account • The coupon rate is listed as a percentage of par value • A 5 percent coupon rate pays 5 percent of $1000 (or $50) each year, or $25 every six months

  6. Bond Price • When first issued, bonds sell at par value • Bond prices change as interest rates and firm risk change • When the bonds trade among investors in the secondary market, the price will likely differ from par value • Corporate bond prices are quoted in terms of percent of par • Examples: a bond worth $1,150 would be listed at 115, while a bond worth $870 is quoted as 87

  7. Bond Issuers • U.S. Treasury bonds • Corporate bonds • Municipal bonds

  8. U.S. Treasury Bonds • Backed by the full faith and credit of the U.S. government • Safest fixed-income investments • Fed sells Treasury securities through public auction • Finance the federal deficit; implement monetary policy • Maturities differ: • Less than one year: Treasury bills • One to ten years: Treasury notes • Greater than ten years: Treasury bonds

  9. Corporate Bonds • Used by corporations to raise capital • Firms have a choice when they raise capital: • Debt (bonds) • Equity (stock) • Firms seek to minimize their overall capital costs (capital structure decision)

  10. Municipal Bonds • Issued by state and local governments • Streets, highways, hospitals, schools, sewer systems • General Obligation Bonds • Projects that benefit the entire community • Repaid through tax revenues • Revenue Bonds • Projects that benefit certain groups, such as toll roads and airports • Repaid from user fees • Interest is tax-free

  11. Other Bonds and Bond-based Securities • Treasury Inflation Protected Securities (TIPS) • These were first issued in 1997 • They have fixed coupon rates • They are indexed to inflation • The federal government adjusts the par value to adjust for inflation reflected by changes in the CPI • As the par value changes over time, so do the interest payments • The total return from TIPS comes from the interest payments and the inflation adjustment to par value

  12. Reading Bond Quotes • Volume of trading in Treasury bonds and notes is huge • Average over a half billion dollars daily • Trading in corporate bonds and municipals is much less active

  13. Treasury bonds are quoted in 32s of a percent • Example: a quoted price of 105:19 means 105 and 19/32 percent, or 105.594% of par. This translates into a dollar price of $1,055.94. • Bid price, Ask price, Bid-Ask spread • Premium bonds - sell at premium • Discount bonds - sell at discount • Sell at par

  14. Corporate bonds quotes are listed as a percentage of par • Example: a quote of 97.876 -> price $978.76 • Corporate bonds are riskier than Treasuries • Coupon rate (default risk, maturity, market interest rate) • In the U.S., corporate bonds typically pay their coupons semiannually. • Example: pays $55.70 per year, or $27.85 every six months

  15. Municipal bonds are quoted in terms of percent of par • Municipal bonds often have a par value of $5,000 rather than $1,000 • Example: a quote of 100.46 translates into a dollar price of (1.0046 x $5,000) = $5,002.30

  16. Bond Valuation The value of a bond represents the present value of future cash flows. Bonds are easier to value than stocks because in the case of bonds, the cash flows are known Investors also know the time remaining to maturity, and the prevailing market interest rate for bonds of similar risk

  17. 0 1000 INPUT 40 3 N I/YR PV PMT FV OUTPUT 306.56 Zero Coupon Bond • Zero coupon bonds sell at a substantial discount to par • Example: Par value = $1,000; maturity = 20 years from now; discount rate = 6% (assume semi-annual compounding)

  18. 35 1000 INPUT 40 3 N I/YR PV PMT FV OUTPUT 1,115.37 What if it is an ordinary bond that pays a 7 percent coupon

  19. Bond Prices and Interest Rate Risk A bond’s interest payments and par value are fixed Interest rates rise Bond prices fall Interest rates fall Bond prices rise

  20. 25 1000 INPUT 30 4.5 N I/YR PV PMT FV OUTPUT 674.22 • Example: • 5% bonds, semiannual compounding • 15 years to maturity • Par value = $1,000 • Required yield to maturity = 9%

  21. 25 1000 INPUT 10 4.5 N I/YR PV PMT FV OUTPUT 841.75 Same problem, but now the time to maturity is only 5 years: The amount of the discount is much less for the 5-year bond versus the 15-year bond

