Essentials of Managerial Finance by S. Besley & E. Brigham Slide 1 of 22 Chapter 6 Bonds (Debt) – Characteristics and Valuation.

Essentials of Managerial Finance by S. Besley & E. Brigham Slide 1 of 22

Chapter Chapter 66

Bonds (Debt) – Characteristics and Valuation


Background on Bonds

• Bonds represents long-term debt securities that are issued by government agencies or corporations

• Interest payments occur annually or semiannually• Par value is repaid at maturity• Most bonds have maturities between 10 and 30 years• Bearer bonds require the owner to clip coupons

attached to the bonds• Registered bonds require the issuer to maintain

records of who owns the bond and automatically send coupon payments to the owners


Background on Bonds (cont’d)

• Bond yields– The issuer’s cost of financing is measured by the yield to

maturity• The annualized yield that is paid by the issuer over the life of

the bond• Equates the future coupon and principal payments to the initial

proceeds received• Does not include transaction costs associated with issuing the

bond• Earned by an investor who invests in a bond when it is issued

and holds it until maturity

– The holding period return is used by investors who do not hold a bond to maturity


Treasury and Federal Agency Bonds

• The U.S. Treasury issues Treasury notes or bonds to finance federal government expenditures– Note maturities are usually less than 10

years– Bonds maturities are 10 years or more– An active secondary market exists– The 30-year bond was discontinued in

October 2001


Treasury and Federal Agency Bonds (cont’d)

• Trading Treasury bonds– Bond dealers serve as intermediaries in the

secondary market and also take positions in the bonds

– 30 primary dealers dominate the trading• Profit from the bid-ask spread• Conduct trading with the Fed during open market

operations• Typical daily volume is about $200 billion

– Online trading• TreasuryDirect program (http://www.treasurydirect.gov)



• Treasury bond quotations– Published in financial newspapers

• The Wall Street Journal• Barron’s• Investor’s Business Daily

– Bond quotations are organized according to their maturity, with the shortest maturity listed first

– Bid and ask prices are quoted per hundreds of dollars of par value

– Online quotations at • http://www.investinginbonds.com • http://www.federalreserve.gov/releases/H15/



• Savings bonds– Issued by the Treasury– Have a 30-year maturity and no secondary market– Series EE bonds provide a market-based interest rate– Series I bonds provide a rate of interest tied to inflation– Interest on savings bonds is not subject to state and local

taxes• Federal agency bonds

– Ginnie Mae issues bonds and purchases mortgages that are insured by the FHA and the VA

– Freddie Mac issues bonds and purchases conventional mortgages

– Fannie Mae issues bonds and purchases residential mortgages


Municipal Bonds

• Municipal bonds can be classified as either general obligation bonds or revenue bonds– General obligation bonds are supported by he municipal

government’s ability to tax– Revenue bonds are supported by the revenues of the

project for which the bonds were issued

• Municipal bonds typically pay interest semiannually, with minimum denominations of $5,000

• Municipal bonds have a secondary market• Most municipal bonds contain a call provision


Municipal Bonds (cont’d)

• Trading and quotations– Investors can buy or sell munis by

contacting brokerage firms– Electronic trading has become popular

• http://www.tradingedge.com

– Online quotations are available at http://www.munidirect.com and http://www.investinginbonds.com


Corporate Bonds

• Corporations issue corporate bonds to borrow for long-term periods

• Corporate bonds have a minimum denomination of $1,000• Larger bonds offerings are achieved through public offerings

registered with the SEC• Secondary market activity varies• Financial and nonfinancial institutions as well as individuals are

common purchasers• Most corporate bonds have maturities between 10 and 30 years• Interest paid by corporations is tax-deductible, which reduces

the corporate cost of financing with bonds


Corporate Bonds (cont’d)

• Corporate bond yields and risk– Interest income earned on corporate represents

ordinary income– Yield curve

• Affected by interest rate expectations, a liquidity premium, and maturity preferences of corporations

• Similar shape as the municipal bond yield curve– Default rate

• Depends on economic conditions• Less than 1 percent in the late 1990s• Exceeded 3 percent in 2002



• Corporate bond yields and risk (cont’d)– Investor assessment of risk

• Investors may only consider purchasing corporate bonds after assessing the issuing firm’s financial condition and ability to cover its debt payments

• Investors may rely heavily on financial statements created by the issuing firm, which may be misleading

– Bond ratings• Bonds with higher ratings have lower yields• Corporations seek investment-grade ratings, since commercial

banks will only invest in bonds with that status• Rating agencies will not necessarily detect any misleading

information contained in financial statements



• Corporate bond characteristics (cont’d)– Call provisions:

