Ch06 Ppt Brighamfm1ce

8/3/2019 Ch06 Ppt Brighamfm1ce

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PowerPoint Presentationprepared by

Traven ReedCanadore College


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chapter6Bonds, Bond Valuation,

and Interest Rates


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CH6

Copyright 2011 by Nelson Education Ltd. All rights reserved. 6-3

Corporate Valuation and Risk


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Topics in Chapter

Key features of bonds

Bond valuation

Measuring yield

Determining interest rate

Term structure

Assessing risk


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Bond Issuers

Bond is a promissory note (i.e. a fancy IOU)issued by a business, a government unit or a

foreign party. Each type differs in risk and expected return.

Although Government of Canada bonds haveno default risk, they are not riskless.

Depending on th

e business,c

orporate bondsare exposed to default risk.

Foreign bonds have additional exchange raterisk. With C$ denominations, Maple bonds areappealing.



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Key Features of a Bond

Par value: Face amount; paid atmaturity. Assume $1,000.

Coupon interest rate: Statedinterest rate. Multiply by par value

to get dollars of interest. Generallyfixed, but can vary.


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Maturity: Years until bond must berepaid. Declines.

Issue date: Date when bond wasissued.

Default risk: Risk that issuer willnot make interest or principalpayments.

Key Features of a Bond (contd)


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Call Provision

Issuercan refund if interest ratesdecline. That helps the issuer but hurts

the investor. Therefore, borrowers are willing to pay

more, and lenders require more, oncallable bonds.

Most bonds have a deferred call and adeclining call premium. The Canadacall feature restricts the call price to acertain level.


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Retractable Bonds

Investors have the right to sell thebonds back before maturity to the

issuing company at a pre-set price.

Protect investors from the risinginterest rates or the event risk.



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Whats a sinking fund?

Provision to pay off a loan over itslife rather than all at maturity.

Similar to amortization on a termloan.

Reduces risk to investor, shortens

average maturity.

But not good for investors if ratesdecline after issuance.


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Sinking funds are generallyhandled in 2 ways

1. Call x% at par per year forsinking fund purposes.

2. Buy bonds on open market. Company would call if the going

market rate of interest (rd) is below

thecoupon rate and bond sells at apremium. Use open market

purchase if rd is above coupon rateand bond sells at a discount.


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Other Bond Features

Convertible bonds: convert intoshares ofcommon stock, at a fixed

price, at the bondholders discretion

Income bonds: pay interest onlywhen the issuercan afford.

Real return bonds: principal andinterests are indexed and protectedagainst inflation.



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PV =

INT

1+ rd

... +(INT+M)

1+rd1 2

1

INT

rdn

0 1 2 n

Rd%

INT INT +MINTValue

...

+ ++

Bond Valuation


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15 10 100 1000N I/YR PV PMT FV

-1,000

$ 760.61

239.39$1,000.00

PV annuity

PV maturity valueValue of bond

=

==

INPUTS

OUTPUT

The bond consists of a 15-year, 10% annuityof $100/year plus a $1,000 lump sum at t = 15:


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Zero-coupon Bond Prices

With no intern interest payments,the price of a zero is the present

value of the principal payment atmaturity.


N

d

zero

r

M

V)1(

!


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When rd rises, above the couponrate, the bonds value falls belowpar, so it sells at a discount.

15 15 100 1000

N I/YR PV PMT FV-707.63

INPUTS

OUTPUT

What would happen if going marketrate of interest r

d

= 15%?


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What would happen if rddeclined to 5%?

If coupon rate > rd, price risesabove par, and bond sells at apremium.

15 5 100 1000

N I/YR PV PMT FV-1,518.98

INPUTS

OUTPUT


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Whats yield-to-maturity?

YTM is the expected rate of total returnearned on a bond held to maturity. Also

called promised yield. YTM = expected current (interest) yield +

expected capital gains yield.

It assumes the bond will not default andcannot be called.

YTM changes whenever market interestrates change.


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YTM on a 14-year, 10% annual coupon,$1,000 par value bond selling for $1,494.93

100 100100

0 1 13 14rd=?

1,000PV1..

.PV10PVM

1,494.93 Find rd that works!

...


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VINT

r

M

r

B

d

N

d

N!

1 1

1... +

INT

1+ rd

1494.93 100

1

1,000

11 14 14!

r rd d+

100

1+ rd

++

++

++++

Solving for the unknown rd is tedious.Need a financial calculator.

...

Find rd


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Callable Bonds and Yield to Call

A 10-year, 10% annual coupon,$1,000 par value bond is selling for

$1,494.93 with an 5% yield-to-maturity.It can be called after 1 year at

$1,100

N

d

N

tt

d

CALLr

callprice

r

INTV

)1()1(1

!!


