004

Document Sample
004 Powered By Docstoc
					                       Valuing Bonds


                     Professor Dr. Rainer Stachuletz
                           Corporate Finance

                      Berlin School of Economics


Berlin, 04.01.2006                Fußzeile             1
      Valuation Fundamentals



                     Present Value of Future Cash Flows

                             Link Risk & Return

                               Expected Return
                                  on Assets




                                 Valuation

Berlin, 04.01.2006                 Fußzeile               2
The Basic Valuation Model
                        CF 1     CF 2              CF n
                 P0 =        1
                               +      2
                                        + . . .+
                      (1+ r ) (1+ r )            (1+ r )n

                     •    P0 = Price of asset at time 0 (today)
                     •    CFt = Cash flow expected at time t
                     •    r = Discount rate (reflecting asset’s risk)
                     •    n = Number of discounting periods (usually years)

             This model can express the price of any asset at
                          t = 0 mathematically.
                         Marginal benefit of owning the asset: right to
                                    receive the cash flows
                         Marginal cost: opportunity cost of owning the
Berlin, 04.01.2006
                                             assetFußzeile                    3
   Valuation Fundamentals: Example

      Company issues a 5% coupon interest rate, 10-year
      instrument with a $1,000 par value
         Assume annual interest payments

     Investors in company’s financial instrument
      receive the contractual rights
      - $50 coupon interest paid at the end of each
        year
      - $1,000 principal at the end of the 10th year

                     P = $1,000
Berlin, 04.01.2006           Fußzeile                  4
Yield to Maturity (YTM)


Estimate of return investors earn if they buy
  the bond at P0 and hold it until maturity


The YTM on a bond selling at par will always equal
the coupon rate.


YTM is the discount rate that equates the
PV of a bond’s cash flows with its price.

Berlin, 04.01.2006          Fußzeile                 5
Bond Premiums and Discounts

                     What happens to bond values if required return is not
                                 equal to the coupon rate?



                       The bond's price will differ from its par value

               r > Coupon Interest Rate                P0 < par value
                                                                        =   DISCOUNT




               r < Coupon Interest Rate                P0 > par value
                                                                        =   PREMIUM

Berlin, 04.01.2006                          Fußzeile                                   6
Semi-Annual Interest Payments
                 C       C         C             C
                                                    F
      Price      2     2         2     .... 2
                   r 1    r 2        r 3            r 2n
              (1  ) (1  )     (1  )          (1  )
                   2      2          2              2

Value a T-Bond                   $40          $40        $40      $40
                                                                       1,000
                       P0        2           2         2      2
Par value = $1,000                      1          2          3               4
                                0.044   0.044   0.044   0.044 
                            1         1       1       1          
Maturity = 2 years                2          2        2          2 

Coupon rate = 4%             $20      =
                                      $20 $992.43 $1,020
                                              $20
                                        2
                                                 3
                                                          4
                                                             
                           (1.022) (1.022) (1.022) (1.022)
r = 4.4% per year
Berlin, 04.01.2006                  Fußzeile                                  7
Factors that Affect Bond Prices


Time to maturity: bond prices converge to par
value (plus final coupon) with passage of time.


Interest rates: bond prices and interest rates move
in opposite directions.


Changes in interest rates have larger impact on long-
term bonds than on short-term bonds.

Berlin, 04.01.2006        Fußzeile                      8
      Interest Rate Risk


            $1,500
            $1,300
            $1,100
                 $900
                 $700
                 $500
                          1   2   3   4   5    6     7         8    9    10   11   12   13   14   15

                                          Yield to maturity, %
                                          2-year bond              10-year bond




                     What does this tell you about the relationship
                     between bond prices and yields for bonds with
                                different maturities?
Berlin, 04.01.2006                                  Fußzeile                                           9
       Primary vs. Secondary Markets



             Primary market: the initial sale of bonds by issuers
                      to large investors or syndicates


                Secondary market: the market in which investors
                            trade with each other


             Trades in the secondary market do not raise
                     any capital for issuing firms.

Berlin, 04.01.2006                  Fußzeile                   10
        Bonds by Issuer

                                • Usually with par $1000 and semi-
                Corporate         annual coupon
                 Bonds          • Bonds if maturity > 10 years; notes if
                                  maturity < 10 years

                 Municipal      • Issued by local and state government
                  Bonds         • Interest on municipal bonds tax-free
                                • If maturity < 1 year: Treasury Bills
                                • If 1 year < maturity < 10 years:
                     Treasury     Treasury Notes
                      Bonds     • Maturity > 10 years: Treasury Bonds
                                • Used to fund budget deficits

                     Agency     • Issued by government agencies:
                                  FHLB, FNMA (Fannie Mae), GNMA
Berlin, 04.01.2006
                     Bonds        (Ginnie Mae), FHLMC (Freddie Mac)
                                   Fußzeile                          11
        Bonds by Features


                                 • Floating-rate bonds: coupon tied to
                     Fixed vs.     prime rate, LIBOR, Treasury rate or
                                   other interest rate
                     Floating    • Floating rate = benchmark rate +
                       Rates       spread
                                 • Floating rate can also be tied to the
                                   inflation rate: TIPS, for example
                                 • Unsecured bonds (debentures) are
                                   backed only by general faith and
             Secured vs.           credit of issuer
             Unsecured           • Secured bonds are backed by specific
                                   assets (collateral)
               Bonds             • Mortgage bonds, collateral trust
                                   bonds, equipment trust certificates

