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Chapter 7

BONDS AND THEIR VALUATION

Learning Objectives

After reading this chapter, students should be able to:


Identify the different features of corporate and government bonds.
Discuss how bond prices are determined in the market, what the
relationship is between interest rates and bond prices, and how a
bonds price changes over time as it approaches maturity.
Calculate a bonds yield to maturity, its yield to call if it is callable, and
determine the true yield.
Explain the different types of risk that bond investors and issuers face,
and discuss how a bonds terms and collateral can be changed to affect
its interest rate.

Overview
This chapter presents a discussion of the key characteristics of bonds, and
then uses time value of money concepts to determine bond values. Bonds
are one of the most important types of securities to investors and a major
source of financing for corporations and governments.
The value of any financial asset is the present value of the cash flows
expected from that asset. Therefore, once the cash flows have been
estimated and a discount rate determined, the value of the financial asset
can be calculated.
A bond is valued as the present value of the stream of interest payments (an
annuity) plus the present value of the par value that is received by the
investor on the bonds maturity date. Depending on the relationship
between the current interest rate and the bonds coupon rate, a bond can
sell at its par value, at a discount, or at a premium. The total rate of return
on a bond is comprised of two components: an interest yield and a capital
gains yield.
The bond valuation concepts developed earlier in the chapter are used to
illustrate price and reinvestment risk. In addition, default risk, various types
of corporate bonds, bond ratings, and bond markets are discussed.

