time value of money - valuing debt instruments Flashcards
What are Debt Instruments?
Debt instruments allow firms and governments to borrow money from investors and, therefore, they are issued in order to raise funds for operations. Further, debt instruments have contractually agreed upon terms for:
–Interest payments; and,
–The repayment of the debt.
Types of Debt Instruments
what is the price of these instruments equal to?
–Coupon-paying bonds; and,
–Zero-coupon bonds (types of discount securities): Note that instruments such as bills are examples of **short-term zero-coupon bonds. **
equal to the present value of all cash flows associated with the instrument.
Coupon-Paying Bonds:
coupon-paying bond is a contract under which the borrower agrees to:
–Pay the lender periodic interest (c) for a pre-defined number (n) periods. More specifically:
- •The periodic interest payment is known as a coupon payment (C), which is equal to the coupon rate multiplied by the face value (or cF); and,
•Coupons are almost always paid on a semi-annual basis.
Repay the principal (or face value, F) of the instrument at a pre-defined maturity date
Cash Flows Associated with Coupon-Paying Bonds:
Zero-Coupon Bonds:
zero coupon bond does not pay coupons during its life. Instead, only the face value (F) is repaid at the end of n periods
–Because no coupon payments are made, these instruments are issued for a price below their face value;
–The difference between the issue price and the face value represents the interest accruing to the holder of the instrument over its life; and,
–Because zero-coupon bonds are always issued for a price lower than their face value, they are also known as discount securities.
Cash Flows Associated with Zero-Coupon Bonds
the main types of bonds issued by two major issuers namely
–Governments; and,
–Corporations.
government debt securities are issued by
Whose obligations are they?
The Treasury Department
these securities are obligations of the Commonwealth Government, thus considered to have no default risk
. The two main types of debt instruments issued by the Australian Government are:
- Treasury Notes
- Treasury bonds
what are treasury notes?
: These are zero-coupon bonds with maturities of up to 6 months. Therefore, treasury notes only involve the repayment of the face value at maturity; and
what are treasury bonds?
- These are coupon-paying bonds
- maturities of up to 10 years.
- payment of regular (six-monthly) coupons as well as the repayment of the face value at maturity.
four major types of corporate bonds
- Bank accepted bills
- mortgage bonds
- debentures
- convertible bonds
Bank Accepted Bills
- are short-term debt instruments that do not pay coupons
- the only cash flow is the repayment of face value at the bill’s maturity
-Typically having maturities of 90 days to 180 days
–the repayment of the face value at maturity is guaranteed by the accepting bank
Mortgage bonds
- secured by property including real estate or buildings.
- in the event of default, the property can be sold and the proceeds used to repay bond holders
Debentures:
coupon bonds which, similar to mortgage bonds, are secured by tangible assets
Convertible bonds
are debt instruments that can be exchanged for shares in the corporation
price of a coupon-paying bond (B) given a required rate of return on debt or yield equal to rd is simply calculated
Bond prices that are quoted in the financial media follow a several important reporting conventions, including
–Face value amounts: Bond prices are quoted as if the face value was $100. Therefore, if a bond with a face value of $100,000 has a reported price of 95.00, its actual value is 95% of $100,000 or $95,000; and,
–Coupon payments: The majority of coupon-paying bonds pay coupons semi-annually. Further, coupon rates and yields are quoted as annual nominal rates compounded semi-annually.
unless told otherwise
–assume coupons are paid semi-annually and face value is $100.
How to determine whether a bond’s price will exceed its face value?
by comparing its percentage yield to it’s percentage coupon rate.
–c > rd if and only if B > F;
–c = rd if and only if B = F; and,
–c < rd if and only if B < F.
how to calculate C (Coupon Payment)?
C= Coupon rate x Face value / Number of coupon payments per year
the price of a zero-coupon bond maturing in n periods is calculated as follows:
Quotation Conventions for Zero-Coupon Bonds:
–Face Value: As was the case with coupon-paying bonds, zero coupon bond prices are quoted as if the face value is $100; and,
–Bank Accepted Bill Yields: Bank Accepted Bill Yields are quoted on a nominal basis, with the price able to be computed simply by discounting the face value of the bill at the periodic rate.
The price of a zero-coupon bond that matures in 3 years given a required return of 10% p.a. is calculated as:
The price of a 90-day bank accepted bill quoted as having a yield of 8% p.a. is calculated as:
- 10 year bond yield
- . 5 year bond yield
- 180 day dealers bill rate
- 90 day dealers bill rate
what is a bond?
a debt instrument
- issued by borrower, who promises to pay coupons to the bondholder, in addition to the face value when the bond matures
what is par value?
face value
this is the amount the bond issuer has to pay to the bondholder on the maturity date
what are other terminologies for required rate of return?
rd
expected rate of return
yield to maturity
discount rate
what are zero coupon bonds also called?
pure discount bonds, as they always trade at a discount (price below face value)
what are treasury-indexed bonds?
medium-long term securities for which the face value of the security is adjusted for movements in CPI
what does it mean when a bonds is traded at par?
the price of the bond is close to or at par (at the bond’s face value)
benefit for investor if they purchase a bond that is at discount (below par)?
investor will earn a return from
- receiving coupons
- receiving a face value> price paid for bond
when the bond price is above par or at a premium,
coupon rate > yield to maturity (required rate of return)
when the bond price is below par or at a discount,
coupon rate < yield to maturity
what happens when interest rate rises?
Interest rates rise, bond yields rise
as a higher discount rate is applied to bond’s remaining cash flows –> present value is reduced –> fall in bond’s price
what happens to the bond prices when interest rate falls?
investors demand a lower yield to maturity –> reducing the discount rate applied to the bond’s cash flows and raising the bond price
relationship between the coupon rate of bond and its yield to maturity
when coupon rate of the bond is > yield to maturity, it is trading at a premium
coupn rate= yield to maturity, trades at par
Coupon rate < yield to maturity, trades at a discount
why are Australian securities risk free?
no chance government will fail to pay the interest and default on bonds
what is the risk of default?
what is used to compensate this?
credit risk
yield of bonds with credit risk will be higher to compensate for the credit risk, also investors pay less for bonds with credit risk
what are bonds in the top four categories referred to?
- investment grade bonds (low default risk)
what are bonds in the bottom 5 categories referred to?
- speculative bonds
- Junk bonds
- High-yield bonds
Due to high risk of default
what does the bond rating depend on?
risk of bankrupty
whether the bondholder has made a claim on the firm’s assets in the event of bankruptcy
what is credit or default spread?
difference between the yields of the corporate bonds and that of the Treasury’s
as creditworthiness of corporate bonds decrease –> credit spread on the bonds increase
what is yield to maturity?
rate of return of investing in the bond and holding it to maturity
What will happen to the price of the bond immediately after a coupon is paid? Why?
The price of the bond will fall by exactly $4.00. This is because the price of the instrument is the present value of the future cash flows given by the instrument. Immediately before the coupon payment, the price would reflect the imminent coupon payment of $4.00 (as it is about to be paid, the present value of this cash flow is $4.00). Following the coupon payment, it would no longer form part of the future cash flows of the instrument and this would be reflected by the price decreasing by $4.00.
if your share is 9.50 and the shares in VC Limited are currently trading at $10.00, do they represent a good investment from your perspective? Why?
No, they don’t as the value to you of a share in VC Limited is $9.50 (ie this is what you would be willing to pay for a share in the company), but they are trading at a price higher than this, namely $10.00.
