Valuing Bonds - Valuing Bonds Readings Text Chapter 10(up...

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Unformatted text preview: Valuing Bonds Readings: Text Chapter 10 (up to page 354) OVERVIEW Characteristics/Types of Bonds. Basic Bond Pricing. Yield to Maturity and Associated Pricing Issues. 1 Characteristics of Bonds Bonds (or Fixed Income Securities) promise a stream of fixed cash flows payable at specific dates. Principal, Par Value, Maturity Value Maturity Coupon, Coupon Rate, Interest Rate Contingent Control Rights Covenants 2 Customizing a Bond Covenants refer to special characteristics written into the bond contract to "customize" the bond. Seniority/Subordination Callable & Sinking Funds Convertible Collateral (Secured) Constraints on further borrowing Constraints on dividends Constraints on asset sales How will various covenants affect price? 3 U.S. Treasury Securities Treasury Bills (T-Bills): Maturity 1 year (13, 26, 52 weeks). Issued as zero coupon (discount) bonds. Issued either weekly or monthly refunding. Maturity: 2 to 10 years. Semi-annual coupon payments. Treasury Notes (T-Notes): Treasury Bonds (T-Bonds): Maturity: 10 to 30 years. Semi-annual coupon payments. Treasury STRIPS (~25% of long bonds are stripped): Separate Trading of Registered Principal and Interest Securities. Inflation Indexed Bonds (TIPS) 4 Corporate Bonds Corporate bonds can be either publicly or privately issued and traded Maturity: overnight (Commercial Paper) to 30+ years. Usually multiple issues per company. Often tailored with covenants. Risky: default risk + liquidity risk. 5 Bond Ratings Credit rating agencies (Moody's, Standard & Poor's, Fitch) assign ratings to bonds to "quantify" default risk. Description Moody's S&P Gilt Edge Very High Grade Upper Medium Grade Lower Medium Grade Low Grade/Speculative " " In Default Aaa Aa A Baa Ba B ... D AAA AA A BBB BB B ... D 6 Historical Corporate Default Frequencies Rating at Issue AAA AA A BBB BB B CCC 1 year 0% 0% 0% 0% .4% 1.5% 2.3% 5 years .1% .7% .2% 1.6% 8.3% 22% 35.4% 10 years .1% .7% .6% 2.8% 16.4% 33% 47.5% 7 Additional Bonds MUNICIPAL BONDS Issued to finance State, County, Town, School Districts Exempt from federal taxes! Issues are small and generally illiquid. OTHER BONDS Agency Bonds Fannie Mae, Ginnie Mae, etc.. Structured Finance. Collateralized Mortgage Obligations (CMO's) Auto Loans Credit Card Receivables 8 Pricing a Bond Value Additivity: Bond Price = Present Value of Promised Cash Flows. INT: coupon payment M: par value (maturity payment) N: number of periods to maturity kd: appropriate risk-adjusted discount rate (e.g. required rate of return) INT INT M + INT Vd = + + ... + 2 ( 1 + k d ) (1 + k d ) (1 + k d ) n INTn M Vd = + n n (1 + k d ) n =1 (1 + k d ) N 9 Pricing a Bond: Longhand Example: GE issues a bond: maturity = 3 years, face value = $1,000, coupon rate = 6%, rating = Aa Assume appropriate discount rate for similar bonds rated Aa is 5% and that coupons are annual. 10 Pricing a Bond: Annuity Example: GE issues a bond: maturity = 3 years, face value = $1,000, coupon rate = 6%, rating = Aa Assume appropriate discount rate for similar bonds rated Aa is 5% and that coupons are annual. 11 Pricing a Bond: Calculator Example: GE issues a bond: maturity = 3 years, face value = $1,000, coupon rate = 6%, rating = Aa Assume appropriate discount rate for similar bonds rated Aa is 5% and that coupons are annual. 12 Yield to Maturity Yield to Maturity: Average Rate of Return investors will realize if the bond is held to maturity. Calculated as the single discount rate which makes price = PV of discounted cash flows. Also referred to as the bond's average rate of return or investors required rate of return. $ INT $M Vd = + t n (1 + ytm ) t =1 (1 + ytm ) 13 n Calculating YTM: Calculator Assume IBM has a 10 year, 7 % coupon bond that is priced at 985.33. Assume coupons are annual, what is its ytm? 14 Approximation for YTM Assume IBM has a 10 year, 7 % coupon bond that is priced at 985.33. Assume coupons are annual, what is its ytm? M - Vd INT + N ytm 2Vd + M 3 15 Various Domestic Yield Curves 16 Corporate Credit Spreads 17 Semi-Annual Coupons Coupon payments in U.S. are almost always semi-annual. Yield-to-maturity is reported as 2*semi-annual yield. Example: IBM has a 10 year, 7 % coupon bond that is priced at 985.33. Assume coupons are semi-annual, what is its ytm? 18 Semi-Annual Coupons (II) Assume Ford has a 20 year, 6.5% coupon bond. Your broker indicates that it is priced to yield 6.3%. What is its price (assume semi-annual coupons). 19 Bond Price Relationships (1) Interest Rate Price Risk: The value (price) of a bond is inversely related to changes in interest rates (and ytm). ... Price Rates ... Price Rates INT M Vd = + t (1 + k ) (1 + k ) n t =1 n Vd n - tINT - nM = + t -1 n -1 k t =1 ( 1 + k ) (1 + k ) 20 Bond Price Relationships (2) Interest Rate Price Risk and Maturity: Long term bond prices are generally more sensitive to changes in interest rates than are short term bond prices. Example: Assume that kd is 8%. Bond A Maturity Face Value 15 years $1,000 Bond B 30 years $1,000 8% Coupon Rate 8% What is the current price of each bond? What will be the new price of each bond if kd suddenly increases to 9%? 21 Bond Price Relationships (3) Price (Vd) will be < par value (M) if the coupon rate (c) is less than the ytm. Conversely, Vd > M if c > ytm. A bond where Vd > M is a premium bond. A bond where Vd < M is a discount bond. A bond where Vd = M is a par bond Heuristic explanation: Coupon payments compensate investors for "giving up" their $. "Low" coupon rate bonds: 22 Bond Price Relationships (4) As maturity date approaches, Vd converges to M. Vd increases with maturity if c < ytm. Vd decreases with maturity if c > ytm. 23 Bond Price Relationships (4) Example: Calculate the price of the following two bonds assuming 10 years and 9 years to maturity respectively, annual coupons, and kd = 8% Bond A Bond B $1,000 $1,000 6% 10% 24 Par Value (M) Coupon Rate (c) Bond Price Relationships (4) 10 years Bond A 9 years Bond B 25 Relationship #4 Continued Assume you purchased bond A and held it for a year. What would be your total return? Initial investment: Gross return after 1 year: Coupon Payment: Capital Appreciation: Percentage Return: 26 Relationship #4 Continued What about bond B? Initial investment: Gross return after 1 year: Coupon Payment: Capital Appreciation: Percentage Return: 27 Summary Characteristics of bonds. Overview of bond market Treasury bonds, notes bills, strips Corporate bonds Other bonds Valuing bonds Calculating yield-to-maturity 4 Characteristics of bond prices 28 ...
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