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EXPERIENCE INTERNATIONALITY EMPLOYABILITY

Bond Valuation and term structure of interest rate

BFS2780_ semester 1_2018

Gladman Moyana

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Key Concepts and Skills
 Know the important bond features and bond types
 Know how to calculate the value of a bond
 Understand why bond values fluctuate
 Understand bond ratings and what they mean
 Understand the role of the Bond Exchange
 Understand the impact of inflation on interest rates
 Understand the term structure of interest rates and the
determinants of bond yields

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Some judging definitions
 Issuer- is the borrower or the company /government that wants to borrow
money- receives the principal amount, pay coupon and pays back the
nominal amount/principal amount at the end of contract
 Holder/investor- gives out money and received the cash flows(coupons and
the principal amount lend at the beginning of contract
 Student reflection: How does the above link with TVM principles learnt
previously
 Student reflection: Why are bonds referred to as fixed interest securities
or fixed income securities/instruments

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Bond Features-judging definitions
Prof Wiseman’s Tutorial Note: You should pick up variables for application of TVM to value
bonds from the following definitions

 Par value (face value)-paid at the end

 Coupon rate- The annual coupon divided by nominal value of bond. The rate used to
determine the periodic coupon payments(annual or semi-annual payments)

 Coupon payment- stated interest PAYMENT on a bond

 Maturity date(term of loan agreement)- specified date at which principal amount is paid

 Time to maturity is number of years until nominal amount is paid back

 Yield or Yield to maturity(YTM)- rate required on the market in the bond. This is the
normal discount rate the we calculated as IRR or I/Y

 Professor Wiseman’s tutorial note: Remember that PV calculated using a market related
rate is market value or current value and that given market value of a bond, and cash
flows we can calculate YTM as the discount rate for discounting cash flows to PV

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Explain the relationship between bond value(Present
Value) and interest rates
 When the interest rate increase, the price of the bond decrease because
 CF/(1+r)- mathematical intuition
 The investors now require a higher yield to compensate for increased risk
This return required by investors is part of the market interest rate
 Risk of the bond has increased since it was issued
 Professor Wiseman’s Tutorial note: You need to think about what the risk is when
the market interest rate goes up. The risk is called interest rate risk and refers to the
effect of changes in the prevailing(market) interest rate on bond values(market value
of bonds).
 The decrease in interest rate increase the price of Bonds. Explain the above factors
in reverse!
 The same relationship can be used to explain movement of house prices in the
housing market when interest rates in the market change( prime lending rate)

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Present Value of Cash Flows

 Bond Value = PV of coupons + PV of par


 Therefore, Bond Value = PV annuity + PV of lump sum
 Remember, as interest rates increase the PV’s decrease!!
 Also remember ,as interest rates increase, bond prices
decrease and vice versa!!

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Lecture illustration(also n=9 and interest rate =10 %and interest rate of 6%
Cash flows for Dogge bond

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Valuing a Discount Bond with Annual Coupons
 Consider a bond with a coupon rate of 10% and
coupons paid annually. The par value is R1 000
and the bond has 5 years to maturity. The yield to
maturity is 11%. What is the value of the bond?
– Long method:
• B = PV of annuity + PV of lump sum
• B = 369,59 + 593,45 = 963,04
– Using the calculator:
• N = 5; I/YR = 11; PMT = 100; FV = 1 000
• PV = -963,04

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Valuing a Premium Bond with Annual Coupons

 Suppose you are looking at a bond that has a 10%


annual coupon and a face value of R1 000. There
are 20 years to maturity and the yield to maturity is
8%. What is the price of this bond?
– Long method
• B = PV of annuity + PV of lump sum
• B = 981,81 + 214,55 = 1 196,36
– Using the calculator:
• N = 20; I/YR = 8; PMT = 100; FV = 1 000
• PV = -1 196,36

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Graphical Relationship Between Price and
Yield-to-maturity for an 8% Coupon R1000 Par Value Bond

1500
1400
1300
1200
1100
1000
900
800
700
600
0% 2% 4% 6% 8% 10% 12% 14%

7-11
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Bond Prices: Relationship Between Coupon
and Yield
 If YTM = coupon rate, then par value = bond price
 If YTM > coupon rate, then par value > bond price
– Why?
– Selling at a discount, called a discount bond
 If YTM < coupon rate, then par value < bond price
– Why?
– Selling at a premium, called a premium bond

