Bonds and Bond Valuation

• A bond is a simple financial instrument where you lend money to a company.
• The company pays you interest and repays the original loan amount in the future.
• In 2002, Berkshire Hathaway issued bonds requiring buyers to make interest payments to them.
• This chapter explains how to value bonds using time value of money concepts
• It also discusses bond features, types, and the bond market
• Bond prices depend on interest rates.

Chapter Goal

• Introduce bonds, show how previous techniques apply to bond valuation
• Discuss bond features and how they are bought and sold
• Explain that bond values depend on interest rates and examine interest rate behavior.

Bonds and Bond Valuation

• Corporations and governments issue bonds to borrow money from the public on a long-term basis.
• This section describes corporate bond features, terminology, cash flows, and valuation.

Bond Features and Prices

• A bond is typically an interest-only loan, where the borrower pays interest each period and repays the principal at the end of the loan.
• If Beck Corp. wants to borrow $1,000 for 30 years at 12% interest, they'll pay $120 annually and repay $1,000 at the end.
• The regular interest payments are called coupons
• A level coupon bond has a constant coupon paid every year.
• The face value, or par value, is the amount repaid at the end of the loan.
• For corporate bonds, the face value is usually $1,000, and the bonds are called par value bonds.
• The annual coupon divided by the face value is the coupon rate.
• The coupon rate is 12% in the Beck Corp. example ($120/$1,000).
• The time to maturity is the number of years until the face value is paid.

Bond Values and Yields

• Bond values fluctuate as market interest rates change
• Bond values decline when interest rates rise.
• Bond values increase when interest rates fall.
• The yield to maturity (YTM) is the market interest rate required for bonds with similar features.
• YTM can be used to estimate a bond’s current market value by calculating the present value of its cash flows.
• If Xanth Co. issues a bond with 10 years to maturity and an $80 annual coupon, and similar bonds have a YTM of 8%, the bond will sell for $1,000
• The Xanth bond's cash flows include annuity component (coupons) and a lump sum (face value at maturity).

Interest Rate Risk

• Interest rate risk is the risk that bond owners face due to fluctuating interest rates
• Sensitivity of a bond’s price and time to maturity directly relates to interest rate changes
• All other things being equal, the longer the time to maturity, the greater the interest rate risk.
• All other things being equal, the lower the coupon rate, the greater the interest rate risk.
• Longer-term bonds are more sensitive to interest rate changes because a large portion of their value comes from the face amount.
• Interest rate risk increases at a decreasing rate.
• Bonds with lower coupons have greater interest rate risk because their value is more dependent on the face amount.

More about Bond Features

• Securities issued by corporations may be classified roughly as equity securities and debt securities.
• A debt represents something that must be repaid and is the result of borrowing money.
• From a financial point of view, the main differences between debt and equity are the following
• Debt is not an ownership interest in the firm.
• The corporation's payment of interest on debt is a cost of doing business and is fully tax deductible.
• Unpaid debt is a liability, giving creditors a legal claim on the firm's assets.

Debt Versus Equity

• It is not always clear if a particular security is debt or equity.
• A general rule is that equity represents an ownership interest and is a residual claim
• Equity holders are paid after debt holders.
• The maximum reward for owning a debt security is ultimately fixed by the loan amount
• There is no upper limit on the potential reward from owning an equity interest.

Long-term Debt

• All long-term debt securities are promises made by the issuing firm to pay principal when due and to make timely interest payments on the unpaid balance.
• Types of long term debt include notes, debentures and bonds
• Debt securities can be short-term (maturities of one year or less) or long-term (maturities of more than one year).
• Short-term debt is sometimes referred to as unfunded debt.
• Longer-term issues are called bonds.
• The two major forms of long-term debt are public issue and privately placed.
• Public-issue bonds are offered to the public
• Private-issue bonds are directly placed with a lender.
• Security, call features, sinking funds, ratings, and protective covenants are dimensions of long-term debt.

The Indenture

• The indenture is the written agreement between the corporation (the borrower) and its creditors.
• Includes basic terms, the total amount issued, property description as security, repayment arrangements, call provisions, and protective covenants.
• Corporate bonds usually have a face value of $1,000
• Usually in registered form where the registrar of the company records ownership of each bond and payment is made directly to the owner of record.
• Alternatively, the bond could be in bearer form, meaning that the certificate is treated as basic evidence of ownership and the corporation will pay the bearer.

