Finance - I Session # 9 Bond Valuation . . . Equity Valuation
Any Questions ?? Basic principle in valuing any financial instrument..… 1. Write down the timeline of all expected future cash inflows / outflows 2. Discount all the future cash flows to time 0 3. Intrinsic / fair value of financial instrument is PV of all future cash flows.
The value of a bond therefore is…
1 1− M (1 + rd )t Bond Value = 𝐼𝑁𝑇 + rd (1 + rd )t
The Present Value of a
The Present Value of Lumpsum received at ‘n’ Annuity payments The time of maturity How is bond value determined? What is the value of the bond that has TTM = 15-year, Par value = $1,000 Coupon rate = 10% Annual coupon if its required rate of return (market rate of interest) is 10 percent? Valuing a Straight Bond You are trying to value a straight bond with a fifteen year maturity and a 10% coupon rate. The current (market) interest rate on bonds of this risk level is 10%. PV of cash flows on bond = 100* PV(A,10%,15 years) + 1000/1.115 = $ 1000 If (market) interest rates rise to 15%, PV of cash flows on bond = 100* PV(A,15%,15 years)+ 1000/1.1515 =100*5.8474+1000*0.1229 = $707.6 If (market) interest rate fall to 5%, PV of cash flows on bond = 100* PV(A,5%,15 years)+ 1000/1.0515 = 100*10.3797+1000*0.481 =$1,518
The longer the maturity of a bond, the more sensitive it is to changes in interest rates. The lower the coupon rate on the bond, the more sensitive it is to changes in interest rates. At maturity, the value of any bond must equal its par value. The value of a premium bond would decrease to $1,000. The value of a discount bond would increase to $1,000. A par bond stays at $1,000 if rd remains constant. 1,372 rd = 7%. 1,211
1,000 rd = 10%. M
837 rd = 13%. 775
30 25 20 15 10 5 0
Years remaining to Maturity
Yield-to-Maturity:
Yield to maturity (YTM) is the rate of return earned on a bond held to
maturity.
It is the discount rate that equates the present value of the future cash flows with the current market price of the bond.
Yield-to-maturity is the rate (market discount rate) implied
by the current bond price Given the market price of bond, find the implied market interest rate :YTM What’s the YTM on a 10-year, 9% annual coupon, $1,000 par value bond that sells for $887? 0 1 9 10 rd=? ... 90 90 90 PV1 1,000 . . . PV10 PVM
C=coupon payment; F=face value; P=market price; N= Years to maturity
What is the YTM on a 10-yr, 9% annual coupon, $1,000 par value bond that sells for: $1,134.20? What does the fact that a bond sells at a discount or at a premium tell you about the relationship between rd and the bond's coupon rate? 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 Example Coupon rate = 14%, semiannual coupons YTM = 16% Maturity = 7 years Par value = $1000 Find the Bond value ? How many coupon payments are there? What is the semiannual coupon payment?
B = 70[1 – 1/(1.08)14] / .08 + 1000 / (1.08)14
= 70*8.2442+1000*0.3405 =917.56 Example A taxable bond has a yield of 8% and a municipal (not taxable) bond has a yield of 6% If you are in a 40% tax bracket, which bond do you prefer? 8%(1 - .4) = 4.8% The after-tax return on the corporate bond is 4.8%, compared to a 6% return on the municipal At what tax rate would you be indifferent between the two bonds? 8%(1 – T) = 6% T = 25% Definitions
Current yield = Annual coupon pmt
Current price
Capital gains yield = Change in price
Beginning price
Exp total Exp Exp cap
= YTM = + return Curr yld gains yld Bond Current and Capital gains Yield Calculation What is the current yield for a bond with a face value of $1,000, a current price of $921.01, and a coupon rate of 10.95%, with a 10 yr maturity? Assume that the price of bond one year later is $925.39. Calculate current yield,YTM and capital gains yield?
ic = C / P = $109.50 / $921.01 = 11.89%
C ( coupon) = 10.95% $1,000 = $109.50
YTM = Rate(nper,pmt,-pv,fv)=Rate(10,109.5,-921.01,1000)=12.37% For capital gains yield: -- PV of the bond one year later: PV(rate,periods,pmt,fv) =PV(0.1237,9,109.5,1000)=925.39 -- Capital gains yield= (Change in Price)/Beginning Price = 925.39-921.01/921.01 =0.47% YTM (12.37) = Current Yield (11.89) + Capital Gains Yield(0.47) Variations in coupon rates Zero-coupon (or deep discount) a bond that pays no annual interest; it provides compensation to investors in the form of capital appreciation.
Originally issued at discount
Coupon rate < going market rate
Floating-rate a bond whose coupon rate fluctuates with shifts in the general level of interest rates. Tied to a short-term IR such as T-bill rate or LIBOR Floors, fixed to convertible (teaser home loans of SBI!)
