Chapter 6 Valuation and Characteristics of Bonds

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Chapter 6 Valuation and Characteristics of Bonds
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LEARNNG OBJECTIVESAfter reading this chapter you
should be able to1.      Distinguish between
different kinds of bonds.2.      Explain the
more popular features of bonds.3.      Define
the term value as used for several different
purposes.4.      Describe the basic process for
valuing assets.5.      Estimate the value of a
bond.6.      Compute a bondholders expected
rate of return.7.      Explain three important
relationships that exist in bond valuation.
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OBJECTIVE 1 TYPES OF BONDS A
bond is a type of debt or long-term promissory
note, issued by the borrower, promising to pay
its holder a predetermined and fixed amount of
interest per year. However, there are a wide
variety of such creatures. Just to mention a few,
we have Debentures
Subordinated debentures
Mortgage bonds Eurobonds
Zero and very low coupon
bonds Junk bondsWe will
briefly explain each of these types of bonds.
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Debentures The term debentures applied
to any unsecured long-term debt. Subordinated
debentures Many firms have more than one
issue of debentures outstanding. In this
case a hierarchy may be specified, in which some
debentures are given subordinated standing in
case of insolvency. Mortgage bonds A
mortgage bond is a bond secured by a lien on real
property. Eurobonds Eurobonds are not so
much a different type of security as they are
securities, in this case bonds, issued in a
country different from the one in whose currency
the bond is denominated.
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Zero and very low coupon bonds Zero and
very low coupon bonds allow the issuing firm to
issue bonds at a substantial discount from their
1,000 face value with a zero or very low coupon
rate. Junk bonds Junk bonds are
high-risk debt with ratings of BB or below by
Moodys and Standard and Poors. Junk bonds are
also called high-yield bonds for the high
interest rates they pay the investor, typically
having an interesting rate of between 3 and 5
percent more than AAA grade long-term debt.
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BACK TO THE FUNDATIONS Axiom 1 The
Risk-Return Trade-offWe Wont Take on
Additional Risk Unless We Except to be
Compensated with Additional Return.
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OBJECTIVE 2

