The Valuation and Characteristics of Bonds

1
The Valuation and Characteristics of Bonds

• Chapter 6

2
The Basis of Value

• Securities are worth the present value of the
  future cash income associated with owning them
• The security should sell in financial markets for
  a price very close to that value
• However, I might think Security A has a different
  intrinsic value then someone else thinks, because
  we have different estimates for the
• Discount rate
• Expected future cash flows

3
The Basis for Value

• Investing
• Using a resource to benefit the future rather
  than for current satisfaction
• Putting money to work to earn more money
• Common types of investments
• Debtlending money
• Equitybuying an ownership in a business
• A return is what the investor receives divided by
  what s/he invests
• Debt investors receive interest

4
The Basis for Value

• Rate of return is the interest rate that equates
  the present value of its expected future cash
  flows with its current price
• PV FV ? (1 k)
• Return is also known as
• Yield
• Interest

5
Bond Valuation

• A bond issue represents borrowing from many
  lenders at one time under a single agreement
• While one person may not be willing to lend a
  single company 10 million, 10,000 investors may
  be willing to lend the firm 1,000 each

6
Bond Terminology and Practice

• A bonds term (or maturity) is the time from the
  present until the principal is to be returned
• Bonds mature on the last day of their term
• A bonds face value (or par) represents the
  amount the firm intends to borrow (the principal)
  at the coupon rate of interest
• Bonds typically pay interest (coupon rate) every
  six months
• Bonds are non-amortized (meaning the principal is
  repaid at once when the bond matures rather than
  being repaid in increments throughout the bonds
  life)

7
Interest Rates for Various Treasury Securities of
Differing Maturities
Note that bonds with a longer maturity generally
have a higher interest rate and that interest
rates on Treasury securities move in tandem.
8
Bond ValuationBasic Ideas

• Adjusting to interest rate changes
• Bonds are sold in both primary (original sale)
  and secondary markets (subsequent trading among
  investors)
• Interest rates change all the time
• Most bonds pay a fixed interest rate
• What happens to the price of a bond paying a
  fixed interest rate in the secondary market when
  interest rates change?

9
Bond ValuationBasic Ideas

• You buy a 20 year, 1000 par bond today for par
  (meaning you pay 1,000 for it) when the coupon
  rate is 10
• This implies that your required rate of return
  was 10
• For that purchase price, you are promised 20
  years of coupon payments of 100 each, and a
  principal repayment of 1,000 in 20 years
• After youve held the bond investment for a week,
  you decide that you need the money (cash) more
  than you need the investment
• You decide to sell the bond
• Unfortunately, interest rates have risen
• Other investors now have a required rate of
  return of 11
• They can buy new bonds with an 11 coupon rate in
  the market for 1,000
• Will they buy your bond from you for 1,000?
• NO! Theyll buy it for less than 1,000

10
Determining the Price of a Bond

• Remember, Intrinsic Value is the present value of
  all future expected cash flows
• With a bond, predicting the future cash flows is
  somewhat easy, because the promised cash flows
  are specified.
• Interest (usually)
• Principal (usually)
• Maturity (in years)

In practice most bonds pay interest semi-annually.
11
Determining the Price of a Bond
12
Determining the Price of a Bond

• The Bond Valuation Formula
• The price of a bond is the present value of a
  stream of interest payments plus the present
  value of the principal repayment

13
Figure 6.1 Cash Flow Time Line for a Bond
14
Determining the Price of a Bond

• Two Interest Rates and One More
• Coupon rate
• Determines the size of the interest payments
• Kthe current market yield on comparable bonds
• The appropriate discount rate that makes the
  present value of the payments equal to the price
  of the bond in the market
• AKA yield to maturity (YTM)
• Current yieldannual interest payment divided by
  bonds current price

15
Solving Bond Problems with a Financial Calculator

• Financial calculators have five time value of
  money keys
• With a bond problem, all five keys are used
• Nnumber of periods until maturity
• Imarket interest rate
• PVprice of bond
• FVface value (par) of bond
• PMTcoupon interest payment per period
• With calculators that have a sign convention the
  PMT and FV must be of one sign while the PV will
  be the other sign
• The unknown will be either the interest rate or
  the present value
• When solving for the interest rate, the price of
  the bond must be inputted as a negative value
  while the PMT and FV must be inputted as a
  positive value
• Sophisticated calculators have a bond mode
  allowing easy calculations dealing with accrued
  interest

