Chapter 5

Bonds, Bond Valuation, and Interest Rates

Topics in Chapter

Key features of bonds Bond valuation Measuring yield Assessing risk

Determinants of Intrinsic Value: The Cost of Debt

Net operating profit after taxes

Required investments in operating capital =

Free cash flow (FCF)

Value =

FCF1 FCF2 FCF ... + + + (1 + WACC)1 (1 + WACC)2 (1 + WACC)

Weighted average cost of capital (WACC)

Market interest rates

Market risk aversion

Cost of debt
Cost of equity

Firms debt/equity mix

Firms business risk
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Interest Rates & InterestBearing Securities

Interest rates:

Based on supply & demand for money

Driven by risk factors

Role of Federal Reserve Basis Point

.01% or .0001
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Risk & Term Structure of Interest Rates

rd = r* + IP + DRP + LP + MRP rd = Required rate of return on a debt security.

r* IP DRP LP MRP

= = = = =

Real risk-free rate. Inflation premium. Default risk premium. Liquidity premium. Maturity risk premium.
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Risk & Term Structure

r = r* + IP + DRP + LP + MRP r = nominal interest rate of a particular security (or required rate of return) r* = real risk-free interest rate typically 1-4% depending on monetary policy assumes expected inflation = zero IP = Inflation premium Ave. inflation over life of bond DRP = Default risk premium Compensation for possible default Function of bond ratings
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Risk & Term Structure

r = r* + IP + DRP + LP + MRP LP = Liquidity Premium Compensation for possible difficulty selling bond quickly at fair market value MRP = Maturity Risk Premium Compensation for possible loss in value due to increase in interest rates over maturity of bond. Affects longer maturities more than shorter.
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Premiums Added to r* (real risk-free rate) for Different Types of Debt

ST Treasury:

only IP for ST inflation IP for LT inflation, MRP ST IP, DRP, LP IP, DRP, MRP, LP
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LT Treasury:

ST corporate:

LT corporate:

Inflation & Interest Rates

Nominal Interest=
- Inflation = Real Int. %

12%
-1% =11%

12% - 8% =4%

If inflation = & reqd real return = Then Nominal rate =? =

8% 11% =19%
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Relationship b/w Nominal & Real Interest Rates, & Inflation

Nom = Real + Inflation But, inflation not additive, it grows or compounds, so multiply

Nom = (Real) x (Infl)

And (1+Nom) = (1 + real) x (1 + infl) Is better determinant; known as Fisher effect

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Estimating Inflation Premium (IP)

Treasury Inflation-Protected Securities (TIPS) are indexed to inflation. 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.
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Bond Spreads, the DRP, and the LP

A bond spread is often calculated as the difference between a corporate bonds yield and a Treasury securitys yield of the same maturity. Therefore:

Spread = DRP + LP.

Bonds of large, strong companies often have very small LPs. Bonds of small companies often have LPs as high as 2%.
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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.

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Hypothetical Treasury Yield Curve

14% 12%

Interest Rate

10% 8% 6% 4% 2% 0%

MRP IP r*

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13

15

17

Years to Maturity
14

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What factors can explain shape of this yield curve?

Upward slope due to:

Increasing expected inflation Increasing maturity risk premium

What about liquidity & default risk?

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Treasury vs. Corporate Yield Curves relationships

Corp yield curves are higher than Treasuries, but not necessarily parallel. Spread b/w the two yield curves widens as corporate bond rating decreases due to:

DRP & LP

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Computing Yields

Estimate the inflation premium (IP) for each future year. This is the estimated average inflation over that time period. Step 2: Estimate the maturity risk premium (MRP) for each future year.

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Assume investors expect inflation to be 5% next year, 6% the following year, and 8% per year thereafter.

Step 1: Find the average expected inflation rate over years 1 to n:

= 5%/1.0 = 5.00%.

IP1

IP10 = [5 + 6 + 8(8)]/10 = 7.5%. IP20 = [5 + 6 + 8(18)]/20 = 7.75%.

Must earn these IPs to break even versus inflation; that is, these IPs would permit you to earn r* (before taxes).
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Assume the MRP is zero for Year 1 and increases by 0.1% each year.