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9 -1494.93 100 1100N I/YR PV PMT FV

4.21=YTC

INPUTS

OUTPUT

Yield to Call (YTC)


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If you bought bonds, would you bemore likely to earn YTM or YTC?

Coupon rate = 10% vs. YTC = rd =4.21%. Firm could raise money by

selling new bonds which pay 4.21% Could thus replace bonds which

pay $100/year with bonds that payonly $42.1/year.

Investors should expect a call,hence YTC = 4.21%, not YTM = 5%


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Current yield

Current yield =

= 0.0669 = 6.69%

$100$1,494.93

10% coupon, 14-year bond, P =$1,494.93, and YTM = 5.0%

Current yield =Annual coupon pmt

Current price


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Cap gains yield = YTM - Current yield

= 5.00% - 6.69%= - 1.69%

Capital gains yield

Cap gains yield= Change in price/beginning price= -25.25/1494.93 = - 1.69%


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M

1,495

1,000

714

0 1 2 3 14 15

Premium bond

Discount bond

rd = 10% (par bond)

Changes in Bond Values ($)Over Time


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At maturity, the value of any bondmust equal its par value.

The value of a premium bond woulddecrease to $1,000

The value of a discount bond would

inc

rease to $1,000 A par bond stays at $1,000 if rdremains constant.

Changes in Bond Values ($)Over Time (contd)


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Ifcoupon rate < rd, bond sells at adiscount.

Ifcoupon rate = rd, bond sells at itspar value.

Ifcoupon rate > rd, bond sells at a

premium. If r d rises, price falls.

Price = par at maturity.

Changes in Bond Values ($)Over Time (contd)


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Semiannual Bonds

1. Multiply years by 2 to get periods = 2n.

2. Divide nominal rate by 2 to get periodicrate = rd/2.

3. Divide annual INT by 2 to get PMT =INT/2.

2n rd/2 OK INT/2 OK

N I/YR PV PMT FV

INPUTS

OUTPUT


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2(15) 5/2 100/230 2.5 50 1000N I/YR PV PMT FV

-1523.26

INPUTS

OUTPUT

Value of 15-year, 10% coupon,semiannual bond if r

d

= 5%


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Market Interest Rate

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

where rd

= Required rate of return on a

debt security.

r* = Real risk-free rate.

IP = Inflation premium.

DRP = Default risk premium.

LP= Liquidity premium.

MRP= Maturity risk premium.


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Real Risk-free Rate of

Interest (r*) R* = rate of return on a riskless

security if no inflation is expected

The best estimate is the short-termgovernment of Canada T-bills in aninflation-free world

R* is not static, changing over time



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Inflation Premium (IP)

Inflation erodes the purchasingpower of money.

The IP for a particular lengthmaturity can be approximated asthe difference between the yield on

a non-indexed security of t

hatmaturity minus the yield on a

default-free government bond ofthat maturity.


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What is the nominal risk-free rate?

rRF = (1+r*)(1+IP)-1

= r*+ IP + (r*x IP)

r*+ IP. (Because r*x IP is small)

rRF = Rate on short- or long-termgovernment bonds.


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Default Risk Premium (DRP)

Investors want to be compensated forthe chance that interest or principal

will not be paid on the due date and inthe promised amount

The greater the default risk, the higher

th

e bonds DRP While Canada bonds is default free,default risk can be substantial forcorporate bonds



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Bond Provisions that

Influence Default Risk

Provisions in the bond contract

Secured versus unsecured debt:

mortgage bonds vs. debentures Senior versus subordinated debt

Guarantee provisions: agency bonds

such

as CMHC, EDC Sinking fund provisions

Debt maturity



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Bond Ratings ProvideOne Measure of Default Risk

Investment Grade Junk Bonds

Moodys Aaa Aa A Baa Ba B Caa C

S&P AAA AA A BBB BB B CCC D

DBRS AAA AA A BBB BB B CCC D


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What factors affect defaultrisk and bond ratings?

Financial performance Debt ratio

Coverage ratios, such as interest coverage ratioor EBITDA coverage ratio

Current ratios

Other factors

Earnings stability Regulatory environment

Potential product liability

Accounting policies


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Bond Ratings and BondSpreads (Canadian Fixed Income, 2008)

Long-term Bonds (5 yr) Example Yield Spread

Government of Canada(Reference)

3.01%

AAA-rated Can. Savings Bond 3.01% --

AA-rated BOM 4.68% 1.67%

A-rated Telus Corp 4.88% 1.87%

BBB-rated Loblaws 5.61% 2.60%

BB-rated Sherritt International 7.47% 4.46%


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Liquidity Premium (LP)

A liquid asset can be convertedinto cash quickly and at a fair

market price. Liquidity is also known as

marketability

Financial assets are generally moreliquid than real assets

Often difficult to accurately measure



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Bond Spreads, the DRP, andthe LP

A bond spread is often calculated asthe difference between a corporate

bonds yield and a Government ofCanada bonds yield of the samematurity. Therefore:

Spread = DRP + LP.

