Ch06 PPT Brighamfm1ce

PowerPoint Presentation
prepared by
Traven Reed Canadore College
chapter 6
Bonds, Bond Valuation, and Interest Rates
Corporate Valuation and Risk

CH6
Copyright 2011 by Nelson Education Ltd. All rights reserved.
6-3
Topics in Chapter
CH6
Key features of bonds Bond valuation Measuring yield Determining interest rate Term structure Assessing risk
6-4
Bond Issuers
CH6
Bond is a promissory note (i.e. a fancy IOU) issued by a business, a government unit or a foreign party. Each type differs in risk and expected return. Although Government of Canada bonds have no default risk, they are not riskless. Depending on the business, corporate bonds are exposed to default risk. Foreign bonds have additional exchange rate risk. With C$ denominations, Maple bonds are appealing.
6-5
Key Features of a Bond

CH6
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, but can vary.
6-6
Key Features of a Bond (contd)

CH6
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.
6-7
Call Provision
CH6
Issuer can refund if interest 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. The Canada call feature restricts the call price to a certain level.
6-8
Retractable Bonds
CH6
Investors have the right to sell the bonds back before maturity to the issuing company at a pre-set price. Protect investors from the rising interest rates or the event risk.
6-9
Whats a sinking fund?

CH6
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.
6-10
Sinking funds are generally handled in 2 ways

CH6
1. Call x% at par per year for sinking fund purposes. 2. Buy bonds on open market. Company would call if the going market rate of interest (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.
6-11
Other Bond Features

CH6
Convertible bonds: convert into shares of common stock, at a fixed price, at the bondholders discretion Income bonds: pay interest only when the issuer can afford. Real return bonds: principal and interests are indexed and protected against inflation.
6-12
Bond Valuation
CH6
0
Rd%
...
INT INT INT +M
Value
PV =
INT
1+ rd
INT
1 + rd
+ ... +
(INT+M)
1+ rd
6-13
CH6
Value of a 15-year, 10% coupon bond if rd = 10%

0 Rd=10% V=? 100 100 1 2 15
...
100 + 1,000
VB !
$100
1 + rd
+ .. . +
$100
1 + r d
15
$1,000
1+ r d
15
= $90.91 + = $1,000
. . . + $23.94 + $239.39
6-14
The bond consists of a 15-year, 10% annuity of $100/year plus a $1,000 lump sum at t = 15:
CH6
= $ 760.61 PV annuity PV maturity value = 239.39 = $1,000.00 Value of bond

INPUTS OUTPUT
15 N
10 I/YR
PV -1,000
100 PMT
1000 FV
6-15
Zero-coupon Bond Prices

CH6
With no intern interest payments, the price of a zero is the present value of the principal payment at maturity.
Vzero
M ! N (1 rd )
6-16
CH6
What would happen if going market rate of interest rd = 15%?

INPUTS OUTPUT
15 N
15 I/YR
PV -707.63
100 PMT
1000 FV
When rd rises, above the coupon rate, the bonds value falls below par, so it sells at a discount.
6-17
What would happen if rd declined to 5%?

CH6
INPUTS OUTPUT
15 N
5 I/YR
PV -1,518.98
100 PMT
1000 FV
If coupon rate > rd, price rises above par, and bond sells at a premium.
6-18
Whats yield-to-maturity?
CH6
YTM is the expected rate of total return earned on a bond held to maturity. Also called promised yield. YTM = expected current (interest) yield + expected capital gains yield. It assumes the bond will not default and cannot be called. YTM changes whenever market interest rates change.
6-19
YTM on a 14-year, 10% annual coupon, $1,000 par value bond selling for $1,494.93
CH6
rd=?
13
14 100 1,000
...
100 100
PV1 . . . PV10 PVM
1,494.93
Find rd that works!

6-20
CH6
Find rd
VB ! INT
1 + r d
+ ... +
INT
1 + r d
1 + r d
1494.93 ! 100 1 + 1 + r d
... +
1,000 100 14 + 14 1+ r d 1 + r d
Solving for the unknown rd is tedious. Need a financial calculator.

