Intro to Finance Lecture 10: Bonds PDF

# Introduction to Finance ## Chapter 10: Bonds ### Balázs Fazekas, PhD ### Assistant Lecturer ### DE-GTK, Institute of Finance and Accounting # Bonds ## Corporate Borrowings There are two main sources of borrowing for a corporation: - Loan from a financial institution (known as private debt) - B...

# Introduction to Finance ## Chapter 10: Bonds ### Balázs Fazekas, PhD ### Assistant Lecturer ### DE-GTK, Institute of Finance and Accounting # Bonds ## Corporate Borrowings There are two main sources of borrowing for a corporation: - Loan from a financial institution (known as private debt) - Bonds (known as public debt since they can be traded in public financial markets) - Smaller firms choose to raise money from banks in the form of loans because of the high costs associated with issuing bonds. - Larger firms generally raise money from banks for short-term needs and depend on the bond market for long-term financing needs. ## Borrowings - Financial Markets - Firms also raise money by selling debt securities to individual investors and financial institutions such as mutual funds. - In order to sell debt securities to the public, the issuing firm must meet the legal requirements as specified by the securities laws. ## Bonds - Corporate bond is a debt security issued by corporation that has promised future payments and a maturity date. - External debt like financing. - If the firm fails to pay the promised future payments of interest and principal, the bond trustee can classify the firm as insolvent and force the firm into bankruptcy. ## The impact of bonds on the issuer (when the bond is issued) A diagram showing the impact of bonds on the issuer. Before issuing bonds, the issuer has assets including debt and equity. After issuing bonds, the issuer has assets including cash (the price of bonds), debt (the bond), and equity. ## Why issue bonds Bonds provide long-term funding (capital) for issuers. The firm wants to buy a new equipment (real asset). - The firm gets money (capital) by issuing bonds. - **or...** - The firm operates better with the new equipment (real asset) and it generates more income. The firm pays back the capital and the interest (income) to the bondholders using the extra money that was generated by the new equipment (real asset). - The new equipment is unsuccessful and does not able to generate extra money. The firm is not able to pay back the loans and goes bankrupt. (or takes away the profits of other assets.) ## Features of bonds - Face value (par value) - Coupon - Discount and premium - Maturity - Intrinsic value - Market value - Undervalued and Overvalued - Bond rating ## Face value - Face value represents the principle of the loan that must be repaid to the bondholder up to the maturity. - Coupon is paid after the face value of the bond. - The price is usually expressed as a % of the face value. ## Coupon Represents the regular interest payments occurring within the lifespan of the bond. ### Types of coupon payments - Zero-coupon: there is no interest payment - Fixed coupon rate: coupon is pre-fixed, the bond pays the same amount of money as interest. coupon rate * face value - Floating coupon rate: interest payment changes based on a pre-fixed benchmark. inflation, base rate, LIBOR ## Market price vs intrinsic value - Intrinsic value: The present value of the bond's cash flows calculated with an interest rate that represents the risks. - Market price: the price where the securities can be traded on the secondary markets. ## Under and Overvalued bonds By comparing the market value and intrinsic value, we can categorize the securities. - **Undervalued**: market price < intrinsic value. We are willing to buy this security because we expect that its price is going to increase. - **Overrvalued**: market price > intrinsic value. We are not willing to buy this security because we expect that its price is going to decrease. ## Premium, par and discount - **Discount bond**: bonds traded on a lower price than the face value. coupon rate is lower than the expected return - **Premium bond**: bonds traded on a higher price than the face value. coupon rate is higher than the expected return - **Par bond**: bonds that are traded on face value. coupon rate is equal to the expected return ## Bond rating - Shows the riskiness of securities. - International credit rating agencies: Moody's, Standard & Poor's, Fitch - The ranking of credit rating agencies plays an important role in expressing the expected return. - Bad ranking -> higher risk premium -> higher expected return -> higher interest expenses -> higher debt. ## Code system of rating agencies A table comparing the code systems of Moody's, S&P, and Fitch credit rating agencies. AAA: best creditability BBB: good creditability, but recessions might cause problems. CCC: actual threat of default D: actual delay or missed payment. ## Expected return - Return expected from the bond based on its risks. - The discount rate that we use when we compute the intrinsic value $r = risk\ free\ rate + spread$ ## The yields of EU 28 and their S&P classification (06/2019) A bar graph showing the yields of EU 28 countries and their S&P classification. ## Some questions - What is the relationship of bond ratings and yields? - What is the rating's impact on a country's economy? - Is it possible that bonds have negative yields? ## Risks of bonds ## Risk Factors - Market risks - Liquidity risks - Default risk ## Market risks - **Risk of interest rate**: Interest rates change in the lifespan of the bond. - **Market interest rates influence the price of bonds** - If market interesgt rates increase than bond values decrease. **Example** We buy a bond that pays 5% coupon. Similar bonds offer 5% interests as well. After 1 year the market interest rates increase up to 7%. The alternative investments offer higher income relative to our bond. If we sell the bond than we have a loss, as the price of the bond decreases. If we keep the bond than we have a loss, because we cannot enjoy the higher interests. ## Liquidity risk - We are able to sell the bond, if we wish. (without significant losses) - **Liquidity risk means, that we are unable to sell the bond and convert it into cash.** - We are 'stuck' in the investment. - Lack of secondary markets. - High bid-ask spread. ## Deafault risk - Not all loans are paid back - **The risk that the issuer is not able to pay back its debt.** - We can have an insurance for default (CDS) ## Credit Default Swap (CDS) - **CDS is a deal when** - Thebuyer of CDS pays a premium for the seller of CDS - The seller is liable to pay for the holder of the CDS if the issuer of the bond defaults - **In practice such deals are used in case of government bonds.** ## Goverment bonds - **Bonds issued by goverments.** - **In case of budgetary deficits goverments fund the deficits by bonds.** - **The bondholders lend money to the goverments.** ## Net and gross value of bonds ## Gross and net price $Pgross ­­= \frac{t}{365} ­* rn ­* Pn ­= Pnet$ Pnet: net price Pgross: gross price rn: coupon rate t: days since last coupon payment A graph showing the gross and net price of a bond over time. ## Thank you for your attention!