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The Bond-Pricing Equation???use calculator

 1 
1 -
 (1  r) t  F
Bond Value  C 
 (1  r)
t
 r
 

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Clean price and Dirty price(all-in one price)

 Clean price of a bond excludes the accrued interest

 Dirty price(all-in one price) includes accrued interest

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Accrued interest and the price of a bond

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Interest Rate Risk and reinvestment risk

 Interest rate risk


– Change in price due to changes in interest rates
– Long-term bonds have more price(interest rate) risk than short-
term bonds
– The lower the coupon rate the greater the interest rate risk
 Reinvestment Rate Risk
– Uncertainty concerning rates at which cash flows can be
reinvested, that is when interest rates fall, the principal and coupon
will be reinvested at lower rates reducing the returns from
investment for the investor
– Short-term bonds have more reinvestment rate risk than long-term
bonds

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Computing Yield-to-maturity

 Yield-to-maturity is the rate implied by the current


bond price
 Finding the YTM requires trial and error if you do not
have a financial calculator and is similar to the
process for finding r with an annuity
 NB :If you have a financial calculator, enter N, PV,
PMT and FV, remembering the sign convention
(PMT and FV need to have the same sign, PV the
opposite sign)

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YTM with Annual Coupons
 Consider a bond with a 10% annual
coupon rate, 15 years to maturity and a
par value of R1 000. The current price is
R928,09.
– Will the yield be more or less than 10%?
– N = 15; PV = -928,09; FV = 1 000; PMT = 100;P/Y=1
– I/YR = 11%

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YTM with Semiannual Coupons
 Suppose a bond with a 10% coupon rate and semi-
annual coupons, has a face value of
R1 000,20 years to maturity and is selling for R1
197,93.
– Is the YTM more or less than 10%?
– What is the semi-annual coupon payment?
– How many periods are there?
– N = 40; PV = -1 197,93; PMT = 50; FV =
1 000; P/Y=1; I/YR = 4% (Is this the YTM?)
– YTM = 4%*2 = 8%
– Alternative method, better method??

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Bond Pricing Theorems(NB!!!)
 Bonds of similar risk (and maturity) will be priced to
yield about the same return, regardless of the
coupon rate
 If you know the price of one bond, you can
estimate its YTM and use that to find the price of the
second bond
 This is a useful concept that can be transferred to
valuing assets other than bonds and this represents
an interpretation of the return on bond(YTM) as
compensation for risk

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Differences Between Debt and Equity

 Debt  Equity
– Not an ownership – Ownership interest
interest – Ordinary shareholders
– Lenders do not have vote for the board of
directors and other
voting rights
issues
– Interest is considered – Dividends are not
a cost of doing considered a cost of
business and is tax doing business and
deductible are not tax deductible
– Lenders have legal – Dividends are not a
recourse if interest or liability of the firm and
principal payments shareholders have no
are missed legal recourse if
dividends are not paid
– Excess debt can lead
– An all equity firm can
to financial distress not go bankrupt??
and bankruptcy
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The Bond Trust Deed(Bond Indenture)
 Contract between the company and the
bondholders and includes
– The basic terms of the bonds
– The total amount of bonds issued
– A description of property used as security, if applicable
– Sinking fund provisions
– Call provisions
– Details of protective covenants

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Some Bond Classifications

 Registered vs. Bearer


 Security
– Collateral – secured by financial securities(cash, bonds,
shares)
– Mortgage – secured by real property, normally land or
buildings
– Debentures – unsecured with maturity of 10 year or more
– Commercial paper – unsecured debt with original
maturity less than 5 years
 Seniority

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Bond Characteristics and Required Returns(NB)

 The coupon rate depends on the risk characteristics of the bond when issued
 Which bonds will have the higher coupon, all else equal?
– Secured debt versus a debenture
– Subordinated debenture versus senior debt
– A bond with a sinking fund versus one without
– A callable bond versus a non-callable bond(deferred call)

– Professor Wiseman’s Tutorial note; What is important is to link bond


characteristics with Required Return( a concept directly related to risk).
You will be given bond characteristics and asked to decide on which
ones have the higher return and thus risk. Make sure you can do this!!!
Refer class discussion. The less desirable a bond is, the higher the risk
and required return, as shareholders need to be compensated for risk.