Bonds of large, strong companies oftenhave very small LPs. Bonds of smallcompanies often have LPs as high as2%.


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Maturity Risk Premium

(MRP) All bonds, including Government of

Canada bonds, are exposed to two

extra risks: interest rate (price) riskand reinvestment risk.

MRP is the net effect of these two

sources of risk on a bonds yield



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Interest rate (or price) risk for 1-year and 10-year 10% bonds

rd 1-year Change 10-yearChange

5% $1,048 $1,386

10% 1,000 4.8% 1,000 38.6%

15% 956 4.4% 749 25.1%

Interest rate risk: Rising rd causes

bonds price to fall.


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0

500

1,000

1,500

0% 5% 10% 15%

1-year

10-year

rd

Value


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What is reinvestment rate risk?

The risk that CFs will have to bereinvested in the future at lower rates,

reducing income.

Illustration: Suppose you just won$500,000 playing the lottery. Youll

invest the money and live off the interest.You buy a 1-year bond with a YTM of10%.


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Year 1 income = $50,000. At year-end get back $500,000 to reinvest.

If rates fall to 3%, income will dropfrom $50,000 to $15,000. Had you

bought 30-year bonds, incomewould have remained constant.

What is reinvestment raterisk? (contd)


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Remarks of MRP

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, sothe MRP is more affected by interest raterisk than by reinvestment rate risk.


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Term Structureand Yield Curve

Term structure of interest rates: therelationship between interest rates

(or yields) and maturities. A graph of the term structure iscalled the yield curve.


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Hypothetical Govt of CanadaYield Curve

0%

2%

4%

6%

8%10%

12%

14%

1 3 5 7 911 13 15 17 19

Years to Maturity

Interest

Ra

te

MRP

IP

r*


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Relationship Between Govt ofCanada Yields and Corporate Yields

Corporate yield curves are higherthan that of the Govt of Canada

bond. However, corporate yieldcurves are not necessarily parallelto the Govt of Canada curve.

Th

e spread between ac

orporateyield curve and the Govt of Canadacurve widens as the corporate bondrating decreases.

H h i l G f C d


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Hypothetical Govt of Canadaand Corporate Yield Curves

6.0%5.9%5.2%

0.0%

2.0%

4.0%

6.0%

8.0%

10.0%

12.0%

1 10 20

Years to Maturity

Interest

R

ate

BB Bond

AAA Bond

Gov't of Canada


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Junk Bonds

Belong to the non-investmentgrades (with a BB or lower in the

S&P and DBRS rating or a Ba orworse in the Moodys)

Also called as high-yield or low-

grade bonds Junk bonds are risky because their

default rates are high



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Bankruptcy

Two main chapters of FederalBankruptcy Act:

Bankruptcy and Insolvency,bankruptcy

Companies Creditors Arrangement,reorganization


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Ifcompany cant meet its obligations, itfiles under CRA. That stops creditors

from foreclosing, taking assets, andshutting down the business.

Company has 120 days to file areorganization plan.

Court appoints a trustee to supervisereorganization.

Management usually stays in control.

Bankruptcy (contd)


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Company must demonstrate in itsreorganization plan that it is worth

more alive than dead. Otherwise, judge will order

liquidation under the Bankruptcy

and Insolvency Act.

Bankruptcy (contd)

If th i li id t d


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If the company is liquidated,heres the payment priority:

Costs for environmental damage Unremitted payroll taxes and deductions Secured creditors from sales of secured assets. Trustees costs Expenses incurred after bankruptcy filing Wages and unpaid benefit contributions, subject to limits

of $2,000 per worker Municipal taxes Claims for rent, up to 3 months prior to bankruptcy

Creditor costs who first filed a claim Injury claim costs to employees not covered underWorkers Compensation

Other unsecured creditors Preferred stock Common stock


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In a liquidation, unsecured creditorsgenerally get zero. This makes themmore willing to participate inreorganization even though theirclaimsare greatly scaled back.

Various groups ofcreditors vote on thereorganization plan. If both the majority

of the creditors and the judge approve,company emerges from bankruptcywith lower debts, reduced interestcharges, and a chance for success.

If the company is liquidated, heresthe payment priority: (contd)

Ch06 Ppt Brighamfm1ce

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