PIK : Payment-in-Kind Bonds
Companies with cash flow problems; Low ratings; high IRs;
Bonds with step-up provision
Having trouble in servicing debt ➔ rating downgrade ➔ higher coupon rate on bond ➔ exacerbates the CF problem ➔ bankruptcy What determines, going rate of interest, rd? The discount rate (rd) is the opportunity cost of capital, i.e., the rate that could be earned on alternative investments of equal risk. It depends on
rd = r* + IP + LP + MRP + DRP for debt securities. Factors Affecting Required Return Inflation premium – to account for expected inflationary conditions Default risk premium and anything else that affects the risk of the cash flows to the bondholders Liquidity premium – bonds that have more frequent trading will generally have lower required returns Reinvestment Rate Risk --Uncertainty concerning rates at which cash flows can be reinvested Interest rate risk – changes in market interest rate Who issues Bonds?
specific default I R currency
entities risk Risk risk Treasury bonds Central Govt. No Yes No State Govt., Muni bonds City councils yes Yes No Banks, companies, Corporate bonds Trusts Yes Yes No Govts, banks, Foreign bonds cos, trusts, Yes Yes Yes
Tax-free bonds Govts, banks, cos,Yes
trusts, / No Yes No Different corp bonds have different levels of default risk, depending on the issuer’s characteristics and the terms of specific bond. Coupon rate default risk at the time of issuance. What would be the value of the bond if, just after it had been issued, the expected inflation rate rose by 3 percentage points, causing investors to require a 13% return? Would we now have a discount or a premium bond?
What would happen to the bonds' value if inflation fell, and rd declined to 7%? Would we now have a premium or a discount bond? Fixed Income Valuation (only first 2 exercises) (Exercise 1) On Dec. 20, 1994 the NTT issued ¥1 billion of 10-year AAA-rated debentures due on 20-Dec- 2004. The debentures carried 4.75% coupon. They were priced at par, that is, they cost the investor ¥100 per ¥100 of face value. The entire amount of borrowed principal would be repaid at maturity.
Interest would be paid annually upon the anniversary date of the issuance (i.e., on December 20th of every year).
Calculate YTM if the bonds were priced at 101? And priced at 99? YTM approximation F −P C + YTM = n 0 . 5( F + P )
If it sells at 99, then the bond YTM = 4.85/99.5 = 4.87%
By 1996, yield on AAA yen bonds maturing in 8 years dropped to 3%. At what price it should sell?
When rd falls, below the coupon rate,
the bond’s value rises above par, so it sells at a premium. (premium bond). What would happen to its value over time if the required rate of return remained at 4.75%, or at 6%, or at 3%? TTM 3.00% 4.75% 6.00% 115 8 112.284 100.000 92.238 110 7 110.903 100.000 93.022 6 109.480 100.000 93.853 105 5 108.014 100.000 94.735 100 4 106.505 100.000 95.669 3 104.950 100.000 96.659 95 2 103.349 100.000 97.708 90 1 101.699 100.000 98.821 0 1 2 3 4 5 6 7 8 0 100.000 100.000 100.000 Bond Value (¥) 112.3 rd = 3%. 104.9
kd = 4.75%. M 100
96.7 rd = 6%. 92.2
8 7 6 5 4 3 2 1 0
Years remaining to Maturity
Exercise 2 Ms. Alumm is the portfolio manager for a large insurance co. She is investing $1 million to purchase some bonds of Patriot Enterprises, Inc. All the 3 issues have same 8% BEY. Bond A Bond B Bond C Type (MT Note) Bond ZCB cpn rate 9% 8% 0% freq 2 2 2 TTM (yrs) 5 10 10 Par value 1000 1000 1000 req yield (BEY) 8% 8% 8% Price estimated $1,040.55 $1,000.00 $463
a. At what price should each bond currently sell ?
Exercise 2 (contd.) As an alternative, Ms. Alumm has been invited to invest $1 mil in a 10-year Eurobond of a second firm, Naliste, S.A. Nationaliste bonds are similar in risk to “Bond B” above.: 8% for 10-years, but coupons are paid annually. These bonds are priced at 99% of par, or $990 per $1,000 par.
b. What yield to maturity is implied by the Nationaliste Bond?
Compare this yield to the 8% BEY of Patriot bond (Bond B). In which bond should she invest? YTM of Nationaliste Bond? BEY is not appropriate basis for comparison. The Bond B has effective annual yield (EAY%): m 2 i 0.08 EFF % = 1 + Nom − 1 = 1 + − 1 = 8.16 % m 2 EAY of Nationaliste Bond = 8.14% < 8.16% ➔ Nationaliste Bond is overpriced.
. Bond A has a price of Rs.942 while Bond B has a price of Rs.960. The former has a coupon of 4.2% per annum while the latter has a coupon of 4.5% per annum. Both the bonds have a face value of Rs.1000 and 8 years to maturity and pay annual coupons. If an investor has to choose between the two bonds, which one will he pick?
Calculate YTM for A and B and select the one which has high YTM.
YTM of A = 5.07% YTM of B = 5.1% Investor will choose B.
