lecture 5: characteristics and valuation of bonds Flashcards
bonds (meaning)
-type of debt or long-term promissory note. issued by borrowers, promising to its holder a predetermined and fixed amount of interest/ year and repayment of principal at maturity
-issued by corps/ gov
debenture
-form of corporate debt backed only by the promise of the borrower to pay and not mortgage/ lien on any specific property
-for an issuing firm- debentures provide benefit of not tying up assets as collateral
-for bondholders, debentures are more risky than secured bonds and provide higher yield than secured
subordinate debentures
-hierarchy of payout in case of insolvency
-claims of subordinate debentures are honoured only after claims of secured debt and unsubordinated debentures have been paid
mortgage bonds
-secured by lien on a real property
-typically, value of real property is greater than that of bond issued, providing bondholders a margin of safety
eurobonds
-issued in a country different from the one in whose currency bond is denominated
-e.g. bond issued by American corporation in Japan that pays interest and principle in dollars
convertible bonds
debt securities that can be converted to a firm’s stock at a pre-specified price
claims on assets/income
-seniority in claims: in case of insolvency, claims of debt are generally honoured before common stock
Par value (face value)
-face value of bond, returned to the bondholder at maturity
-in general, corporate bonds are issued at denominations or par value of $1000 in US, or £100 in UK
-prices are represented as a % of face value. thus, a bond quoted at 104% can be bought at 104% of its par value in the market. bonds will return the par value at maturity, regardless of price paid at time of purchase
coupon and coupon rate
-coupon: stated interest payment made on a bond
-coupon rate: % of the par value of the bond that will be paid periodically in the form of interest
-e.g. a bond with $1000 par value and 5% annual coupon rate will pay $50 annually (0.05x1000= 5% coupon rate)
0 coupon bonds
have 0 or very low coupon rate. instead of paying interest, these bonds are issued at a substantial discount value below face or par value
maturity
-length of time until bond issuer return the par value to the bondholder and terminates or redeems the bond
call provision
-gives a corporation the option to redeem the bonds before the maturity date. e.g. if the prevailing interest rate declines, the firm may want to pay off the bonds early and reissue at a more favourable interest rate
-to do so, the bond must be callable/redeemable
-issuer must pay the bondholder a premium (1 years interest e.g.
-there is also a call protection period where the firm cannot call the bond for a specified period of time
bond ratings
-reflect future risk potential of bonds
-Standard % Poors, Moody’s and Fitch Investor Services
-lower bond rating indicates higher probability of default, it also means that the rate of return demanded by the capital markets will be higher on such bonds
factors having a favourable effect on bond ratings
-greater reliance on equity as opposed to debt in financing the firm
-profitable operations
-low variability in past earnings
-large firm size
-little use of subordinated debt
junk bonds
-high-risk with ratings of BB or below by Moody’s and S&P
-referred to as high-yield bonds because they pay a high interest rate, generally 3-5% more than AAA rated bonds
defining value
-book value: value of an asset as shown on a firm’s balance sheet
-liquidation value: dollar sum that could be realised if an asset were sold individually and not as part of a going concern
-market value: observed value for the asset in the marketplace
-intrinsic or economic value: also called fair value- represents the present value of the asset’s expected future cash flows
value and efficient markets
in an efficient market, the values of all securities at any instant fully reflect all available public information
-if the markets are efficient, the market value and the intrinsic value will be the same
-the field of behavioural finance studies irrationality of investors
what determines value
-for our purpose, the value of an asset is its intrinsic valye, or the present value of its expected future cash flows using investor’s required rate of return as the discount rate
-thus value is affected by 3 elements: amount and timing of assets expected future cash flows, riskiness of cash flows, investors required rate of return for undertaking investment
bond valuation pixie example 1
-Pixie has bond with face value 1k and 10 years to maturity. annual coupon of £80
-annual coupon is ordinary annuity, 1k is future value
-PV of annuity= 80(1-1/0.08^10)/0.08
-PV of face value=1000/1.08^10
-bond value is them added up
bond valuation- general principle
a bond value is given by present value of face value at maturity plus present value of annuity formed by coupon payments
bond value formula
C[1-(1/(1+r)^t)]/r x F/(1+r)^t
-f is face value paid at maturity, C is coupon paid per period, t is period to maturity, r is required rate of return
bond yields
-yield to maturity refers to the rate of return the investor will earn if the bond is held to maturity. YTM also known as bondholder’s expected rate of return
-YTM= discount rate that equates the present value of the future cash flows with current market price of the bond
-when referring to bonds, the terms expected rate of return and yield to maturity are often used interchangably
current yield
-ratio of interest payment to the bond’s current market price
-current yield=annual interest payment/current market price of the bond
bond valuation: three relationshps
1) value of bond is inversely related to changes in the investor’s present required rate of return. as interest rates increase, value of bond decreases
2) market value of a bond will be less than the par value if the investor’s required rate of return is above the coupon interest rates- known as discount bonds. bonds will be valued above par value if the investor’s required rate of return is below the coupon interest rate- known as premium bonds. if investors required rate of return is equal to the coupon interest rate, the bonds will be at par value
3) long-term bonds have greater interest rate risk than do short-term bonds. a change in interest rate will have relatively greater impact on long-term bonds
main risks for bondholder
-interest rate risk: if interest rates rise, the market value of bonds will fall
-default risk: this may mean no or partial payment on debt as in bankruptcy cases
-call risk: if bonds are called before maturity date; bonds are generally called when interest rates decrease. thus, investors will have to reinvest the money received from the corporation at a lower rate