Step 2: Find MRP based on this equation:

MRPt = 0.1%(t - 1). MRP1 = 0.1% x 0 = 0.0%. MRP10 = 0.1% x 9 = 0.9%. MRP20 = 0.1% x 19 = 1.9%.

Step 3: Add the IPs and MRPs to r*: rRFt = r* + IPt + MRPt . rRF = Quoted market interest rate on treasury securities. Assume r* = 3%: rRF1 = 3% + 5% + 0.0% = 8.0%. rRF10 = 3% + 7.5% + 0.9% = 11.4%. rRF20 = 3% + 7.75% + 1.9% = 12.65%.

Upward vs. Downward sloping yield curves due to?

Real risk-free rate = 3% Expected inflation for

Year 1 =7%, Yr 2 = 5%; Yr 3 = 3%

What are interest rates for 1, 2, & 3 yr borrowings?

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Interest Rates & MRP problem

Assume the real risk-free rate (r*) is 4% and inflation is expected to be 7 percent in Year1; 4% in yr 2; and 3% thereafter. Assume all Treasury Bonds are highly liquid and free of default risk. If 2-yr and 5-yr T-Bonds both yield 11%, what is the difference in the maturity risk premiums (MRPs) on the two bonds; that is, what is MRP5 MRP2?

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Interest Rates & Inflation Problem

Due to the recession, the rate of inflation expected for the coming year is only 3.5%. However, the rate of inflation in Yr 2 and thereafter is expected to be constant at some level above 3.5%. Assume the real risk-free rate (r*) = 2% for all maturities, and there are no maturity premiums. If 3-year T-Bonds yield 3% (0.03) more than the 1-year T-Bonds, what rate of inflation is expected after year 1?

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Coupon Bonds

Bond = Debt = Borrowing Fixed Maturity (Maturity Date) = N Par Value=Face Value=Maturity Value=$1000=FV Coupon Rate=Stated Rate (locked in in bond contract) Coupon payment= Coupon rate x face value=PMT Market Rate of interest = Yield to Maturity = rate used to discount bond CFs = I **PV cash flow of bonds always opposite sign of PMT & FV!!!
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Bond Perspectives
Debt

Asset

Needs $

Borrower
Issuer or seller Debtholder Cost of borrowing

Interest Paid (Expense)

Cost of Debt

generates tax benefit (Svgs)

Has $ Lender Buyer or Investor Bondholder Creditor Requires return to invest $ in bonds based on risk

= Rd or Kd; After-tax cost = Rd (1-t)

Interest Received (earned) (Revenue) - pay tax on it Capital Appreciation

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Key Features of a Bond

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.

(More)
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Key Features of a Bond

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.

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Value of Financial Security

Value of any asset based on the net present value of the expected future cash flows discounted by the interest (discount) rate that reflects risk factors Discount (interest rate) depends on:

Riskiness of CFs reflected by DRP, MRP, LP General level of interest rates, which reflects inflation, supply & demand for $, production opportunities, time preferences for consumption

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

0 10% V=? 100 100 1 2 10

...
100 + 1,000

VB =

$100 (1 + rd)

. . . + + 1

$100 (1 + rd)N

$1,000 (1 + rd)N

= $90.91 + = $1,000.

. . . + $38.55 + $385.54
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The bond consists of a 10-year, 10% annuity of $100/year plus a $1,000 lump sum at t = 10: PV annuity PV maturity value Value of bond
INPUTS OUTPUT

= $ 614.46 = 385.54 = $1,000.00

10 N

10 I/YR

PV -1,000

100 PMT

1000 FV

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What would happen if expected inflation rose by 3%, causing r = 13%?

INPUTS OUTPUT

10 N

13 I/YR

PV -837.21

100 PMT

1000 FV

When market interest rate (rd)rises above coupon rate, bonds value (PV or price) falls below par, so sells @ discount.
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What happens if one year passes but the market i stays at 13%?

INPUTS OUTPUT

9 N

13 I/YR

PV -846.05

100 PMT

1000 FV

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What happens if a second year passes but the market i stays at 13%?

INPUTS OUTPUT

8 N

13 I/YR

PV -856.04

100 PMT

1000 FV

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What happens if 9 years pass but the market i stays at 13%?