Outline

I. A bond is a long-term contract under which a borrower agrees


to make payments of interest and principal, on specific dates,
to the bondholders. There are four main types of bonds:
Treasury, corporate, municipal, and foreign. Each type differs
with respect to expected return and degree of risk.
A. Treasury bonds, generally called Treasuries and sometimes referred
to as government bonds, are issued by the Federal government.
1. They are not exposed to default risk.
2. Treasury bond prices decline when interest rates rise, so they
are not completely riskless.
B. Corporate bonds are issued by business firms and are exposed to
default risk.
1. Different corporate bonds have different levels of default risk,
depending on the issuing companys characteristics and on the
terms of the specific bond.
a. Default risk is often referred to as credit risk.
b. The larger the default risk, the higher the interest rate
investors demand.
C. Municipal bonds are issued by state and local governments.
1. The interest earned on most municipal bonds is exempt from
federal taxes and from state taxes if the holder is a resident of
the issuing state.
2. Municipal bonds carry interest rates that are considerably lower
than those on corporate bonds with equivalent risk because of
the interest tax exemption.
D. Foreign bonds are issued by foreign governments or foreign
corporations.
1. These bonds are not only exposed to default risk, but are also
exposed to an additional risk if the bonds are denominated in a
currency other than that of the investors home currency.
II. Differences in contractual provisions, and in the underlying
strength of the companies backing the bonds, lead to major
differences in bonds risks, prices, and expected returns. It is
important to understand the key characteristics, which are
common to all bonds, and how differences in these
characteristics affect the values and risks of individual bonds.
A. The par value is the stated face value of a bond, usually $1,000.
1. This is the amount of money that the firm borrows and promises
to repay on the maturity date.
B. The coupon payment is the specified dollar amount that is paid each
period to a bondholder by the issuer for use of the loan.
1. For a fixed-rate bond, this payment is a fixed amount,
established at the time the bond is issued.
2. The coupon interest rate is obtained by dividing the coupon
payment (calculated as the coupon interest rate times par value)
by the par value of the bond.
3. Floating-rate bonds are bonds with a coupon payment that
varies over time.
a. Floating-rate debt is popular with investors because the
market value of the debt is stabilized.
b. It is advantageous to corporations because firms can issue
long-term debt without committing themselves to paying a
historically high interest rate for the entire life of the loan.
4. Zero coupon bonds pay no coupons at all, but are offered at a
substantial discount below their par values.
a. They provide capital appreciation rather than interest income.
b. Web Appendix 7A discusses zero coupon bonds and their
valuation in more detail.
5. In general, any bond originally offered at a price significantly
below its par value is called an original issue discount bond
(OID).
C. The maturity date is the date on which the par value must be
repaid.
1. Original maturity is the number of years to maturity at the time
a bond is issued.
2. Most bonds have original maturities of from 10 to 40 years, but
any maturity is legally permissible.
D. A call provision gives the issuing corporation the right to call the
bonds for redemption under specified terms prior to the normal
maturity date.
1. The call provision generally states that if the bonds are called,
the company must pay the bondholders an amount greater than
the par value, a call premium.
a. The call premium is often set equal to one years interest if
the bonds are called during the first year, and the premium
declines at a constant rate of INT/N each year thereafter,
where INT = annual interest and N = original maturity in
years.
2. A deferred call occurs when bonds are not callable until several
years after they are issued. Bonds with a deferred call are said
to have call protection.
3. The call privilege is valuable to the firm but potentially
detrimental to the investor, especially if the bonds were issued in
a period when interest rates were cyclically high.
a. The interest rate on a new issue of callable bonds will exceed
that on a new issue of noncallable bonds.
4. The process of using the proceeds of a new lower-interest-rate
bond issue to retire a higher-interest-rate issue and reducing the
firms interest expense is called a refunding operation.
a. The refunding operation is similar to a homeowner refinancing
his or her home mortgage after a decline in rates.
E. A sinking fund provision facilitates the orderly retirement of a bond
issue.
1. The issuer can handle the sinking fund requirement in one of two
ways, and the firm will choose the least-cost method.
a. The company can call in for redemption (at par value) a
certain percentage of bonds each year. If interest rates have
fallen, a firm will call the bonds.
b. The company may buy the required amount of bonds on the
open market. If interest rates have risen, causing bond prices
to fall, it will buy bonds in the open market at a discount.
2. Bonds that have a sinking fund are regarded as being safer than
those without such a provision, so at the time they are issued
sinking fund bonds have lower coupon rates than otherwise
similar bonds without sinking funds.
3. A sinking fund call typically requires no call premium, but only a
small percentage of the issue is normally callable in any one
year.
4. A failure to meet the sinking fund requirement constitutes a
default, which may throw the company into bankruptcy.
Therefore, a sinking fund is a mandatory payment.
F. Several other types of bonds may be used.
1. Convertible bonds are securities that are exchangeable into
shares of common stock, at a fixed price, at the option of the
bondholder.
a. Convertibles have a lower coupon rate than nonconvertible
debt with similar credit risk, but they offer investors a chance
for capital gains in exchange for the lower coupon rate.
2. Bonds issued with warrants are similar to convertibles.
a. Warrants are options that permit the holder to buy stock for a
stated price, thereby providing a capital gain if the stocks
price rises.
b. Bonds that are issued with warrants carry lower coupon rates
than otherwise similar nonconvertible bonds.
3. Putable bonds contain provisions that allow the bonds investors
to sell the bonds back to the company prior to maturity at a
specified price.
a. If interest rates rise, then investors will put these bonds back
to the company and reinvest in higher coupon bonds.
4. Income bonds pay interest only if the interest is earned.
a. These securities cannot bankrupt a company, but from an
investors standpoint they are riskier than regular bonds.
5. The interest rate of an indexed, or purchasing power, bond is
based on an inflation index such as the consumer price index
(CPI), so the interest paid rises automatically when the inflation
rate rises, thus protecting the bondholders against inflation.
a. The U.S. Treasury is the main issuer of indexed bonds called
Treasury Inflation Protected Securities (TIPS).
III. The value of any financial asset is simply the present value of
the cash flows the asset is expected to produce. The cash
flows from a specific bond depend on its contractual features.
A. A bond represents an annuity plus a lump sum, and its value is
found as the present value of this payment stream:
0 rd 1 2 3 N
| | | | |
VB INT INT INT INT
M
N
INT M
Bond value = VB = (1 r )
t 1
t

