Bonds, Bond Valuation and interest rate

Question 1

What is a bond?

Answer 1

A bond is a long-term contract under which a borrower agrees to make payments of interest and principal, on specific dates, to the holders of the bond.

Question 2

Key Features of a bond

Answer 2

• Par value: Face value/amount; is the borrowed amount repaid at maturity.
• Coupon interest rate: Stated interest rate. Generally,
  fixed for the whole life of the bond.
  →Floating-rate bonds: often tied to gov. bond rates, LIBOR, caps & floors
  → Zero coupon bonds: no coupon, but offered at a discount below par value
• Maturity: Years until bond must be repaid. Declines.
• Issue date: Date when bond was issued.
• Default: Risk that issuer will not make interest or principal payments → credit (default) risk

Question 3

Call Provision

Answer 3

• Most corporate bonds contain a call provision, which gives the issuing corporation the right to call the bonds for redemption.
• The call provision/premium generally states that the company must pay the bondholders an amount greater than the par value if they are called. (It is often set equal to 1 year’s interest if the bonds are called during the first year)
• Most bonds have a deferred call (= not callable until several years) and a declining call premium

Question 4

Redeem Bond

Answer 4

• Bonds that are redeemable at par protect an investor against a rise in interest rates
• If interest rates rise, the price of a fixed rate bond declines
• If holders turn in the bonds, they can reinvest the proceeds at higher rates

Question 5

What is a sinking fund?

Answer 5

• Some bonds include a sinking fund provision to pay
  off a loan over its life rather than all at maturity.
• Similar to amortization on a term loan.
• Shortens average maturity.
• Call x% at par per year for sinking fund purposes.
• Buy bonds on open market.

Question 6

Bond valuation

Answer 6

Slide 12-15

Question 7

Bond Value ($) vs. Years remaining to maturity

Answer 7

• New issue vs. outstanding bond / seasoned issue
• Microdrive: The in the bond placement involved investment bankers defined the par value at 1,000$ with a maturity of 15 years and estimated the coupon rate at 9%.

Question 8

changes in bond value of fixed-rate bonds over time

Answer 8

– At maturity, the value of any fixed-rate bond must equal its par value.
– The value of a premium bond would decrease to $1,000.
– The value of a discount bond would increase to $1,000.
– A par bond stays at $1,000 if rd remains constant.
Slide 17-18

Question 9

What’s “yield to maturity”?

Answer 9

• Yield to maturity (YTM) is the rate of return earned on a bond held to maturity.
• Also called “promised yield.”
• It assumes the bond will not default.

Question 10

Pricing of bonds

Answer 10

• If coupon rate < rd, bond sells at a discount.
• If coupon rate = rd, bond sells at its par value.
• If coupon rate > rd, bond sells at a premium.
• If rd rises, the bond price falls.
• If rd declines, the bond price increases.
• Price = par at maturity.

Question 11

Yield to maturity = expected total return

Answer 11

Formula : Slide 25

Question 12

Callable Bonds and Yield to Call

Answer 12

• If bond is callable bond and the firm called it, the investor would not have the option of holding the bond until it matured → YTM would not be earned!
• Yield to call
• If interest rates fall, likely that the firm would call
  → its debt can be financed by new bonds at lower rates

Question 13

Assessing Risk Formula

Answer 13

Slide 36

Question 14

What is the real risk-free rate?

Answer 14

• Rate that a hypothetical riskless security pays each moment if zero inflation were expected.
• r* changes over time depending on economic conditions.
• r* can be approximated e.g. by rate on short-term Treasury Inflation-Protected Securities (TIPS).

Question 15

What is the nominal risk-free rate?

Answer 15

• The rate on a government bond – e.g. Bundesschatz, U.S. Treasury security
• > Short-term security: T-bill
• > Long-term security: T-bond

Question 16

Estimating IP

Answer 16

• Estimation based on government bonds: differential between unprotected and inflation- indexed securities – e.g. Treasury Inflation- Protected Securities (TIPS) are indexed to inflation.
• The IP for a particular length maturity can be approximated as the difference between the yield on a non-indexed Treasury security of that maturity minus the yield on a TIPS of that maturity.

Question 17

Bond spreads:

Answer 17

A “bond spread” is often calculated as the difference between a corporate bond’s yield and a Treasury security’s yield of the same maturity. Therefore:
Spread = DRP + LP.

Question 18

Bond ratings

Answer 18

Slide 41-42

Question 19

What factors affect default risk and bond ratings?

Answer 19

Financial ratios

• Debt ratio
• Coverage ratios, such as interest coverage ratio or EBITDA coverage ratio
• Profitability ratios
• Current ratios

Question 20

Other factory that affect bond ratings

Answer 20

Provisions in the bond contract

• Secured versus unsecured debt
• Senior versus subordinated debt
• Guarantee provisions
• Sinking fund provisions
• Debt maturity

Question 21

Other factors that affect bond ratings

Answer 21

• Earnings stability
• Regulatory environment
• Potential product liability
• Accounting policies

Question 22

What is reinvestment rate risk?

Answer 22

The risk that CFs will have to be reinvested in the future at lower rates, reducing income.

Question 23

The maturity risk premium

Answer 23

• Long-term bonds: High interest rate risk, low reinvestment rate risk.
• Short-term bonds: Low interest rate risk, high reinvestment rate risk.
• Nothing is riskless!
• Yields on longer term bonds usually are greater than on shorter term bonds, so the MRP is more affected by interest rate risk than by reinvestment rate risk.

Question 24

Term Structure Yield Curve

Answer 24

• Term structure of interest rates:
  the relationship between interest rates (or yields) and maturities.
• A graph of the term structure is called the yield curve.

Question 25

Credit default

Answer 25

• Arrears - delay of payment
• Bankruptcy
• > Rescheduling of debt and reorganization
• > Liquidation
• Typically, company and creditors prefer different solutions.

Question 26

If the company is liquidated , what are the payment priority?

Answer 26

• Past due property taxes
• Secured creditors from sales of secured assets.
• Trustee’s costs
• Expenses incurred after bankruptcy filing
• Wages and unpaid benefit contributions, subject to limits
• Unsecured customer deposits, subject to limits
• Taxes
• Unfunded pension liabilities
• Unsecured creditors
• Preferred stock Common stock

Question 27

Bankruptcy

Answer 27

• 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.