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Week 5 – Overview & Learning Objectives

Week 5 – Overview & Learning ObjectivesAttached Files:

Chapter 5-Bonds, Bond Valuation, and Interest Rates..pptx Chapter 5-Bonds, Bond Valuation, and Interest Rates..pptx – Alternative Formats (894.635 KB)

Assigned Readings:Chapter 5. Bonds, Bond Valuation, and Interest Rates.Overview:Some of the various types of bonds are treasury bonds, treasury bills, corporate bonds, municipal bonds, and foreign bonds. The market interest rate of a bond is determined by the risk-free rate, the inflation premium, the maturity risk premium, default risk premium and the liquidity premium. It is important to understand that a bond’s price has an inverse relationship to current market rate of interest, therefore, as interest rates rise, the value or your bond will decrease.Learning Objectives:Chapter 5: Bonds, Bond Valuation, and Interest RatesLearning Objectives:

Understand Bonds issuance and the Key Characteristics of Bonds
Understand Bond Valuation
Determinants of Market Interest Rates
Understand Risk-Free Interest Rate
Understand Inflation Premium (IP)
Understand Maturity Risk Premium (MRP)
Understand Default Risk Premium (DRP)
Understand Liquidity Premium (LP)
Understand the Term Structure of Interest Rates
Financing with Junk Bonds
Bankruptcy and Reorganization

Problem Set #5

1. Jackson Corporation’s bonds have 10 years remaining to maturity. Interest is paid annually, the bonds have a $1,000 par value, and the coupon interest rate is 9%. The bonds have a yield to maturity of 10%. What is the current market price of these bonds?2. Renfro Rentals has issued bonds that have a 10% coupon rate, payable semiannually. The bonds mature in 10 years, have a face value of $1,000, and a yield to maturity of 9%. What is the price of the bonds?3. Wilson Wonders’s bonds have 10 years remaining to maturity. Interest is paid annually, the bonds have a $1,000 par value, and the coupon interest rate is 10%. The bonds sell at a price of $900. What is their yield to maturity?4. Heath Foods’s bonds have 10 years remaining to maturity. The bonds have a face value of $1,000 and a yield to maturity of 9%. They pay interest annually and have a 10% coupon rate. What is their current yield?5. Suppose Hillard Manufacturing sold an issue of bonds with a 12-year maturity, a $1,000 par value, a 10% coupon rate, and semiannual interest payments.

Two years after the bonds were issued, the going rate of interest on bonds such as these fell to 5%. At what price would the bonds sell?
Suppose that 2 years after the initial offering, the going interest rate had risen to 11%. At what price would the bonds sell?
Suppose that 2 years after the issue date (as in part a) interest rates fell to 5%. Suppose further that the interest rate remained at 6% for the next 10 years. What would happen to the price of the bonds over time?

Submit your answers in a Word document.

Bonds, Bond Valuation, and Interest Rates

CHAPTER 5

© 2020 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Topics in Chapter
Key features of bonds
Bond valuation
Measuring yield
Assessing risk

Determinants of Intrinsic Value: The Cost of Debt

Key Features of a Bond (1 of 2)
Par value: Face amount; paid at maturity. Assume $1,000.
Coupon interest rate: Stated interest rate. Multiply by par value to get dollars of interest. Generally fixed.

Key Features of a Bond (2 of 2)
Maturity: Years until bond must be repaid. Declines.
Issue date: Date when bond was issued.
Default risk: Risk that issuer will not make interest or principal payments.

Call Provision
Issuer can refund if rates decline. That helps the issuer but hurts the investor.
Therefore, borrowers are willing to pay more, and lenders require more, on callable bonds.
Most bonds have a deferred call and a declining call premium.

What’s a sinking fund?
Provision to pay off a loan over its life rather than all at maturity.
Similar to amortization on a term loan.
Reduces risk to investor, shortens average maturity.
But not good for investors if rates decline after issuance.

Sinking funds are generally handled in 2 ways
Call x% at par per year for sinking
fund purposes.
Call if rd is below the coupon rate and bond sells at a premium.
Buy bonds on open market.
Use open market purchase if rd is above coupon rate and bond sells at a discount.

Value of a 10-year, 10% coupon bond if rd = 10%

The bond consists of a 10-year, 10% annuity of $100/year plus a $1,000 lump sum at t = 10:
PV annuity = $614.46
PV maturity value = 385.54
Value of bond = $1,000.00

What would happen if expected inflation rose by 3%, causing r = 13%?
When rd rises, above the coupon rate, the bond’s value falls below par, so it sells at a discount.