16
Determining the Price of a BondExample
17
Bond Example
18
Maturity Risk Revisited

• Relates to term of the debt
• Longer term bonds fluctuate more in response to
  changes in interest rates than shorter term bonds
• AKA price risk and interest rate risk
• As time passes, if interest rates dont change
  the price of a bond will approach its par

19
Table 6.1
20
Maturity Risk Revisited
21
Finding the Yield at a Given Price

• Weve been calculating the intrinsic value of a
  bond, but we could calculate the bond yield
  (based on its current value in the market) and
  compare that yield to our required rate of return

Involves solving for k, which is more complicated
because it involves both an annuity and a FV
Use trial and error to solve for k, or use a
financial calculator.
22
Finding the Yield at a Given PriceExample
23
Call Provisions

• If interest rates have dropped substantially
  since a bond was originally issued, a firm may
  wish to refinance, or retire their old high
  interest bond issue
• However, the issuing corporation would have to
  get all the bondholders to agree to this
• From the bondholders viewpoint, this could be a
  bad ideathey would be giving up high coupon
  bonds and would have to reinvest their cash in a
  market with lower interest rates
• To ensure that the corporation can refinance
  their bonds should they wish to do so, the
  corporation makes the bonds callable

24
Call Provisions

• Call provisions allow bond issuers to retire
  bonds before maturity by paying a premium
  (penalty) to bondholders
• Many corporations offer a deferred call period
  (meaning the bond wont be called for at least x
  years after the initial issuing date)
• Known as the call-protected period

25
Call Provisions

• The Effect of A Call Provision on Price
• When valuing a bond that is probably going to be
  called when the call-protected period is over
• Cannot use the traditional bond valuation
  procedure
• Cash flows will not be received through maturity
  because bond will probably be called

26
Figure 6.5 Valuation of a Bond Subject to Call
27
Call Provisions

• Valuing the Sure-To-Be-Called Bond
• Requires that two changes be made to bond
  valuation formula

The future value becomes the call price (face
value plus call premium).
N now represents the number of periods until the
bond is likely to be called.
28
The Refunding Decision

• When current interest rates fall below the coupon
  rate on a bond, company has to decide whether or
  not to call in the issue
• Compare interest savings of issuing a new bond to
  the cost of making the call
• Calling in the bond requires the payment of a
  call premium
• Issuing a new bond to raise cash to pay off the
  old bond requires payment of administrative
  expenses and flotation costs

29
Dangerous Bonds with Surprising Calls

• Some bonds have contingency call features buried
  in the fine print
• For instance, some issuers would like to retire a
  portion of their bond issue periodically
• Versus paying a huge principal repayment on the
  entire issue at maturity
• This feature does not require a call provision
• Rather, those bondholders who must retire their
  bond are determined by lottery

30
Risky Issues

• Sometimes bonds sell for a price far below what
  valuation techniques suggest
• Investors are worried that company may not be
  able to pay promised cash flows
• Valuation model should determine a price similar
  to the market price if the correct discount rate
  is used
• Riskier loans should be discounted at a higher
  interest rate leading to a lower calculated price

31
Convertible Bonds

• Unsecured bonds that are exchangeable for a fixed
  number of shares of the companys stock at the
  bondholder's discretion
• Allows bondholders to participate in a stocks
  price appreciation should the firm be successful
• Conversion ratio represents the number of shares
  of stock that will be received for each bond
• Conversion price is the implied stock price if
  bond is converted into a certain number of shares
• Usually set 15-30 higher than the stocks market
  value at the time the bond is issued
• Can usually be issued at lower coupon rates

32
Convertible Bonds

• The effect of conversion on financial statements
  and cash flow
• Upon conversion an accounting entry removes the
  convertible bonds from long-term debt and places
  it into the equity accounts
• There is no immediate cash flow impact, but
  ongoing cash flow implications exist
• Interest payments will stop
• If the firms stock pays a dividend the newly
  created shares are entitled to those dividends
• Improves debt management ratios