6-21
Find YTM with financial calculator

CH6
INPUTS 14 N OUTPUT
-1494.93 100 I/YR PV PMT 5 = YTM
1000 FV
Sells at a premium. Because coupon = 10% > rd = 5% (YTM), bonds value > par.
6-22
Callable Bonds and Yield to Call

CH6
A 10-year, 10% annual coupon, $1,000 par value bond is selling for $1,494.93 with an 5% yield-tomaturity. It can be called after 1 year at $1,100
VCALL INT callprice ! t (1 rd ) (1 rd ) N t !1
6-23
Yield to Call (YTC)

CH6
INPUTS 9 -1494.93 100 1100 N I/YR PV PMT FV 4.21=YTC OUTPUT
6-24
If you bought bonds, would you be more likely to earn YTM or YTC?
CH6
Coupon rate = 10% vs. YTC = rd = 4.21%. Firm could raise money by selling new bonds which pay 4.21% Could thus replace bonds which pay $100/year with bonds that pay only $42.1/year. Investors should expect a call, hence YTC = 4.21%, not YTM = 5%
6-25
If you bought bonds, would you be more likely to earn YTM or YTC? (contd)
CH6
In general, if a bond sells at a premium, then (1) coupon > rd, so (2) a call is likely. So, expect to earn:
YTC on premium bonds. YTM on par & discount bonds.
6-26
Current yield
CH6
10% coupon, 14-year bond, P = $1,494.93, and YTM = 5.0%
Annual coupon pmt Current yield = Current price Current yield = $100 $1,494.93 = 0.0669 = 6.69%
6-27
Capital gains yield

CH6
Cap gains yield = YTM - Current yield = 5.00% - 6.69% = - 1.69% Cap gains yield = Change in price/beginning price = -25.25/1494.93 = - 1.69%
6-28
Changes in Bond Values ($) Over Time

CH6
1,495
Premium bond
1,000
rd = 10% (par bond) Discount bond
714
0 1 2 3 14 15
6-29
Changes in Bond Values ($) Over Time (contd)

CH6
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 $1,000 if rd remains constant.
6-30
Changes in Bond Values ($) Over Time (contd)

CH6
If coupon rate < rd, bond sells at a discount. If coupon rate = rd, bond sells at its par value. If coupon rate > rd, bond sells at a premium. If rd rises, price falls. Price = par at maturity.
6-31
Semiannual Bonds
CH6
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
2n N
rd/2
I/YR
OK PV
INT/2 PMT
OK FV
6-32
CH6
Value of 15-year, 10% coupon, semiannual bond if rd = 5%
2(15) INPUTS 30 N OUTPUT
5/2 2.5 I/YR
100/2 50 PV PMT -1523.26
1000 FV
6-33
Market Interest Rate

CH6
rd = r* + IP + DRP + LP + MRP
where rd = Required rate of return on a debt security. r* = Real risk-free rate. IP = Inflation premium. DRP = Default risk premium. LP= Liquidity premium. MRP= Maturity risk premium.
6-34
CH6
Real Risk-free Rate of Interest (r*)

R* = rate of return on a riskless security if no inflation is expected The best estimate is the short-term government of Canada T-bills in an inflation-free world R* is not static, changing over time
6-35
Inflation Premium (IP)

CH6
Inflation erodes the purchasing power of money. The IP for a particular length maturity can be approximated as the difference between the yield on a non-indexed security of that maturity minus the yield on a default-free government bond of that maturity.
6-36
What is the nominal risk-free rate?

CH6
rRF = (1+r*)(1+IP)-1
= r*+ IP + (r*x IP) r*+ IP. (Because r*x IP is small)
rRF = Rate on short- or long-term government bonds.
6-37
Default Risk Premium (DRP)

CH6
Investors want to be compensated for the chance that interest or principal will not be paid on the due date and in the promised amount The greater the default risk, the higher the bonds DRP While Canada bonds is default free, default risk can be substantial for corporate bonds
6-38
CH6
Bond Provisions that Influence Default Risk

Provisions in the bond contract
Secured versus unsecured debt: mortgage bonds vs. debentures Senior versus subordinated debt Guarantee provisions: agency bonds such as CMHC, EDC Sinking fund provisions Debt maturity
6-39
Bond Ratings Provide One Measure of Default Risk

CH6
Investment Grade Moodys Aaa S&P DBRS AAA AAA Aa AA AA A A A Baa
Junk Bonds Ba B Caa C
BBB BB BBB BB
B CCC D B CCC D
6-40
What factors affect default risk and bond ratings?