(1 rd ) N
d
1. Here INT = dollars of interest paid each year, M = par, or
maturity, value, which is typically $1,000, rd = market interest
rate on the bond, and N = number of years until the bond
matures.
B. For example, consider a 15-year, $1,000 bond paying $100
annually, when the appropriate interest rate, rd, is 10%. Using a
financial calculator, enter N = 15, rd = I/YR = 10, PMT = 100, and
FV = 1000, and then press the PV key for an answer of $1,000.
1. The value of the bond can be found using Excels built-in function
with the following format: PV(rate,nper,pmt,[fv],[type]).
2. Type indicates whether cash flows occur at the end of periods
or at the beginning of periods. Zero for type indicates end-of-
period cash flows, while 1 indicates beginning-of-period cash
flows.
C. Bond prices and interest rates are inversely related; that is, they
tend to move in the opposite direction from one another. Interest
rates do change over time, but for a fixed-rate bond the coupon
rate remains fixed after the bond has been issued.
1. A fixed-rate bond will sell at par when its coupon interest rate is
equal to the going rate of interest, rd.
2. A discount bond is a bond that sells below its par value, when
the going rate of interest rises above the coupon rate.
3. A premium bond is a bond that sells above its par value, when
the going rate of interest falls below the coupon rate.
IV. Unlike the coupon interest rate, which is fixed, a bonds yield
varies from day to day depending on current market conditions.
The expected interest rate on a bond, also called its yield,
can be calculated in a variety of different ways.
A. To be most useful, the bonds yield should give us an estimate of
the rate of return we would earn if we purchase the bond today and
held it over its remaining life.
1. A bonds yield can be calculated using Excels built-in function
with the following format:
RATE(nper,pmt,pv,[fv],[type],[guess]).
B. The rate of return earned on a bond if it is held until maturity is
known as the yield to maturity (YTM).
1. The yield to maturity is generally the same as the market rate of
interest, rd.
2. The yield to maturity can also be viewed as the bonds promised
rate of return.
3. The yield to maturity equals the expected rate of return only if
the probability of default is zero and the bond cannot be called.
4. An investor who purchases a bond and holds it until it matures
will receive the YTM that existed on the purchase date, but the
bonds calculated YTM will change frequently between the
purchase date and the maturity date.
C. If current interest rates are well below an outstanding bonds
coupon rate, then a callable bond is likely to be called, and
investors should estimate the expected rate of return on the bond
as the yield to call (YTC) rather than as the yield to maturity. To
calculate the YTC, solve this equation for rd:
N
INT Call price
Price of bond = (1 r )
t 1
t

(1 rd ) N
d

1. Here N is the number of years until the company can call the
bond; call price is the price the company must pay in order to
call the bond (which is often set equal to the par value plus one
years interest); and rd is the YTC.
2. Whether a company calls its callable bonds depends on what the
going interest rate is when they become callable and whether
the benefit (interest savings) is greater than the cost of calling
the bonds.
D. Brokerage houses occasionally report a bonds current yield.
1. The current yield is defined as the annual interest payment
divided by the current price.
2. The current yield does not represent the actual return that
investors should expect because it does not account for the
capital gain or loss that will be realized if the bond is held until it
matures or is called.
V. When a coupon bond is issued, the coupon is generally set at a
level that causes the bonds market price to equal its par value.
A. A new issue is the term applied to a bond that has just been issued.
1. Once the bond has been on the market for a while, it is classified
as an outstanding bond, or a seasoned issue.
B. The total rate of return on a bond consists of a current yield plus a
capital gains yield.
1. A bonds current yield is calculated as the coupon interest
divided by the bonds price.
2. A bonds capital gains yield is calculated as the bonds annual
change in price divided by the beginning-of-year price.
3. In the absence of default risk and assuming market equilibrium,
the total return is also equal to YTM and the market interest
rate.
4. The market value of a bond will always approach its par value as
its maturity date approaches, provided the firm does not go
bankrupt.
VI. The bond valuation model must be adjusted when interest is
paid semiannually.
A. Divide the annual coupon interest payment by 2 to determine the
dollars of interest paid each six months; multiply the years to
maturity by 2 to determine the number of semiannual periods; and
divide the nominal interest rate by 2 to determine the periodic
interest rate.
B. The value with semiannual interest payments is larger than the
value when interest is paid annually.
1. This higher value occurs because interest payments are received
somewhat faster under semiannual compounding.
VII. Interest rates fluctuate over time, and an increase in interest
rates leads to a decline in the value of outstanding bonds.
A. People or firms who invest in bonds are exposed to risk from
changing interest rates, or price risk.
1. For bonds with similar coupons, the longer the maturity of the
bond, the greater the exposure to price risk.
2. Even if the risk of default on two bonds is exactly the same, the
bond with the longer maturity is typically exposed to more risk
from a rise in interest rates.
a. This follows because the longer the maturity, the longer
before the bond will be paid off and the bondholder can
replace it with another bond having a higher coupon.
B. The risk of a decline in income due to a drop in interest rates is
called reinvestment risk.
1. Reinvestment risk is high on callable bonds.
2. It is also high on short-term bonds, because the shorter the
bonds maturity, the fewer the years before the relatively high
old-coupon bonds will be replaced with new low-coupon bonds.
C. Price risk relates to the current market value of the bonds in a
portfolio, while reinvestment risk relates to the income the portfolio
produces. No fixed-rate bond can be considered totally riskless.
D. A bonds risk depends critically on how long the investor plans to
hold the bond, which is referred to as the investors investment
horizon.
1. Even a small change in interest rates can have a large effect on
the prices of long-term securities.
2. Investors with shorter investment horizons view long-term bonds
as risky investments.
3. Short-term bonds tend to be riskier than long-term bonds for
investors who have longer investment horizons.
E. To account for the effects related to both a bonds maturity and
coupon, many analysts focus on a measure called duration. Web
Appendix 7B discusses duration and its calculation in greater detail.
1. A bonds duration is the weighted average of the time it takes to
receive each of the bonds cash flows.
2. A zero coupon bond whose only cash flow is paid at maturity has
a duration equal to its maturity.
3. A bonds duration is calculated as follows:
N
t (CFt )
(1 r )
t 1
t