Security

• Collateral is a general term that frequently means securities (for example, bonds and stocks) that are pledged as security for payment of debt.
• Mortgage securities are secured by a mortgage on the real property of the borrower.
• The property involved is usually real estate-for example, land or buildings.
• Bonds frequently represent unsecured obligations of the company.
• A debenture is an unsecured bond, for which no specific pledge of property is made.

The Call Provision

• A call provision allows the company to repurchase or “call” part or all of the bond issue at stated prices over a specific period.
• Generally, the call price is above the bond’s stated value, which is known as the call premium
• A deferred call provision prohibits the company from redeeming a bond prior to a certain date.

Protective Convenants

• A protective covenant is that part of the indenture or loan agreement that limits certain actions a company might otherwise wish to take during the term of the loan.
• Negative covenantis a "thou shalt not" type of covenant, that limits or prohibits actions the company might take
• For example: The firm must limit the amount of dividends it pays according to some formula.
• Positive covenant specifies an action the company agrees to take or a condition the company must abide by.
• For example: The company must maintain its working capital at or above some specified minimum level.

Bond Ratings

• The two leading bond-rating firms are Moody's and Standard & Poor's (S&P).
• The debt ratings are an assessment of the creditworthiness of the corporate issuer.

Some Different Types of Bonds

• Bonds issued by governments
• Bonds with unsusual features

Government Bonds

• Treasury notes and bonds have original maturities ranging from 2 to 30 years.
• U.S. Treasury issues have no default risk and are exempt from state income taxes

Municipal Notes and bonds ("munis")

• Have varying degrees of default risk, are rated much like corporate issues, and are almost always callable.
• Couposns are exempt from federal income taxes.

Zero Coupon Bonds ("Zeroes")

• A bond that pays no coupons at all must be offered at a price that is much lower than its stated value.
• Examples of negative yields to maturity calculations
• Example: In 2006, a NoNo issued by Merrill Lynch was selling at a price of $1,103.75, with a yield to maturity of negative 5.22 percent
• At same time a NoNo issued by Countrywide Financial was selling for $1,640, which implied a yield to maturity of negative 59 percent!

Bond Markets

• Bonds are bought and sold in enormous quantities every day
• The trading volume in bonds on a typical day is many, many times larger than the trading volume in stocks
• Most trading in bonds takes place over the counter, or OTC
• No particular place where buying and selling occur, dealers around the country (and around the world) stand ready to buy and sell, and are connected electronically
• High number of bonds exceeds number of stock issues.
• Lack of transparency in bond market.

Bond Price Reporting

• Corporate bond dealers required to report trade information through Transactions Report and Compliance Engine (TRACE)
• Data from TRACE = Estimates yield spread over a Treasury issue, and reported in basic points, where 1 basis point = 0.01 percent
• U.S. Treasury market is largest securities market with limited transparency and is OTC market

Bid and Asked Prices

• The bid price represents what a dealer is willing to pay for a security.
• The asked price (or just "ask" price) is what a dealer is willing to take for it.
• The difference between the two prices is called the bid-ask spread (or just "spread")
• This represents the dealer's profit.
• For historical reasons, Treasury prices are quoted in 32nds.
• Treasury bonds all make semiannual payments and have a face value of $1,000

Inflation and Interest Rates

• This section covers the impact of inflation
• Discusses real rates and nominal rates

Real verse Nominal Rates

• Nominal rates have not been adjusted for inflation.
• Real rates have been adjusted for inflation.
• An example shows that a $100 investment worth $115.50 in one year yields 15.5% return before accounting for inflation.
• An inflation rate of 5% means that the $115.50 in a year yields a real value of $110, or a 10% real return.

Fisher Effect

• Illustrates a relationship often called Fisher effect based on economist Irving Fisher
• States investors require compensation for inflation
• Expressed as: (1 + R) = (1 + r) x (1 + h)
• R stands for nominal rate
• r stands for real rate
• h stands for inflation rate
• States nominal rate has three components.
• Real rate on investment, r
• Compensation for decrease in value of money due to inflation, h