TERMINOLOGY AND CHARACTERISTICS OF BONDS
Some of the more important terms and
characteristics that you might hear about bonds
are as follows?Claims on assets and income?Par
value?Coupon interest rate?Maturity?Indenture?
Current yield?Bond ratingsLets consider each
in turn.
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Claims on Assets and Income In the case
of insolvency, claims of debt in general,
including bonds, are honored before those of both
common stock and preferred stock. However,
different types of debt may also have a hierarchy
among themselves as to the order of their claim
on assets. Bonds also have a claim on
income that comes ahead of common and preferred
stock. In general if interest on bonds is not
paid, the bond trustees can classify the firm as
insolvent and force it into bankruptcy. Thus, the
bondholders claim on income is more likely to be
honored than that of common and preferred
stockholders, whose dividends are paid at the
discretion of the firms management.
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Par value The par value of a bond is its
face value that is returned the bondholder at
maturity. Coupon Interest Rate The
coupon interest rate on a bond indicates the
percentage of the par value of the bond that will
be paid out annually in the form of interest.
Maturity The maturity of a bond
indicates the length of time until the bond
issuer returns the par value to the bondholder
and terminates or redeems the bond.
IndentureAn Indenture is the legal agreement
between the firm issuing the bonds and the bond
trustee who represents the bondholders.
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Current yield The current yield on a bond
refers to the ratio of the annual interest
payment to the bonds current market price.
Bond Ratings These ratings involve a
judgment about the future risk potential of the
bond.Bond ratings are favorably affected by (1)
a greater reliance on equity as opposed to debt
in financing the firm, (2) profitable
operations, (3) a low variability in past
earnings, (4) large firm size, and (5) little
use of subordinated debt. The poorer the bond
rating, the higher the rate of return demanded in
the capital markets. Table 6-1 provides an
example and description of these ratings.
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Table 6-1 Standard and
Poors Corporate Bond RatingsAAA This is the
highest rating assigned by Standard and Poors
for debt obligation and indicates an extremely
strong capacity to pay principal and interest.AA
Bonds rated AA also qualify as
high-quality debt obligations. Their capacity to
pay principal and interest is very strong, and in
the majority of instances they differ from AAA
issues only in small degree.A Bonds
rated A have a strong capacity to pay principal
and interest, although they are somewhat
susceptible to the adverse effects of changes in
circumstances and economic conditions.BBB
Bonds rated BBB are regarded as having an
adequate capacity to pay principal and interest.
Whereas they normally exhibit adequate protection
parameters, adverse economic conditions or
changing circumstances are more likely to lead to
a weakened capacity to pay principal and interest
for bonds in this category than for bonds n the A
category.BB Bonds rated BB, B, CCC, and CC
are regarded, on balance, as B
predominantly speculative with respect to the
issuers capacity to payCCC interest and
repay principal in accordance with the terms of
the obligation.CC BB indicates the lowest
degree of speculation and CC the highest. While
such bonds will likely have some quality and
protective characteristics, these are outweighed
by large uncertainties or major risk exposures to
adverse conditions.C The rating C is
reserved for income bonds on which no interest is
being paidD Bonds rated D are in
default, and payment of principal and/or interest
is in arrears. Plus () or Minus (-) To provide
more detailed indications of credit quality,the
ratings from AA to BB may be modified by the
addition of a plus or minus sign to show relative
standing within the major rating categories.
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OBJECTIVE 3 DEFINITIONS OF VALUEBook value is
the value of an asset as shown on a firms
balance sheet. Liquidation value is the dollar
sum that could be realized if an asset were sold
individually and not as part of a going concern.
The intrinsic or economic value of an asset
,also called the fair value is the present
value of the assets expected future cash flows.
This value is the amount an investor should be
willing to pay, given the amount, timing, and
riskiness of future cash flows.
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BACK TO THE FUNDATIONSAxiom 6 Efficient Capital
MarketsThe Markets Are Quick and the Prices Are
Right. In an efficient market, the price reflects
all available public information about the
security, and therefore it is priced fairly.
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VALUATION AN OVERVIEWFor our purposes, the
value of an asset is its intrinsic value or the
present value of its expected future cash flows,
where these cash flows are discounted back to the
present using the investor's required rate of
return. This statement is true for valuing all
assets and serves as the basis of almost all that
we do in finance. Thus, value is affected by
three elements 1. The amount and timing of
the asset's expected cash flows 2. The
riskiness of these cash flows 3. The
investor's required rate of return for
undertaking the investment
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BACK TO THE FUNDATIONSAxiom 1 The Risk-Return
Trade-off--We Wont Take on Additional Risk
Unless We Expect to Be Compensated With
Additional Return. Axiom 2 The Time Value of
Money--A Dollar Received Today Is Worth More Than
a Dollar Received in the Future.Axiom 3
CashNot Profits--is King.
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The value of an asset involves 1. Assessing
the asset's characteristics, which include the
amount and timing of the expected cash flows and
the riskiness of these cash flows
2.Determining the investor's required rate of
return, which embodies the investor's attitude
about assuming risk and perception of the
riskiness of the asset and 3. Discounting
the expected cash flows back to the present,
using the investors required rate of return as
the discount rate.
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OBJECTIVE 4 VALUATION THE BACIS PROCESS A
basic security valuation model can be defined
mathematically as follows
V C1/(1k)1 C2/(1k)2 Cn
/(1k)n (6-2)where Ct cash
flow to be received at time t
V the intrinsic value or present value of an
asset producing expected future cash flows, Ct,
in years 1 through n Kthe
investors required rate of return
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• Using equation (6-2), there are three basic steps
  in the valuation process Step l Estimate the
  Ct in equation (6-2), which is the amount and
  timing of the future cash flows the security is
  expected to provide.Step 2 Determine k, the
  investor's required rate of return.Step 3
  Calculate the intrinsic value, V, as the present
  value of expected future cash flows discounted at
  the investor's required rate of return.

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OBJECTIVE 5 BOND VALUTIONThe valuation process
for a bond, as depicted in Figure 6-2, requires
knowledge of three essential elements (1)the
amount of the cash flows to be received by the
investor, (2)the maturity date of the loan, and
(3)the investors required rate of return.
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EXAMPLEConsider a bond issued by American
Airlines with a maturity date of 2016 and a
stated coupon rate of 9 percent. In 1996, with 20
years left to maturity, investors owning the
bonds were requiring an 8.4 percent rate of
return. We can calculate the value of the bonds
to these investors using the following three-step
valuation procedure Step 1 Estimate the
amount and timing of the expected future cash
flows. Two type of cash flows are received by the
bondholder a.      Annual interest payments
equal to the coupon rate of interest times the
face value of the bond. In this example the
bonds coupon interest rate is 9 percent thus
the annual interest payment is 900.091,000.
Assuming that 1996 interest payments have already
been made, these cash flows will be received by
the bondholder in each of the 20 years before the
bond matures (1997 through 2016 20 years).
Figure 6-2 Data Requirements for Bond
Valuation b. The face value of the bond
of l,000 to be received in 2016. To summarize,
the cash flows received by the bondholder are as
follows
YEARS 1 2
3 4 19 20
90 90 90 90
90 90
1,000