Duration d

VB

Here rd is the required return on the bond, N is the bonds years


to maturity, t is the year each cash flow occurs, and CFt is the
cash flow in Year t. (CFt = INT for t < N and CFt = INT + M for t
= N, where INT is the interest payment and M is the principal
payment.)
4. Excels DURATION function can be used to calculate a bonds
duration.
F. One simple way to minimize price risk and reinvestment risk is to
buy a zero-coupon Treasury security with a maturity that equals the
investors investment horizon.
1. The investor will receive a guaranteed payment equal to the
bonds face value; hence, the investor faces no price risk.
2. As there are no coupons to reinvest, there is no reinvestment
risk.
3. Investors in zeros have to pay taxes each year on their
amortized gain in value, even though the bonds dont produce
any cash until the bond matures or is sold.
4. Purchasing a zero-coupon bond with a maturity equal to the
investors investment horizon enables the investor to lock in a
nominal cash flow, but the value of that cash flow will still
depend on what happens to inflation during the investors
investment horizon.
G. A positive maturity risk premium would suggest that investors on
average regard longer-term bonds as being riskier than shorter-
term bonds.
VIII. Potential default is another important risk that bondholders
face. If the issuer defaults, investors receive less than the
promised return on the bond.
A. Default risk is influenced by both the financial strength of the issuer
and the terms of the bond contract, especially whether collateral
has been pledged to secure the bond.
B. The higher the probability of default, the higher the premium and
thus the yield to maturity.
1. Default risk on Treasury securities is zero, but default risk can be
substantial for lower-grade corporate and municipal bonds.
2. If a bonds default risk changes, this will affect the bonds price.
C. Corporations can influence the default risk of their bonds by
changing the types of bonds they issue.
1. With a mortgage bond, the corporation pledges certain assets as
security for the bond.
a. All mortgage bonds are written subject to an indenture, which
is a legal document that spells out in detail the rights of both
the bondholders and the corporation.
b. These indentures are generally open ended, meaning that
new bonds can be issued from time to time under the same
indenture.
c. The amount of new bonds that can be issued is usually limited
to a specific percentage of the firms total bondable
property.
2. A debenture is an unsecured bond, and as such, it provides no
lien against specific property as security for the obligation.
a. Debenture holders are general creditors whose claims are
protected by property not otherwise pledged.
b. In practice, the use of debentures depends both on the nature
of the firms assets and on its general credit strength.
3. Subordinated debentures have claims on assets, in the event of
bankruptcy, only after senior debt as named in the subordinated
debts indenture has been paid.
a. Subordinated debentures may be subordinated to designated
notes payable or to all other debt.
b. How subordination works, and how it strengthens the position
of senior debtholders, is explained in detail in Web Appendix
7C.
D. Bond issues are normally assigned quality ratings by rating
agencies. The three major rating agencies are Moodys Investors
Service (Moodys), Standard & Poors Corporation (S&P), and Fitchs
Investor Service. These ratings reflect the probability that a bond
will go into default.
1. Aaa (Moodys) and AAA (S&P) are the highest ratings. The
triple- and double-A bonds are extremely safe.
2. Single-A and triple-B bonds are also strong enough to be called
investment-grade bonds and they are the lowest-rated bonds
that many banks and other institutional investors are permitted
by law to hold.
3. Double-B and lower-rated bonds are speculative, or junk, bonds,