33
Advantages of Convertible Bonds

• To issuing companies
• Convertible features are sweeteners that let the
  firm pay a lower interest rate (coupon)
• Can be viewed as a way to sell equity at a price
  above market
• Convertible bonds usually have few or no
  restrictions
• To buyers
• Offer the chance to participate in stock price
  appreciation
• Offer a way to limit risk associated with a stock
  investment

34
Forced Conversion

• A firm may want its bonds to be converted because
• Eliminates interest payments on bond
• Strengthens balance sheet
• Convertible bonds are always issued with call
  features which can be used to force conversion
• Issuers generally call convertibles when stock
  prices rise to 10-15 above conversion prices
• Rational investors will convert if the conversion
  value is greater than the call value

35
Valuation (Pricing) Convertibles

• A convertibles price can depend on
• Its value as a traditional bond or
• The market value of the stock into which it can
  be converted
• At any stock price the convertible is worth at
  least the larger of its value as a bond or as
  stock
• The market value will be greater due to the
  possibility that the stocks price will rise

36
Figure 6.7 Value of a Convertible Bond
37
Effect on Earnings Per ShareDiluted EPS

• Upon conversion convertible bonds cause dilution
  in EPS
• EPS drops due to the increase in the number of
  shares of stock
• Thus convertible bonds have the potential to
  dilute EPS
• Therefore convertible bonds will impact the
  calculation of Diluted EPS according to FASB 128

38
Effect on Earnings Per ShareDiluted EPSExample
39
Effect on Earnings Per ShareDiluted EPSExample
40
Effect on Earnings Per ShareDiluted EPSExample
41
Institutional Characteristics of Bonds

• Registration, Transfer Agents, and Owners of
  Record
• A record of registered securities is kept by a
  transfer agent
• Payments are sent to owners of record as the
  dates as of the dates the payments are made
• Bearer bonds vs. registered bonds
• Bearer bondsinterest payment is made to the
  bearer of the bond
• Registered bondsinterest payment is made to the
  holder of record

42
Kinds of Bonds

• Secured bonds and mortgage bonds
• Backed by collateral
• Debentures
• Unsecured bonds
• Subordinated debentures
• Lower in priority than senior debt
• Junk bonds
• Issued by risky companies and pay high interest
  rates

43
Bond RatingsAssessing Default Risk

• Bond rating agencies (such as Moodys, SP)
  evaluate bonds (and issuing firms) and assign a
  rating to each bond issued by a corporation
• These ratings gauge the probability that issuers
  will fail to meet their obligations

44
Bond RatingsAssessing Default Risk

• Why Ratings Are Important
• Ratings are the primary measure of the default
  risk associated with bonds
• Thus, ratings play a big part in the interest
  rate that investors demand
• The rating a firms bonds receive basically
  determines the rate at which the firm can borrow
• A lower quality rating implies a higher borrowing
  rate

45
Bond RatingsAssessing Default Risk

• The differential between the yields on high and
  low quality bonds is an indicators of the health
  of the economy
• The Differential Over Time
• The quality differential tends to be larger when
  interest rates are generally high
• May indicate a recession and marginal firms are
  more likely to fail, making them riskier
• The Significance of the Investment Grade Rating
• Many institutional investors are prohibited from
  trading below-investment-grade bonds

46
Table 6.2
47
Bond IndenturesControlling Default Risk

• As a bondholder, you would like to ensure that
  you will receive your promised interest and
  principal payments
• Bond indentures attempt to prevent firms from
  becoming riskier after the bonds are purchased,
  and includes such protective covenants as
• Limits to managements salary
• Limits to dividends
• Maintenance of certain financial ratios
• Restrictions on additional debt issues
• Sinking funds provide money for the repayment of
  bond principal

48
Appendix 6-A Lease Financing

• A lease is a contract giving one party (lessee)
  the right to use an asset owned by another
  (lessor) for a periodic payment
• Individuals may lease houses, apartments and
  automobiles
• Corporations may lease equipment and real estate
• Approximately 30 of all equipment today is leased

49
Appendix 6-A Leasing and Financial Statements

• Originally leasing allowed the lessee to use the
  asset without ownership
• Lease payments were recognized as expenses on the
  income statement
• Had no impact on balance sheet
• Led to large use of lease financing
• Became the leading form of off balance sheet
  financing