1,090
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Step 2 Determine the investor's required rate
of return by evaluating the riskiness of the
bond's future cash flows. An 8.4 percent required
rate of return for the bondholders is given. In
Chapter 8, we will learn how this rate is
determined. For now, simply realize that the
investors required rate of return is equal to a
rate earned on a risk-free security plus a risk
premium for assuming risk. Step 3 Calculate
the intrinsic value of the bond as the present
value of the expected future interest and
principal payments discounted at the investor's
required rate of return. The present value of
American Airlines bonds is found as followsbond
value Vb interest in yare 1/(1required rate
of return)1 interest in year
2/(1required rate of return)2
(6-3a) interest
in year 20/(1required rate of return)20
par value of bond/(1required rate of
return)20
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Semiannual Interest PaymentsIn the preceding
American Airlines illustration, the interest
payments were assumed to be paid annually.
However, companies typically pay interest to
bondholders semi-annually. First, thinking in
terms of periods instead of years, a bond with a
life of n years paying interest semiannually has
a life of 2n periods. In other words, a five-year
bond (n5) that remits its interest on a
semiannual basis actually, makes 10 payments. Yet
although the number of periods has doubled, the
dollar amount of interest being sent to the
investors for each period and the bondholders
required rate of return are half of the
equivalent annual figures. It becomes It /2 and
kb is changed to kb /2 thus, for semiannual
compounding, equation (6-3b) becomes

(6-4)
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Alternatively, using the notations introduced in
Chapter 5 for discounting cash flows, the above
equation may be restated as follows Vb
(It/2)(PVIFAkb/2,2n) M(PVIFkb/2,2n)
(6-5)
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OBJECTIVE 6 THE BONDHOLDERS EXPECTED RATE OF
RETURN (YIELD TO MATURITY)
To measure the bondholders
expected rate of return, kb, we would find the
discount rate that equates the present value of
the future cash flows (interest and maturity
value) with the current market price of the bond.
The expected rate of return for a bond is also
the rate of return the investor will earn if the
bond is to maturity, or the yield to maturity.
Thus, when referring to bonds, the terms expected
rate of return and yield to maturity are often
used interchangeably.
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To illustrate this concept, consider the
Brister Corporations bonds, which are selling
for 1100. The bonds carry a coupon interest rate
of 9 percent and mature in 10 years. (Remember,
the coupon rate determines the interest
payment----coupon ratepar value).In determining
the expected rate of return (kb), implicit in the
current market price, we need to find the rate
that discounts the anticipated cash flows back to
a present value of l,1 00, the current market
price (P0) for the bond. Finding the
expected rate of return for a bond using the
present value tables is done by trial and error.
We have to keep trying new rates until we find
the discount rate that results in the present
value of the future interest and maturity value
of the bond just equaling the current market
value of the bond. If the expected rate is
somewhere between rates in the present value
tables, we then must interpolate between the
rates.
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OBJECTIVE 7 BOND VALUATION THERE IMPORTANT
RELATIONSHIPSWe have now learned to find the
value of a bond (Vb), given (1) the mount of
interest payment (It),(2) the maturity value
(M), (3) the length of time to maturity (n
years), and (4) the investors required rate of
return, kb. .We also know how to compute the
expected rate of return (kb), which also happens
to be the current interest rate on the bond,
given (1) the current market value (P0), (2)
the amount of interest payments (It), (3) the
maturity value (M), and (4) the length of time
to maturity (n years). We now have the basics.
But lets go further in our understanding of bond
valuation by studying several important
relationships.
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First RelationshipThe value of a bond is
inversely related to changes in the investors
present required rate of return (the current
interest rate). In other words, as interest rates
increase (decrease), the value of the bond
decreases (increases). Second Relationship
The 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 rate but it
will be valued above par value if the investor's
required rate of return is below the coupon
interest rate. Third RelationshipLong-term
bonds have greater interest rate risk than do
short-term bonds.As already noted, a change in
current interest rates (required rate of return)
causes an inverse change in the market value of a
bond. However, the impact on value is greater for
long-term bonds than it is for short-term
bonds.In Figure 6-3 we observed the effect of
interest rate changes on a 5-year bond paying a
12 percent coupon interest rate.
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Figure 6-3 Value and Required Rates for a 5-Year
Bond at 12 Percent Coupon Rate\
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MARKET VALUE FOR A 12
COUPON-RATE BOND MATURING IN REOUIRED
RATE 5 YEARS 10 YEARS
9 1,116.80
1,192.16 12
1,000.00 1,000.00 15
899.24
849.28
Figure
6-4 Market Values of a 5-Year and a 10-Year Bond
at Different Required Rates
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THE END