INPUTS OUTPUT

1 N

13 I/YR

PV -973.45

100 PMT

1000 FV

As a bond approaches maturity, its price approaches the face or maturity value of $1000
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Bond Pricing in Excel

Years to Mat: Coupon rate: Annual Pmt: Par value = FV: Going rate, rd:

10 10% $100 $1,000 10%

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What would happen if inflation fell, and rd declined to 7%?

INPUTS 10 N 7 I/YR 100 PMT 1000 FV

OUTPUT

PV -1,210.71

If coupon rate > mrkt i% (rd), price rises above par, and bond sells at a premium.
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Bond Pricing in Excel

PV = ? $1210.71

Years to Mat: Coupon rate: Annual Pmt: Par value = FV: Going rate, rd:

10 10% $100 $1,000 7%

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Summary of Bond price and interest rate relationships

If market rate of interest increases above the stated (coupon) rate, then bonds price falls and sells at discount If market rate of interest drops below the stated (coupon) rate, then bonds price increases and sells at a premium **INVERSE RELATIONSHIP b/w Market i% and Bonds PRICE!***
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Bond prices & changing interest rates

Suppose the bond was issued 20 years ago and now has 10 years to maturity. What would happen to its value over time if required rate of return remained at 10%, or at 13%, or at 7%?

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Bond Value ($) vs Years remaining to Maturity

1,372

rd = 7%.

1,211

1,000

rd = 10%.

837 775
30 25 20 15 10 5

rd = 13%.
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Bond Price Movements over time

At maturity, value of any bond must equal its par value. Value of a premium bond decreases to $1,000. Value of a discount bond increases to $1,000. A par bond stays at $1,000 if mrkt i% (rd)remains constant.
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Whats market value of 10 year 10% coupon bond when market = 7%?

INPUTS

10 N

7 I/YR

OUTPUT

PV ?

100 PMT

1000 FV

Bond sells at a premium:: Price today = $1,210.71.

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If you buy a 10%, 10 year bond today for $1,210.71, and hold it to maturity, whats your rate of return?

INPUTS

10 N

OUTPUT

(1210.71) 100 1000 I/YR PV PMT FV ?

Solve for i% = 7% = Yield to maturity (YTM)

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Whats yield to maturity?

YTM is rate of return earned on a bond held to maturity. Also called promised yield. It assumes bond will not default. Includes both interest pmt component & cap gains over bonds life Interest rate equating bonds price today to NPV of PMTs & FV. (Think market rate of interest) Vs. Annualized Return which reflects only a oneyear holding period
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YTM on a 10-year, 9% annual coupon, $1,000 par value bond selling for $887
0 1 9 10 90 1,000

rd=?

...
90 90

PV1 . . . PV10 PVM

887

Find i % (rd) that works!

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Find YTM (i % or rd)

VB =

... + + + N 1 (1 + rd) (1 + rd) (1 + rd)N

INT

INT

1,000 90 90 ... 887 = + + + 1 N (1 + rd) (1 + rd) (1 + rd)N

INPUTS OUTPUT

10 N

I/YR 10.91

-887 PV

90 PMT

1000 FV
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YTM in Excel

Years to Mat: Coupon rate: Annual Pmt: Current price: Par value = FV:

10 9% $90.00 $887.00 $1,000.00

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Bond Prices & Int. Rates

If coupon rate < mrkt i % (rd), bond sells at a discount. If coupon rate = i %, bond sells at its par value. If coupon rate > i%, bond sells at a premium. If market i% rises, price falls. Price = par at maturity.
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Find YTM if price were $1,134.20.

INPUTS 10 N OUTPUT -1134.2 90 PV PMT 1000 FV

I/YR 7.08

Sells at a premium. Because coupon = 9% > mrkt i% = 7.08%, bonds value > par.
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Definitions
Current yield = Interest Yield Capital gains yield =Change in value
Exp total = YTM = Exp + Exp cap return gains yld Curr yld

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Definitions
Current yield =

Annual coupon pmt Current price Change in price Beginning price

Capital gains yield = Exp total return

Exp Exp cap = YTM = + Curr yld gains yld

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

Current yield

$90 = $887 = 0.1015 = 10.15%.