What would happen if inflation fell, and rd declined to 7%?
If coupon rate > rd, price rises above par, and bond sells at a premium.

Bond Value ($) vs. Years remaining to Maturity
(1 of 2)
Suppose the bond was issued 20 years ago and now has 10 years to maturity. What would happen to its value over time if the required rate of return remained at 10%, or at 13%, or at 7%?
See next slide.

Bond Value ($) vs. Years remaining to Maturity
(2 of 2)

Bond Value ($) vs. Years remaining to Maturity
(2 of 3)
At maturity, the value of any bond must equal its par value.
The value of a premium bond would decrease to $1,000.
The value of a discount bond would increase to $1,000.
A par bond stays at $1,000 if rd remains constant.

What’s “yield to maturity”?
YTM is the rate of return earned on a bond held to maturity. Also called “promised yield.”
It assumes the bond will not default.

YTM on a 10-year, 9% annual coupon, $1,000 par value bond selling for $887

Find rd

If coupon rate < rd, bond sells at a discount. If coupon rate = rd, bond sells at its par value. If coupon rate > rd, bond sells at a premium.
If rd rises, price falls.
Price = par at maturity.

Find YTM if price were $1,134.20.
Sells at a premium.
Because coupon = 9% > rd = 7.08%,
bond’s value > par.

Definitions

9% coupon, 10-year bond, P = $887, and YTM = 10.91%

YTM = Current yield + Capital gains yield.

Could also find values in Years 1 and 2,
get difference, and divide by value in
Year 1. Same answer.

Semiannual Bonds
1. Multiply years by 2 to get periods = 2N.
2. Divide nominal rate by 2 to get periodic rate = rd/2.
3. Divide annual INT by 2 to get PMT = INT/2.

Value of 10-year, 10% coupon, semiannual bond if rd = 13%.

Spreadsheet Functions for Bond Valuation
See Ch04 Mini Case.xls for details.
PRICE
YIELD

Callable Bonds and Yield to Call
A 10-year, 10% semiannual coupon,
$1,000 par value bond is selling for
$1,135.90 with an 8% yield to maturity.
It can be called after 5 years at $1,050.

Nominal Yield to Call (YTC)

If you bought bonds, would you be more likely to earn YTM or YTC?
Coupon rate = 10% vs. YTC = rd = 7.53%. Could raise money by selling new bonds which pay 7.53%.
Could thus replace bonds which pay $100/year with bonds that pay only $75.30/year.
Investors should expect a call, hence YTC = 7.5%, not YTM = 8%.

In general, if a bond sells at a premium, then coupon > rd, so a call is likely.
So, expect to earn:
YTC on premium bonds.
YTM on par & discount bonds.

rd = r* + IP + MRP + DRP + LP.

What is the real risk-free rate (r*)?
Rate that a hypothetical riskless security pays each moment if zero inflation were expected.
r* changes over time depending on economic conditions.
r* can be approximated by rate on short-term Treasury Inflation-Protected Securities (TIPS).

What is the nominal risk-free rate (rRF)?
The rate on a U.S. Treasury security
Short-term security: T-bill
Long-term security: T-bond

Estimating IP
Treasury Inflation-Protected Securities (TIPS) are indexed to inflation.
The IP for a particular length maturity can be approximated as the difference between the yield on a non-indexed Treasury security of that maturity minus the yield on a TIPS of that maturity.

Bond Spreads, the DRP, and the LP
A “bond spread” is often calculated as the difference between a corporate bond’s yield and a Treasury security’s yield of the same maturity. Therefore:
Spread = DRP + LP.
Bond’s of large, strong companies often have very small LPs. Bond’s of small companies often have LPs as high as 2%.

Bond Ratings
Bond Ratings % defaulting within:
S&P and Fitch Moody’s 1 yr. 5 yrs.
Investment grade bonds:
AAA Aaa 0.13 0.68
AA Aa 0.00 0.00
A A 0.09 0.96
BBB Baa 0.07 1.72
Junk bonds:
BB Ba 0.62 6.35
B B 2.06 11.68
CCC Caa 21.36 35.38

Bond Ratings and Bond Spreads (October 2016)
Long-term Bonds Yield (%) Spread (%)
10-Year T-bond 1.72
AAA 2.21 0.49
AA 2.27 0.55
A 2.42 0.70
BBB 3.46 1.74
BB 5.16 3.44
B 6.58 4.86
CCC 8.37 6.65

What factors affect default risk and bond ratings?
Financial ratios
Debt ratio
Coverage ratios, such as interest coverage ratio or EBITDA coverage ratio
Profitability ratios
Current ratios