which have a significant probability of going into default.
4. Bond rating assignments are based on both qualitative and
quantitative factors including the firms financial ratios and a
firms business risk, such as its competitiveness within its
industry and the quality of its management.
a. Companies with lower business risk, lower debt ratios, higher
cash flow to debt, and lower debt to EBITDA typically have
higher bond ratings.
5. Bond ratings are important both to firms and to investors.
a. A bonds rating is an indicator of its default risk, so the rating
has a direct, measurable influence on the bonds interest rate
and the firms cost of debt.
b. Most bonds are purchased by institutional investors rather
than individuals, and many institutions are restricted to
investment-grade securities, securities with ratings of
Baa/BBB or above.
6. Changes in a firms bond rating affect both its ability to borrow
capital and the cost of that capital.
7. Rating agencies review outstanding bonds on a periodic basis,
occasionally upgrading or downgrading a bond as the issuers
circumstances change.
a. If a company issues more bonds, this will trigger a review by
the rating agencies.
b. Over the long run, bond ratings have done a reasonably good
job of measuring the average credit risk of bonds and of
changing ratings whenever there is a significant change in
credit quality.
c. Bond ratings do not adjust immediately to changes in credit
quality, and in some cases there can be a considerable lag
between a change in credit quality and a change in rating.
E. In the event of bankruptcy, debtholders have a prior claim over the
claims of both common and preferred stockholders to a firms
income and assets.
1. When a business becomes insolvent, it does not have enough
cash to meet scheduled interest and principal payments. Thus,
it must decide whether to dissolve the firm through liquidation or
to permit it to reorganize and thus stay alive. These issues are
discussed in Chapters 7 and 11 of the federal bankruptcy
statutes.
2. In a reorganization, a plan may call for restructuring the firms
debt, in which case the interest rate may be reduced, the term
to maturity lengthened, or some of the debt may be exchanged
for equity.
a. The point of the restructuring is to reduce the financial
charges to a level that the firms cash flows can support.
3. Liquidation occurs if the company is deemed to be too far gone
to be saved.
a. Upon liquidation, assets are sold and the cash is distributed
as specified in Chapter 7 of the Bankruptcy Act, beginning
with highest priority to secured creditors and ending with
lowest priority to common stockholders (assuming any assets
are left).
4. Stockholders generally receive little in reorganizations and
nothing in liquidations because the assets are generally worth
less than the amount of debt outstanding.
5. The major points of bankruptcy are:
a. Federal bankruptcy statutes govern reorganization and
liquidation.
b. Bankruptcies occur frequently.
c. A priority of the specified claims must be followed when the
assets of a liquidated firm are distributed.
d. Bondholders treatment depends on the terms of the bond
issue.
e. Stockholders generally receive little in reorganizations and
nothing in liquidations because the firms assets are usually
worth less than the amount of debt outstanding.
6. Web Appendix 7C discusses bankruptcy and reorganization in
more detail.
IX. Bonds are traded primarily in the over-the-counter market.
A. Most bonds are owned by and traded among the large financial
institutions, and it is relatively easy for the over-the-counter bond
dealers to arrange the transfer of large blocks of bonds among the
relatively few holders of the bonds.
B. The Wall Street Journal routinely reports key developments in the
Treasury, corporate, and municipal bond markets.
1. The online edition also lists for each trading day the most
actively traded investment-grade bonds, high-yield bonds, and
convertible bonds.