BA 180.02 Corporate Finance

1
BA 180.02 Corporate Finance

• September 18, 2002

2
Todays Agenda

• Bonds Interest Rates
• Interest Rate Risk (contd)
• Indenture
• Bond Ratings (credit risk) and Types of Bonds
• Interest Rates in the Economy

3
Interest Rate Risk

• How does the value of a bond change as interest
  rates rise?
• Bond values are inversely related to interest
  rates (see slide 18 on Mondays handouts)
• Changes in bond values as interest rates change
  is known as interest rate risk
• How much interest rate risk does a bond have?
• It depends on the maturity of the bond (see slide
  21 on Mondays handouts)

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Contd

• Large portion of the value comes from the
  principal/face value
• At the extreme is a zero coupon bond, which
  returns all value at maturity.
• Thus, ceteris paribus, bonds with longer
  maturities or lower coupon rates will have
  greater interest rate risk
• Even small changes in interest rate will have a
  significant impact on present value due to
  compounding

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A Comparison of Bond Returns
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Eventually Bonds Price Hits the Par
7
A Reminder

• Why is yield to maturity (YTM) an important
  number in bond valuation?
• It is the rate which equates the market price of
  the bond with the value of the discounted cash
  flows. That is, YTM is related to the r in the
  bond equation formula. Actually for an annual
  coupon bond, YTM is itself the r in the
  formula.
• Finding the YTM requires a financial calculator,
  a goal-seeking solver, or trial and error.

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Bond Valuation and Risk

• So far we have ignored risk in valuing the bonds
• We will now discuss qualitatively the types of
  risk a bondholder faces
• Quantification of the price impact due to risk is
  still coming
• In all cases, adding risk to a security increases
  the required, or expected, return
• This implies that an increase in the risk of a
  bond will lower its current price

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Types of Risk Bondholders Face

• Interest Rate Risk
• The risk of a bond changing in value when
  interest rates change. This affects all bonds
  regardless of credit quality, but is more severe
  for longer maturity bonds.
• Reinvestment Risk
• The risk that investors will be unable to
  reinvest the coupon payments at the coupon rate.
  This is more important for high coupon bonds.
• Default (Credit) Risk
• The risk that the firm will go bankrupt and not
  make all payments to bondholders.
• Other Risks Inflation, Call, Liquidity

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Features of a May Department Stores Bond
Term
Explanation Coupon payment dates 2/1, 8/1 Coupons
of 83.75/2 41.875 will be paid on these
dates. Security None The bonds are
debentures. Sinking fund Annual The firm will
make annual payments beginning 8/1/05 toward
the sinking fund. Call provision Not callable
The bonds have a deferred call feature. before
8/1/04 Call price 104.188 initially, After
8/1/04, the company can buy back declining to
100 the bonds for 1,041.88 per bond,
declining to 1,000 on 8/1/14. Rating Moodys
A2 This is one of Moodys higher ratings The
bonds have a low probability ofdefault.
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The Bond Indenture

• The bond indenture is a three-party contract
  between the bond issuer, the bondholders, and the
  trustee. The trustee is hired by the issuer to
  protect the bondholders interests. (What do you
  think would happen if an issuer refused to hire a
  trustee?)
• The indenture includes
• The basic terms of the bond issue
• The total amount of bonds issued
• A description of the security
• The repayment arrangements
• The call provisions
• Details of the protective covenants

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Terms Specified in the Indenture

• Terms of a Bond
• Security
• Seniority
• Repayment
• Call Provision
• Protective Covenants

13
Bond Ratings

• 
  
  
• Low Quality, speculative,
  Investment-Quality Bond
  Ratings and/or Junk
• High Grade Medium Grade Low Grade Very Low
  Grade
• Standard Poors AAA AA A BBB BB B CCC CC C DMoo
  dys Aaa Aa A Baa Ba B Caa Ca C C
• Moodys SP
• Aaa AAA Debt rated Aaa and AAA has the highest
  rating. Capacity to pay interest and principal
  is extremely strong.
• Aa AA Debt rated Aa and AA has a very strong
  capacity to pay interest and repay principal.
  Together with the highest rating, this group
  comprises the high-grade bond class.
• A A Debt rated A has a strong capacity to pay
  interest and repay principal, although it is
  somewhat more susceptible to the adverse
  effects of changes in circumstances
  and economic conditions than debt in high
  rated categories.

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Bond Ratings (contd)

• Baa BBB Debt rated Baa and BBB is regarded as
  having an adequate capacity to pay interest
  and repay principal. Whereas it normally
  exhibits adequate protection parameters,
  adverse economic conditions or changing
  circumstances are more likely to lead to a
  weakened capacity to pay interest and repay
  principal for debt in this category than in
  higher rated categories. These bonds are
  medium-grade obligations.
• Ba, B BB, B Debt rated in these categories is
  regarded, on balance, as Ca, C CC,
  C predominantly speculative with respect to
  capacity to pay interest and repay principal
  in accordance with the terms of the
  obligation. BB and Ba indicate the lowest degree
  of speculation, and CC and Ca the highest
  degree of speculation. Although such debt will
  likely have some quality and protective
  characteristics, these are out-weighed by large
  uncertainties or major risk exposures to adverse
  conditions. Some issues may be in default.
• D D Debt rated D is in default, and payment of
  interest and/or repayment of principal is in
  arrears

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Types of Bonds

• Government Bonds
• Treasury
• State/Local
• Zero Coupon Bonds
• Floating Rate Bonds

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Bond Markets

• Most bond trading takes place in OTC markets
• You may also see smaller transactions in
  regular exchanges (e.g. NYSE)

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Sample Bond Quotation from The Wall Street
Journal
18
Reading The WSJ
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Inflation and Interest Rates

• Inflation is the increase in the nominal (or
  cash) cost of goods and services over time
• Put differently, it is the decrease in purchasing
  power over time
• In the end, we are generally concerned with
  consumption in finance (and in life). The amount
  of dollars you have is really much less important
  than their purchasing power
• Nominal rates are the rates observed in the
  market and quoted in contracts
• Real rates are actually very illusive since
  measuring inflation accurately is difficult

20
The Fisher Effect

• Captures the relationship between real rates,
  nominal rates, and inflation
• It says the nominal rate is roughly equal to the
  sum of the real rate and expected inflation

21
Term Structure of Interest Rates

• The relationship between short-term and long-term
  interest rates
• A graph of interest rates on securities of
  various maturities
• Generally constructed using riskless zero coupon
  bonds (i.e., Treasuries)
• Serves as a measure of the Time Value of Money
• Generally upward sloping, but can also be
  downward sloping, inverted, or humped

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U.S. Interest Rates 1800-1997 (Fig. 7.5 in the
Book)
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Term Structure (Fig. 7.6 from the Book)
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What factors affect observed bond yields?

• The real rate of interest
• Expected future inflation
• Interest rate risk
• Default risk premium
• Taxability premium
• Liquidity premium