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Bond Ratings – Investment Quality

 High Grade
– Moody’s Aaa and S&P AAA – capacity to pay is
extremely strong
– Moody’s Aa and S&P AA – capacity to pay is very
strong
 Medium Grade
– Moody’s A and S&P A – capacity to pay is strong, but
more susceptible to changes in circumstances
– Moody’s Baa and S&P BBB – capacity to pay is
adequate, adverse conditions will have more impact
on the firm’s ability to pay

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Bond Ratings - Speculative
 Low Grade
– Moody’s Ba, B, Caa and Ca
– S&P BB, B, CCC, CC
– Considered speculative with respect to
capacity to pay. The “B” ratings are the lowest
degree of speculation.
 Very Low Grade
– Moody’s C and S&P C – income bonds with no
interest being paid
– Moody’s D and S&P D – in default with
principal and interest in arrears

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Government Bonds
 Government Securities
– SA government debt
– T-bills – pure discount bonds with original maturity of
one year or less
– RSA bonds coupon debt with original maturity greater
than ten years

NNB!!Tutorial note:(return on these bonds(RSA bonds)


are normally used to indicate the risk free rate as
governments are assumed to pay their financial
obligations)

 Municipal Securities
– Debt of local governments
– Varying degrees of default risk, rated similar to
corporate debt
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Zero-Coupon Bonds
 Make no periodic interest payments (coupon rate = 0%)
 The entire yield-to-maturity comes from the difference between the
purchase price and the par value
 Cannot sell for more than par value
 Sometimes called zeroes, or deep discount bonds
 Treasury Bills and RSA bond strips are good examples of zeroes

 Student Reflection: How do we value Zero Coupon Bonds???

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Stripping

 Separating a coupon-bearing bond into

separate interest and principle payments.

 Each separately held and traded as a

zero coupon bond.

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Bond Exchange of South Africa (BESA)

 Licensed 15 May 1996 under the Financial Markets Control Act 55 of


1989
 24 hour trading, Monday to Friday
 Automated screen trading
 Instruments: Bonds and OTC bond options
 725 listed bonds at end 2006

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Inflation and Interest Rates
 Real rate of interest – change in
purchasing power
 Nominal rate of interest – quoted rate of
interest, change in purchasing power and
inflation
 The ex ante nominal rate of interest
includes our desired real rate of return
plus an adjustment for expected inflation

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The Fisher Effect
 The Fisher Effect defines the relationship between real rates, nominal
rates and inflation
 (1 + R) = (1 + r)(1 + i), where
– R = nominal rate
– r = real rate
– i = expected inflation rate
 Approximation(NB)
– R=r+i

– Professor Wiseman’s tutorial Note: This has a direct link with FCF
valuations where we will say operating cash flow grow at the
nominal rate. This is an adaptation of the Fisher identity above.
When do we use the approximation above(R = r + i)

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Example
 If we require a 10% real return and we expect inflation
to be 8%, what is the nominal rate?
 R = (1,1)(1,08) – 1 = 0,188 = 18,8%
 Approximation: R = 10% + 8% = 18%
 Because the real return and expected inflation are
relatively high, there is significant difference between
the actual Fisher Effect and the approximation.

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Term Structure of Interest Rates
 Term structure is the relationship between time to maturity
and yields, all else equal
 It is important to recognize that we pull out the effect of
default risk, different coupons, etc.
 Yield curve – graphical representation of the term structure
– Normal – upward-sloping, long-term yields are higher than
short-term yields
– Inverted – downward-sloping, long-term yields are lower than
short-term yields
– Humped??

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Factors Affecting Required Return(NB)

 Expected future inflation rate


 Default risk premium – remember bond ratings
 Liquidity premium – bonds that have more frequent
trading will generally have lower required returns
 Anything else that affects the risk of the cash flows
to the bondholders, will affect the required returns

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SA interest rates

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Term structure of interest rates

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Term structure of interest rate

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Term structure of interest rates

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Yield curves

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