Bond Ratings Median Ratios (S&P)
Return on capital Debt to capital
AAA 27.6% 12.4%
AA 27.0% 28.3%
A 17.5% 37.5%
BBB 13.4% 42.5%
BB 11.3% 53.7%
B 8.7% 75.9%
CCC 3.2% 113.5%

Other Factors that Affect Bond Ratings (1 of 2)
Provisions in the bond contract
Secured versus unsecured debt
Senior versus subordinated debt
Guarantee provisions
Sinking fund provisions
Debt maturity

Other Factors that Affect Bond Ratings (2 of 2)
Other factors
Earnings stability
Regulatory environment
Potential product liability
Accounting policies

Interest rate (or price) risk for 1-year and 10-year 10% bonds
Interest rate risk:
Rising rd causes bond prices to fall
1-Year 1-Year 10-Year 10-Year
rd Price Change Price Change
5.0% $1,048 $1,386
4.8% 38.6%
10.0% $1,000 $1,000
4.5% 33.5%
15.0% $957 $749

Value

What is reinvestment rate risk? (1 of 2)
The risk that CFs will have to be reinvested in the future at lower rates, reducing income.
Illustration: Suppose you just won $500,000 playing the lottery. You’ll invest the money and live off the interest. You buy a 1-year bond with a YTM of 10%.

What is reinvestment rate risk? (2 of 2)
Year 1 income = $50,000. At year-end get back $500,000 to reinvest.
If rates fall to 3%, income will drop from $50,000 to $15,000. Had you bought 30-year bonds, income would have remained constant.

The Maturity Risk Premium
Long-term bonds: High interest rate risk, low reinvestment rate risk.
Short-term bonds: Low interest rate risk, high reinvestment rate risk.
Nothing is riskless!
Yields on longer term bonds usually are greater than on shorter term bonds, so the MRP is more affected by interest rate risk than by reinvestment rate risk.

Term Structure Yield Curve
Term structure of interest rates: the relationship between interest rates (or yields) and maturities.
A graph of the term structure is called the yield curve.

Hypothetical Treasury Yield Curve

Bankruptcy (1 of 4)
Two main chapters of Federal Bankruptcy Act:
Chapter 11, Reorganization
Chapter 7, Liquidation
Typically, company wants Chapter 11, creditors may prefer Chapter 7.

Bankruptcy (2 of 4)
If company can’t meet its obligations, it files under Chapter 11. That stops creditors from foreclosing, taking assets, and shutting down the business.
Company has 120 days to file a reorganization plan.
Court appoints a “trustee” to supervise reorganization.
Management usually stays in control.

Bankruptcy (3 of 4)
Company must demonstrate in its reorganization plan that it is “worth more alive than dead.”
Otherwise, judge will order liquidation under Chapter 7.

If the company is liquidated, here’s the payment priority:
Past due property taxes
Secured creditors from sales of secured assets.
Trustee’s costs
Expenses incurred after bankruptcy filing
Wages and unpaid benefit contributions, subject to limits
Unsecured customer deposits, subject to limits
Taxes
Unfunded pension liabilities
Unsecured creditors
Preferred stock
Common stock

Bankruptcy (4 of 4)
In a liquidation, unsecured creditors generally get zero. This makes them more willing to participate in reorganization even though their claims are greatly scaled back.
Various groups of creditors vote on the reorganization plan. If both the majority of the creditors and the judge approve, company “emerges” from bankruptcy with lower debts, reduced interest charges, and a chance for success.

(
)
(
)
(
)
B
1NN
ddd
$100$100$1,000
V…
1r1r1r
$90.91…$38.55$385.54
$1,000.
=+++
+++
=+++
=
(
)
(
)
(
)
(
)
(
)
(
)
B
1NN
ddd
1NN
ddd
INTINTM
V…
1r1r1r
90901,000
887…
1r1r1r
=+++
+++
=+++
+++
Annual coupon pmt
Current yield
Current price
Change in price
Capital gains yield
Beginning price
Exp totalreturn= YTM  ExpCurr yldExp cap
gains yld
=
=
=+
$90
Current yield
$887
0.101510.15%.
=
==
Cap gains yieldYTMCurrent yield
10.91%10.15%
0.76%.
=-
=-
=
Here:
rd  Required rate of return on a debt se
curity.
r*  Real riskfree rate.
IP  Inflation premium.
MRP  Maturity risk premium.
DRP  Default risk premium.
LP  Liquidity premium.
=
=-
=
=
=
=

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