CH6
Financial performance
Debt ratio Coverage ratios, such as interest coverage ratio or EBITDA coverage ratio Current ratios
Other factors
Earnings stability Regulatory environment Potential product liability Accounting policies
6-41
Bond Ratings and Bond Spreads (Canadian Fixed Income, 2008)

CH6
Long-term Bonds (5 yr) Government of Canada (Reference) AAA-rated AA-rated A-rated BBB-rated BB-rated
Example
Yield 3.01%
Spread
Can. Savings Bond BOM Telus Corp Loblaws
3.01% 4.68% 4.88% 5.61%
-1.67% 1.87% 2.60% 4.46%
Sherritt International 7.47%
6-42
Liquidity Premium (LP)

CH6
A liquid asset can be converted into cash quickly and at a fair market price. Liquidity is also known as marketability Financial assets are generally more liquid than real assets Often difficult to accurately measure
6-43
Bond Spreads, the DRP, and the LP

CH6
A bond spread is often calculated as the difference between a corporate bonds yield and a Government of Canada bonds 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%.
6-44
CH6
Maturity Risk Premium (MRP)

All bonds, including Government of Canada bonds, are exposed to two extra risks: interest rate (price) risk and reinvestment risk. MRP is the net effect of these two sources of risk on a bonds yield
6-45
Interest rate (or price) risk for 1year and 10-year 10% bonds
CH6
Interest rate risk: Rising rd causes bonds price to fall. rd 1-year Change 10-year Change 5% 10% 15% $1,048 1,000 956 4.8% 4.4% $1,386 1,000 749 38.6% 25.1%
6-46
Value
CH6
1,500
10-year 1-year
1,000
500
0 0% 5% 10% 15%
rd
6-47
What is reinvestment rate risk?

CH6
The risk that CFs will have to be reinvested in the future at lower rates, reducing income. Illustration: Suppose you just won $500,000 playing the lottery. Youll invest the money and live off the interest. You buy a 1-year bond with a YTM of 10%.
6-48
What is reinvestment rate risk? (contd)

CH6
Year 1 income = $50,000. At yearend 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.
6-49
Remarks of MRP
CH6
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.
6-50
Term Structure and Yield Curve

CH6
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.
6-51
Hypothetical Govt of Canada Yield Curve

CH6
14% 12% Interest Rate 10% 8% 6% 4% 2% 0% MRP IP r*
11
13
15
17
Years to Maturity
19
6-52
Relationship Between Govt of Canada Yields and Corporate Yields

CH6
Corporate yield curves are higher than that of the Govt of Canada bond. However, corporate yield curves are not necessarily parallel to the Govt of Canada curve. The spread between a corporate yield curve and the Govt of Canada curve widens as the corporate bond rating decreases.
6-53
Hypothetical Govt of Canada and Corporate Yield Curves

CH6
12.0% 10.0% Interest Rate 8.0% 6.0% 4.0% 2.0% 0.0% 1 10 Years to Maturity
5.2%
5.9%
6.0%
BB Bond AAA Bond Gov't of Canada
20
6-54
Junk Bonds
CH6
Belong to the non-investment grades (with a BB or lower in the S&P and DBRS rating or a Ba or worse in the Moodys) Also called as high-yield or lowgrade bonds Junk bonds are risky because their default rates are high
6-55
Bankruptcy
CH6
Two main chapters of Federal Bankruptcy Act:

Bankruptcy and Insolvency, bankruptcy Companies Creditors Arrangement, reorganization
6-56
Bankruptcy (contd)
CH6
If company cant meet its obligations, it files under CRA. 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.
6-57
Bankruptcy (contd)
CH6
Company must demonstrate in its reorganization plan that it is worth more alive than dead. Otherwise, judge will order liquidation under the Bankruptcy and Insolvency Act.
6-58
If the company is liquidated, heres the payment priority:

CH6
Costs for environmental damage Unremitted payroll taxes and deductions Secured creditors from sales of secured assets. Trustees costs Expenses incurred after bankruptcy filing Wages and unpaid benefit contributions, subject to limits of $2,000 per worker Municipal taxes Claims for rent, up to 3 months prior to bankruptcy Creditor costs who first filed a claim Injury claim costs to employees not covered under Workers Compensation Other unsecured creditors Preferred stock Common stock
6-59
If the company is liquidated, heres the payment priority: (contd)

CH6
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.
6-60

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PowerPoint Presentation

Traven Reed Canadore College

Corporate Valuation and Risk

Copyright 2011 by Nelson Education Ltd. All rights reserved.

Copyright 2011 by Nelson Education Ltd. All rights reserved.

Key Features of a Bond

Key Features of a Bond (contd)

Copyright 2011 by Nelson Education Ltd. All rights reserved.

Whats a sinking fund?

Sinking funds are generally handled in 2 ways

Other Bond Features

Copyright 2011 by Nelson Education Ltd. All rights reserved.

Value of a 15-year, 10% coupon bond if rd = 10%

Copyright 2011 by Nelson Education Ltd. All rights reserved.

= $ 760.61 PV annuity PV maturity value = 239.39 = $1,000.00 Value of bond

Copyright 2011 by Nelson Education Ltd. All rights reserved.

Zero-coupon Bond Prices

Copyright 2011 by Nelson Education Ltd. All rights reserved.

What would happen if going market rate of interest rd = 15%?

What would happen if rd declined to 5%?

PV1 . . . PV10 PVM

Find rd that works!

Solving for the unknown rd is tedious. Need a financial calculator.

Find YTM with financial calculator

-1494.93 100 I/YR PV PMT 5 = YTM

Callable Bonds and Yield to Call

Yield to Call (YTC)

INPUTS 9 -1494.93 100 1100 N I/YR PV PMT FV 4.21=YTC OUTPUT

Copyright 2011 by Nelson Education Ltd. All rights reserved.

Copyright 2011 by Nelson Education Ltd. All rights reserved.

10% coupon, 14-year bond, P = $1,494.93, and YTM = 5.0%

Capital gains yield

Changes in Bond Values ($) Over Time

rd = 10% (par bond) Discount bond

Changes in Bond Values ($) Over Time (contd)

Changes in Bond Values ($) Over Time (contd)

Value of 15-year, 10% coupon, semiannual bond if rd = 5%

2(15) INPUTS 30 N OUTPUT

5/2 2.5 I/YR

100/2 50 PV PMT -1523.26

Copyright 2011 by Nelson Education Ltd. All rights reserved.

Market Interest Rate

Real Risk-free Rate of Interest (r*)

Copyright 2011 by Nelson Education Ltd. All rights reserved.

Inflation Premium (IP)

What is the nominal risk-free rate?

rRF = Rate on short- or long-term government bonds.

Copyright 2011 by Nelson Education Ltd. All rights reserved.

Default Risk Premium (DRP)

Bond Provisions that Influence Default Risk

Bond Ratings Provide One Measure of Default Risk

Investment Grade Moodys Aaa S&P DBRS AAA AAA Aa AA AA A A A Baa

Junk Bonds Ba B Caa C

Copyright 2011 by Nelson Education Ltd. All rights reserved.

What factors affect default risk and bond ratings?

Bond Ratings and Bond Spreads (Canadian Fixed Income, 2008)

Can. Savings Bond BOM Telus Corp Loblaws

3.01% 4.68% 4.88% 5.61%

-1.67% 1.87% 2.60% 4.46%

Sherritt International 7.47%

Copyright 2011 by Nelson Education Ltd. All rights reserved.

Liquidity Premium (LP)