50
Appendix 6-A Misleading Results

• Off balance sheet financing makes financial
  statements misleading
• Missed lease payments can cause the firm to fail
  just like a missed interest payment on debt
• Thus long-term leases are effectively the same as
  debt
• Not having leases appear on the balance sheet can
  mislead investors to think a firm is stronger
  than it is

51
Appendix 6-A Misleading Results

• By the early 1970s concerns led to FASB 13
• Prior to FASB 13 an asset was owned by whoever
  held its title regardless of who used the asset
• FASB 13 stated that the real owner of an asset is
  whoever enjoys its benefits and deals with the
  risks and responsibilities

52
Appendix 6-A Operating and Capital (Financing)
Leases

• Under FASB 13 lessees must capitalize financing
  leases
• Puts the value of leased assets and liabilities
  on the balance sheet
• Makes the balance sheet similar to what it would
  have been had the asset been purchased with
  borrowed money
• Operating leases can still be listed off the
  balance sheet

53
Appendix 6-A Operating and Capital (Financing)
Leases

• Rules that must be met for a lease to be
  classified as an operating lease
• Lease must not transfer legal ownership to the
  lessee at its end
• Must not be a bargain purchase option at the end
  of the lease
• Lease term must be lt 75 of the assets estimated
  economic life
• Present value of the lease payments must be lt 90
  of the assets fair market value at the beginning
  of the lease

54
Appendix 6-A Financial Statement Presentation
of Leases by Lessees

• Operating leases
• No balance sheet entries
• Lease payments are treated as an expense
• Details must be listed in footnotes
• Financing leases
• Lessee must record an asset on balance sheet
• Lessee must record an offsetting liability
• Both of the above amounts are usually the present
  value of the stream of committed lease payments
• The interest rate is generally the rate the
  lessee would pay if it were borrowing money at
  the time the lease begins
• The asset is depreciated while the Lease
  Obligation is treated like a loan

55
Appendix 6-A Leasing from the Perspective of
the Lessor

• Lessors are usually banks, finance companies and
  insurance companies
• Companies buy the equipment and lease it to
  customer
• Lease payments are calculated to offer the lessor
  a given return
• The interest rate is called the lessors return
  or the rate implicit in the lease
• Lessor holds legal titlecan repossess assets if
  lessee defaults
• Lessors get better treatment in bankruptcy
  proceedings than lenders

56
Appendix 6-A Residual Values

• Residual valuethe value of an asset at the end
  of the lease term
• Lessee may buy the equipment
• Lessor may sell it to someone else
• Asset may be re-leased (usually only with
  operating leases)
• Makes lease pricing and return calculations more
  complex
• Often are important negotiating points between
  lessee and lessor

57
Appendix 6-A Lease Vs. BuyThe Lessees
Perspective

• Broad financing possibilities
• Equity
• Debtavailable through bonds or banks
• Leasingavailable through leasing companies
• Should conduct a lease vs. buy comparison
• Choose the lowest cost in a present value sense

58
Appendix 6-A The Advantages of Leasing

• No money down
• Lenders typically require some downpayment
  whereas lessors usually do not
• Restrictions
• Lenders usually require covenants/indentures,
  whereas lessors have few, if any, restrictions
• Easier credit with manufacturers/lessors
• Equipment manufacturers sometimes lease their own
  products and will lease to marginally
  creditworthy customers

59
Appendix 6-A The Advantages of Leasing

• Avoiding the risk obsolescence
• Short leases transfer this risk to lessors
• Tax deducting the cost of land
• If real estate is leased the lease payment can be
  deducted as an expense, whereas if the land is
  owned it is not depreciable
• Increasing liquiditythe sale and leaseback
• A firm may sale an asset (to generate cash) and
  lease the same asset backused to free up cash
  invested in real estate
• Tax advantages for marginally profitable companies

60
Appendix 6-A Leveraged Leases

• The ability to depreciate an asset reduces taxes
• If a company is not making a profit (and not
  paying taxes) then depreciation is not saving the
  firm any money
• A lessor buys equipment but finances a portion of
  the price of the equipment (hence, the term
  leveraged) and is allowed to depreciate the
  leased assets and gain the tax benefits
• The lessor passes along some of the benefits to
  the lessee in the form of lower lease payments