  22. 35 1000 INPUT 60 3 N I/YR PV PMT FV OUTPUT 1,138.38 The size of a bond’s coupon also affects its interest rate risk The larger the coupon, the less the bond’s price changes when interest rates change Example: 30 year maturity, 7% semiannual coupons, 6% yield to maturity, $1,000 par

  23. 35 1000 INPUT 60 3.5 N I/YR PV PMT FV 1,000 OUTPUT Now let’s say interest rates increase by 1% so that the yield to maturity equals 7% So the price changed by 1,138.38 – 1,000 = 138.38, or a decrease of 12.16%

  24. Same problem, interest rates increase from 6% to 7%, coupon rate 10%: • The price percentage change is smaller: • Price change = 1,553.51 – 1,374.17 = 179.34, or a 11.5% decrease • Reinvestment rate risk • Bondholders with higher coupon bonds can take those coupons and reinvest them at the new interest rate, thus offsetting a portion of the effect on price

  25. Term Structure of Interest Rates Yield Curve Different interest rates apply to bonds with different terms to maturity

  26. Bond Yields • Current Yield • Current yield measure the portion of total return that is due to the coupon interest payments • It ignores the portion of return due to price changes, or capital gains

  27. -1150 35 1000 INPUT 16 N I/YR PV PMT FV OUTPUT 2.363 Yield to Maturity (YTM) YTM measures the total return to the bond holder if the bond is held to maturity • It takes into account both the price paid for the bond and the amount of coupon interest • Example: Coupon rate = 7%, semiannual, 8 years left to maturity, current price = $1,150. What is the yield to maturity?

  28. However, this 2.363 yield is for a 6-month period. We must convert this into an annual return • YTM = 2.363 x 2 = 4.73% • Bond prices and yields are inversely related • As a bond price falls, its YTM increases • Premium Bonds have a YTM less than coupon rate • Discount Bonds have a YTM greater than coupon rate

  29. Callable Bond • The issuer “calls” the bonds back prior to maturity • Advantage for the issuer, but a disadvantage for the investor • Pays the principal plus a call premium, which is usually one year’s worth of interest payments • Allows the issuing firm to refinance when interest rates fall

  30. Yield to Call (YTC) • The YTM calculation assumes that the bond is held to maturity • What if the bond is called by the issuer prior to maturity? The investor would receive only the coupon payments up to the point of call, plus the call price • The return from when the bond is purchased to when the bond is called is YTC.

  31. -1106.38 35 1070 INPUT 10 N I/YR PV PMT FV OUTPUT 2.875 • YTC = 2 x 2.875 = 5.75% • Example: • 20-year bond with 7 percent coupons, semiannual • The bond can be called in 5 years at a call price of $1,070 • The bond’s market price is $1,106.38.

  32. Municipal Bonds and Yield • Municipal bonds appear to offer low yields compared with corporate bonds and Treasury securities. • This is because the interest from municipal bonds is tax exempt at the federal level, and generally at the state level as well • In order to compare yields, we must compute the after-tax yield on municipal bonds

  33. Equivalent Taxable Yield • Example: Pre-tax yield on municipal bond is 5%, and investor’s marginal tax rate is 35% • Equivalent taxable yield = 5 / (1-.35) = 7.69% • Municipal bonds are more attractive to high-income investors (with high marginal tax rates)

  34. Credit Risk • Bond Ratings • Measure of an issuer’s credit quality • Bond rating agencies, such as Moody’s and Standard & Poor’s, monitor debt and report their findings as a grade, or rating • Investment grade • Junk bond (speculative bond) • Bonds are sometimes downgraded or upgraded based on changing conditions “Fallen Angels”

  35. Bond Markets • The majority of bond trading occurs in a decentralized, over-the-counter market, a small number of corporate bonds are listed on centralized exchanges such as the NYSE • Most trades occur between bond dealers and large institutional investors such as mutual funds, pension funds, and insurance companies • Bond Indexes track bond price and yield changes • Lehman Brothers Aggregate Bond Index • Merrill Lynch Taxable Bond Index • Bond Buyer Municipal Bond Index

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