The document discusses different types of bonds and their key characteristics. It defines important bond terminology like par value, coupon rate, maturity date, and call provisions. It also covers how bond ratings are determined and factors that influence them. Additionally, the document examines how bond valuation is conducted by discounting expected future cash flows using the required rate of return.
The document discusses different types of bonds and their key characteristics. It defines important bond terminology like par value, coupon rate, maturity date, and call provisions. It also covers how bond ratings are determined and factors that influence them. Additionally, the document examines how bond valuation is conducted by discounting expected future cash flows using the required rate of return.
The document discusses different types of bonds and their key characteristics. It defines important bond terminology like par value, coupon rate, maturity date, and call provisions. It also covers how bond ratings are determined and factors that influence them. Additionally, the document examines how bond valuation is conducted by discounting expected future cash flows using the required rate of return.
The document discusses different types of bonds and their key characteristics. It defines important bond terminology like par value, coupon rate, maturity date, and call provisions. It also covers how bond ratings are determined and factors that influence them. Additionally, the document examines how bond valuation is conducted by discounting expected future cash flows using the required rate of return.
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Chapter 7
Interest Rates and
Bond Valuation Learning Objectives
1. Distinguish between different kinds of bonds.
2. Explain the more popular features of bonds. 3. Define the term value as used for several different purposes. 4. Explain the factors that determine value. 5. Describe the basic process for valuing assets. 6. Estimate the value of a bond. 7. Compute a bond’s expected rate of return and its current yield. 8. Explain three important relationships that exist in bond valuation.
term promissory note, issued by a borrower, promising to its holder a predetermined and fixed amount of interest per year and repayment of principal at maturity.
• For an issuing firm, debentures provide the benefit of not tying up property as collateral. • For bondholders, debentures are more risky than secured bonds and provide a higher yield than secured bonds.
insolvency. • The claims of subordinated debentures are honored only after the claims of secured debt and unsubordinated debentures have been satisfied.
different from the one in whose currency the bond is denominated. • For example, a bond issued by an American corporation in Japan that pays interest and principal in dollars.
returned to the bondholder at maturity. • In general, corporate bonds are issued at denominations or par value of $1,000. • Prices are represented as a % of face value. Thus, a bond quoted at 112 can be bought at 112% of its par value in the market. Bonds will return the par value at maturity, regardless of the price paid at the time of purchase.
corporation the option to redeem the bonds before the maturity date. For example, if the prevailing interest rate declines, the firm may want to pay off the bonds early and reissue at a more favorable interest rate. • Issuer must pay the bondholders a premium. • There is also a call protection period where the firm cannot call the bond for a specified period of time.
between the firm issuing the bond and the trustee who represents the bondholders. • It provides for specific terms of the loan agreement (such as rights of bondholders and issuing firm). • Many of the terms seek to protect the status of bonds from being weakened by managerial actions or by other security holders.
of the bonds. • Three prominent bond rating agencies are Standard & Poor’s, Moody’s, and Fitch Investor Services. • Lower bond rating indicates higher probability of default. It also means that the rate of return demanded by the capital markets will be higher on such bonds.
of BB or below by Moody’s and Standard & Poor’s. • Junk bonds are also referred to as high- yield bonds as they pay a high interest rate, generally 3 to 5% more than AAA- rated bonds.
• Book value: Value of an asset as shown on a firm’s
balance sheet. • Liquidation value: The dollar sum that could be realized if an asset were sold individually and not as part of a going concern. • Market value: The observed value for the asset in the marketplace. • Intrinsic or economic value: Also called fair value—represents the present value of the asset’s expected future cash flows.
expected future cash flows using the investor’s required rate of return as the discount rate. • Thus value is affected by three elements: – Amount and timing of the asset’s expected future cash flows – Riskiness of the cash flows – Investor’s required rate of return for undertaking the investment
C: Future expected cash flows in the form of interest and repayment of principal n: The time to maturity of the loan r: The investor’s required rate of return
maturity date of 2012 and a stated coupon of 4.35%. In December 2007, with 5 years left to maturity, investors owning the bonds are requiring a 3.6% rate of return.
rate of return by evaluating the riskiness of the bond’s future cash flows. Remember the investors required rate of return equals the risk-free rate plus a risk premium. Here, the required rate of return (r) is given as 3.6%.
+ PV ($1000 at year 5, i = 3.6%) = PV of Annuity (A = 43.5; N = 5; r = 3.6%) + PV of single cash flow (FV = $1,000, N = 5, i = 3.6%) = $195.84 + $837.73 = $1,033.57
• YTM refers to the rate of return the investor will earn if the bond is held to maturity. YTM is also known as bondholder’s expected rate of return. • YTM = Discount rate that equates the present value of the future cash flows with the current market price of the bond.
payment to the bond’s current market price. • Current Yield = Annual Interest Payment ÷ Current Market Price of the Bond Example: The current yield on a $1,000 par value bond with 8% coupon rate and market price of $700 = $80 ÷ $700 = 11.4 %
= Current Yield + Capital Gain/Loss from Sale • Thus, if a bond paid $80 in coupon interest, and the bond was originally bought for $700 and sold for $725. • Total Yield = 80 + (725 – 700) = $105 or 105/700 = 15%
Bond Valuation: Three Important Relationships Relationship #2 • The market value of a bond will be less than the par value if the investor’s required rate of return is above the coupon interest rate.
• Bond will be valued above par value if the
investor’s required rate of return is below the coupon interest rate.
the par or face value when the investor’s required rate is lower than the coupon interest rate. These bonds are known as premium bonds. • If investor’s required rate of return is equal to the coupon interest rate, the bonds will trade at par.
Relationship #3 • Long-term bonds have greater interest rate risk than do short-term bonds. • In other words, a change in interest rate will have relatively greater impact on long-term bonds.
the market value of bonds will fall) • Default risk (this may mean no or partial payment on debt as in bankruptcy cases) • Call risk (if bonds are called before maturity date)… bonds are generally called when interest rates decrease. Thus, investors will have to reinvest the money received from the corporation at a lower rate.
• Bond • Discount bond • Book value • Efficient market • Callable bond • Eurobond • Call protection period • Expected rate of • Convertible bond return • Coupon interest rate • Fixed-rate bond • Current yield • Fair value
• Indenture • Maturity • Interest rate risk • Mortgage bond • Intrinsic value • Par value • Junk bond • Premium bond • Liquidation value • Subordinated debentures • Yield to maturity • Zero coupon bond