Berlin, 04.01.2006                  Fußzeile                          12
       Bonds by Features (Continued)



                             • Discount bonds or pure discount
          Zero-Coupon          bonds
                             • Sell below par value
             Bonds           • Treasury Bills (Tbills)
                             • Treasury STRIPs


                             • Convertible bonds, in addition to
           Convertible         paying coupon, offers the right to
              and              convert the bond into common stock
                               of the issuer of the bond
          Exchangeable       • Exchangeable bonds are convertible
             Bonds             in shares of a company other than
                               the issuer’s
Berlin, 04.01.2006              Fußzeile                         13
        Bonds by Features (Continued)


                              • Callable bonds: bond issuer has the
                                right to repurchase the bonds at a
           Callable and         specified price (call price).
                              • Firms could retire and reissue debt if
             Putable            interest rates fall.
              Bonds           • Putable bonds: the investors have
                                the right to sell the bonds to the
                                issuer at the put price.


                              • Sinking fund provisions: the issuer is
              Protection        required to gradually repurchase
                                outstanding bonds.
            from Default      • Protective covenants: requirements
                 Risk           the bond issuer must meet
                              • Positive and negative covenants
Berlin, 04.01.2006               Fußzeile                          14
Bond Markets


              The U.S bond market has grown from $250 billion
                       in 1950 to $22 trillion in 2004
                                       Amount Oustanding in 2004
                                                  $1.900
                              $3.900



                                                                $3.700

                                                                         Municipal Bonds
                                                                         Treasury Bonds
                                                                         Corporate Bonds
                                                                         Federal Agency Bonds
                                                                         Mortgage-related debt
                     $5.300
                                                                         Other

                                                               $4.500



                                         $2.700
Berlin, 04.01.2006                                  Fußzeile                                     15
U.S. Treasury Bond Quotations


                              MATURITY                                                ASK
             RATE                        BID                    ASKED     CHG
                              MO/YR                                                   YLD

                                         Government Bonds & Notes
             5.500            May 09n    107:13                 107:14    3           3.83



                       Rate                                     Coupon rate of 5.5%


                                            Bid price: the price traders receive if they
                                               sell a bond to the dealer. Quoted in
              Bid prices                          increments of 32nds of a dollar
              Ask prices
                                                  Ask price: the price traders pay to the
            (percentage of
                                                           dealer to buy a bond
              par value)
                                               Bid-ask spread: difference between ask
                                                           and bid prices.

                     Ask Yield                      Yield to maturity on the ask price
Berlin, 04.01.2006                                   Fußzeile                                16
Corporate Bond Quotations


           Company                                                             Estimated         Est $ Vol
                      Coupon   Maturity      Last Price           Last Yield               UST
           (Ticker)                                                            Spread            (000s)


           SBC Comm
                      5.875    Aug 15,2012   107.161              4.836        80          10    73,867
           (SBC)




             Corporate prices are quoted as percentage of par,
              without the 32nds of a dollar quoting convention

            Yield spread: the difference in yield-to-maturities
           between a corporate bond and a Treasury bond with
                              same maturity

                      The greater the default risk, the higher
                                 the yield spread
Berlin, 04.01.2006                                     Fußzeile                                              17
Bond Ratings



             Bond ratings: grades assigned to bond issues based
                          on degree of default risk



            Investment-          • Moody’s Aaa to Baa3 ratings
            grade bonds          • S&P and Fitch AAA to BBB-
                                   ratings


              Junk bonds         • Moody’s Ba1 to Caa1 or
                                   lower
                                 • S&P and Fitch BB to CCC+
Berlin, 04.01.2006
                                   or lower
                                   Fußzeile                   18
Term Structure of Interest Rates


            Relationship between yield and maturity is called the Term Structure
             of Interest Rates
                     - Graphical depiction called a Yield Curve
                     - Usually, yields on long-term securities are higher than on short-term
                       securities.
                     - Generally look at risk-free Treasury debt securities
            Yield curves normally upwards-sloping
                     - Long yields > short yields
                     - Can be flat or even inverted during times of financial stress




               What do you think a Yield Curve would look like
                                graphically?
Berlin, 04.01.2006                                  Fußzeile                                   19
Yield Curves U.S. Treasury Securities



                                  16

                                  14                                                May 1981

                                  12
                Interest Rate %




                                  10

                                  8                                              January 1995

                                  6                                                   August 1996
                                                                                  October 1993
                                  4

                                  2


                                       1   3   5   10             15        20                  30

                                                        Years to Maturity

Berlin, 04.01.2006                                         Fußzeile                                  20
    Bond Valuation




     Bond price equals present value of its coupons and principal.

         Bond prices are inversely related to interest rates.

         Bonds could have a number of features: such as convertibility,
    callability.




Berlin, 04.01.2006                          Fußzeile                       21

				
DOCUMENT INFO
Shared By:
Categories:
Stats:
views:14
posted:7/11/2011
language:English
pages:21