• Require the firm to pay a price above par value when it calls its bonds

– The difference between the call price and par value is the call premium

• Are used to:– Issue bonds with a lower interest rate– Retire bonds as required by a sinking-fund provision

• Are a disadvantage to bondholders



• Trading corporate bonds– Bonds are traded through brokers, who communicate orders

to bond dealers– A market order transaction occurs at the prevailing market

price– A limit order transaction will occur only if the price reaches

a specified limit– Bonds listed on the NYSE are traded through the automated

Bond System (ABS)– Online trading is possible at:

• http://www.schwab.com

• http://www.etrade.com



• Corporate bond quotations– More than 2,000 bonds are traded on the

NYSE with a market value of more than $2 trillion

– Corporate bond prices are reported in eighths

– Corporate bond quotations normally include the volume of trading and the yield to maturity



• Junk bonds– Junk bonds have a high degree of credit risk– About two-thirds of junk bonds are used to finance takeovers– Size of the junk bond market

• Currently about 3,700 junk bond offerings exist with a market value of $80 billion

– Participation in the junk bond market• 70 large issuers of junk bonds each have more than $1 billion in

debt outstanding• Primary investors in junk bonds are mutual funds, life insurance

companies, and pension funds• The junk bond secondary market consists of 20 bond traders


Basic Valuation• The (market) value of any investment asset is simply

the present value of expected cash flows.

• The interest rate that these cash flows are discounted

at is called the asset’s required return.

• The higher expected cash flows, the greater the

asset’s value.

• It makes sense that an investor is willing to pay

(invest) some amount today to receive future benefits

(cash flows).


Basic Valuation Model

V0 = CF1 + CF2 + … + CFn

(1 + k)1 (1 + k)2 (1 + k)n

Where:

V0 = value of the asset at time zero

CFt = cash flow expected at the end of year t

k = appropriate required return (discount rate)

n = relevant time period


The basic bond valuation modelB0 = I1 + I2 + … + (In + Mn)

(1+k)1 (1+k)2 (1+k)n

Using the above model, find the (market) price of a 10% coupon bond, 3 years to maturity if market

interest rates are currently 10%(par value= 100).

B0 = €10 + €10 + (€10 + €100)

(1+.10)1 (1+.10)2 (1+.10)3

B0 = 10 * (1 - [1/(1+.10)3]) + 100 * [1/(1+.10)3] =

.10

It can also be calculated by finding the present value of the annuity


Valuation of a bond using ExcelFor example, find the price of a 10% coupon bond with three years to maturity if market interest rates

are currently 10%.

Coupon Interest (€) 10Maturity (periods) 3Face Value (€) 100Market Interest Rate (%) 10%Market Price (€) 100

Valuation of a Bond using Excel

Note: the equationfor calculating

price is =PV(rate,nper,pmt,fv)


Changes in bond values over timeIn the previous example, what would happen to the bond’s price if interest rates drop from 10% to 8%?

When interest rate falls below the coupon rate, then the bond would sell at a premium



When the interestrate goes down, the

bond price will always go up


Changes in bond values over timeIn the previous example, what would happen to the

bond’s price if interest rates increase from 10% to 12%?

When interest rate increases above the coupon rate, then the bond would sell at a discount



When the interestrate goes up, the bond price will always go down


Bond value–interest rate relationship


Bond Return

+=

Rate ofreturn

Current yield

= +Capital

gains yield

kd Vd

INT Vd1 – Vd0

Vd0


Bond Valuation – Change in value over time

Years to Maturity

End of Year Value, Vd

Capital Gain = (Vd1-Vd0)/Vd0

Current Yield = INT/Vd0

Total Return

5 €920.15

4 933.76 1.48% 6.52% 8.00%

3 948.46 1.57 6.43 8.00

2 964.33 1.67 6.33 8.00

1 981.48 1.78 6.22 8.00

0 1,000.00 1.89 6.11 8.00

Bond Characteristics: M = €1,000.00, INT = €60.00, kd

= 8%


Market value converges at par value to maturity


Finding the Yield to Maturity on a Bond

• The yield to maturity measures the compound annual return to an investor and considers all bond cash flows.

PV = I1 + I2 + … + (In + Mn)

(1+k)1 (1+k)2 (1+k)n

Note that this is the same equation of the Basic Valuation Model. The only difference now is that we know the market price but are solving for return.


Valuation with semi-annual compounding

N I PV PMT FV

Example: M = €1,000, C = 5%, Yrs to maturity = 8, kd = 6%

16 3 ? 25 1000

-931,23

• Adjustments to computations– N = # years x m; m = # of interest

payments per year– i = kd/m– INT = interest payment per period = Annual

INT/m

Essentials of Managerial Finance by S. Besley & E. Brigham Slide 1 of 22 Chapter 6 Bonds (Debt) – Characteristics and Valuation.

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