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YTM = Current yield + Capital gains yield.

Cap gains yield = YTM - Current yield = 10.91% - 10.15% = 0.76%. Could also find values in Years 1 and 2, get difference, and divide by value in Year 1. Same answer.
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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.
INPUTS
OUTPUT
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2N N

rd/2
I/YR

OK PV

INT/2 PMT

OK FV

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

2(10) INPUTS 20 N OUTPUT

13/2 6.5 I/YR

PV -834.72

100/2 50 PMT

1000 FV

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Spreadsheet Functions for Bond Valuation

PRICE YIELD

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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 Yield to call: yearly rate of return earned on a bond until its called 57

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.

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Nominal Yield to Call (YTC)

INPUTS 10 N OUTPUT

-1135.9 50 I/YR PV PMT 3.765 x 2 = 7.53%

1050 FV

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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 = 7.53%, not YTM = 8%.
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Investor returns on callable bonds

In general, if a bond sells at a premium, then coupon > market rate, so a call is likely. So, investors expect to earn:

YTC on premium bonds. YTM on par & discount bonds.

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Whats 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.
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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. Use open market purchase if rd is above coupon rate and bond sells at a discount.

Buy bonds on open market.

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Bond Ratings
S&P and Fitch Moodys

% defaulting within: 1 yr. 0.0 0.0 0.1 0.3 1.4 1.8 22.3 5 yrs. 0.0 0.1 0.6 2.9 8.2 9.2 36.9
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Investment grade bonds:

AAA AA A BBB Aaa Aa A Baa Ba B Caa

Junk bonds:
BB B CCC
Source: Fitch Ratings

Bond Ratings and Bond Spreads (YahooFinance, March 2009)

Long-term Bonds 10-Year T-bond
AAA AA

Yield (%)

Spread (%)

A
BBB BB B CCC

2.68 5.50 5.62 5.79 7.53 11.62 13.70 26.30

2.82 2.94 3.11 4.85 8.94 11.02 23.62

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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
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Bond Ratings Median Ratios

(S&P)

AAA AA A BBB BB B CCC

Interest coverage 23.8 19.5 8.0 4.7 2.5 1.2 0.4

Return on capital 27.6% 27.0% 17.5% 13.4% 11.3% 8.7% 3.2%

Debt to capital 12.4% 28.3% 37.5% 42.5% 53.7% 75.9% 113.5%

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Other Factors that Affect Bond Ratings

Provisions in the bond contract

Secured versus unsecured debt Senior versus subordinated debt Guarantee provisions Sinking fund provisions Debt maturity
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Other factors

Earnings stability Regulatory environment Potential product liability Accounting policies

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Interest rate (or price) risk for 1year and 10-year 10% bonds
Interest rate risk: Rising mrkt i % (rd) causes bonds price to fall. i % 1-year Change 10-year Change 5% $1,048 10% 15% 1,000 956 4.8% 4.4% $1,386 1,000 749 38.6% 25.1%
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Value
1,500

10-year 1-year

1,000

500

0 0% 5% 10% 15%

rd
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What is reinvestment rate risk?

The risk that CFs will have to be reinvested at future lower rates, reducing income. Illustration: Suppose you just won $500,000 playing the lottery. Youll invest the money and live off interest. You buy a 1-year bond with a YTM of 10%.
72

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.

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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.
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Other types of Bonds

Zero coupon:

Pays no coupon & sells @ disct below par

Convertible:

To stock @fixed price @ bondholders option

Pays interest only if interest earned by issuer; wont bankrupt co.

Income:

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Other types of Bonds

Revenue:

Interest paid from revenue generated by project being financed by bonds Adjusts coupon rate periodically based on market interest rates

Floating rate:

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Bankruptcy

Two main chapters of Federal Bankruptcy Act:

Chapter 11, Reorganization Chapter 7, Liquidation

Typically, company wants Chapter 11, creditors may prefer Chapter 7.

77

If company cant 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.

78

Company must demonstrate in its reorganization plan that it is worth more alive than dead. Otherwise, judge will order liquidation under Chapter 7.

79

If the company is liquidated, heres the payment priority:

Past due property taxes Secured creditors from sales of secured assets. Trustees 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
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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.
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