7-1 CHAPTER 9 Bonds and Their Valuation Key features of bonds Bond valuation Measuring yield Assessing risk.

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1 7-1 CHAPTER 9 Bonds and Their Valuation Key features of bonds Bond valuation Measuring yield Assessing risk

2 7-2 What is a Bond? Treasury Bonds Corporate Bonds Municipal Bonds Foreign Bonds A long-term debt instrument in which a borrower agrees to make payments of principal and interest, on specific dates, to the holders of the bond.  Fed Government  Corporations  Local Government  Foreign Government or Foreign Corporations Type of BondIssuer

3 7-3 Key Features of a Bond Par value – face amount of the bond, which is paid at maturity (assume $1,000). Coupon interest rate – stated interest rate (generally fixed) paid by the issuer. Multiply by par value to get dollar payment of interest. Maturity date – years until the bond must be repaid. Issue date – when the bond was issued. Yield to maturity - rate of return earned on a bond held until maturity (also called the “promised yield”).

4 7-4 Call Provision Allows issuer to refund the bond issue if rates decline (helps the issuer, but hurts the investor). Borrowers are willing to pay more, and lenders require more, for callable bonds. Effect of a call provision

5 7-5 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. What is a sinking fund?

6 7-6 Other Types (Features) of Bonds Convertible bond – may be exchanged for common stock of the firm, at the holder’s option. Warrant – long-term option to buy a stated number of shares of common stock at a specified price. Putable bond – allows holder to sell the bond back to the company prior to maturity. Income bond – pays interest only when interest is earned by the firm. Indexed bond – interest rate paid is based upon the rate of inflation.

7 7-7 The Value of Bond 012N rd% INT 1 INT N INT 2 Bond’s Value... M N N 2 2 1 1 r)(1 INT... r)(1 INT r)(1 INT Bond’s Value + + + + + + = M N r) + (1+

8 7-8 What is the value of a 10-year, 10% annual coupon bond, if r d = 10%? 012N rd 100 100 + 1,000 100V B = ?... The Value of Bond

9 7-9 What would happen to the value of these three bonds if its required rate of return remained at 10%: Years to Maturity 1,184 1,000 816 10 5 0 13% coupon rate 7% coupon rate 10% coupon rate. VBVB Bond value over time The Value of Bond

10 7-10 At maturity, the value of any bond must equal its par value. If r d remains constant: – The value of a premium bond would decrease over time, until it reached $1,000. – The value of a discount bond would increase over time, until it reached $1,000. – A value of a par bond stays at $1,000. Bond value over time The Value of Bond

11 7-11 Bond Yields Definitions

12 7-12 Current yield Find the current yield and the capital gains yield for a 14-year, 10% annual coupon bond that sells for $1,494.93, and has a face value of $1,000. Current yield = $100 / $1,494.93 = 0.0669 = 6.69% Bond Yields

13 7-13 Bond Yields Must find the r d that solves this model. What is the YTM on a 14-year, 10% annual coupon, $1,000 par value bond, selling for $1,494.93? Yield to Maturity YTM = 5

14 7-14 Capital gains yield YTM = Current yield + Capital gains yield CGY= YTM – CY = 5% - 6.69% = -1.69% Could also find the expected price one year from now and divide the change in price by the beginning price, which gives the same answer. Bond Yields

15 7-15 Yield to Call The rate of return earned on a bond if it is called before its maturity date. Suppose you were offered a 14-year, 10% annual coupon, $1,000 par value bond at a price of $1,494.93. You desired to call them 10 years after their issue date at a price of $1,100. What is the YTC on bonds? Bond Yields YTC = 4.21

16 7-16 When is a call more likely to occur? In general, if a bond sells at a premium, then (1) coupon > r d, so (2) a call is more likely. So, expect to earn: – YTC on premium bonds. – YTM on par & discount bonds. Yield to Call Bond Yields

17 7-17 Semiannual Bonds 1.Multiply years by 2: number of periods = 2n. 2.Divide nominal rate by 2: periodic rate (I/YR) = r d /2. 3.Divide annual coupon by 2: PMT = INT / 2. Semiannual Bond’s Value

18 7-18 What is the value of a 10-year, 10% semiannual coupon bond, if r d = 13%? 1.Multiply years by 2 : N = 2 × 10 = 20. 2.Divide nominal rate by 2 : r d /2 = 13% / 2 = 6.5% 3.Divide annual coupon by 2 : PMT = 10% × $1,000)/2 = $100 / 2 = $50. Semiannual Bonds Illustrating Semiannual Bonds

19 7-19 Default risk If an issuer defaults, investors receive less than the promised return. Bonds with higher default risk will have higher market rates: r d = r* + IP + MRP + DRP + LP. If the default risk on the bond increases, its price will fall and the yield to maturity (YTM = r d ) will increase.

20 7-20 Evaluating default risk: Bond ratings Investment GradeJunk Bonds Moody’s Aaa Aa A BaaBa B Caa C S & P AAA AA A BBBBB B CCC D Bond ratings are designed to reflect the probability of a bond issue going into default.

21 7-21 Factors affecting bond ratings 1.Financial performance – Debt ratio – TIE ratio – Current ratio 2.Bond contract provisions – Secured vs. Unsecured debt – Senior vs. subordinated debt – Guarantee and sinking fund provisions – Debt maturity

22 7-22 Factors affecting bond ratings 3.Qualitative factors:  Earnings stability (strength of economy)  Labor problem  Stability of the countries  Potential environmental problem  Potential antitrust problem  The complexity of the assets backed by such loans

23 7-23 LATIHAN Seandainya suatu obligasi korporat yang memiliki nilai pari Rp1.000.000 dapat dijual dengan harga Rp1.086.260. Return yang diharapkan oleh seorang investor adalah 8%. Berapakah tingkat kupon tahunan obligasi tersebut, jika hingga jatuh temponya memiliki masa selama 7 tahun?