Dr. A.

DeMaskey Corporate Finance

Questions to be answered:
What is a bond? Who issues bonds? What are the key characteristics of bonds? How are bonds valued? What is the rate of return on a bond? What types of risk are bondholders exposed to?

Treasury Bonds
Corporate Bonds Municipal Bonds Foreign Bonds

Bond Par Value Coupon Interest Payment Coupon Interest Rate Maturity Date Bonds Market Rate of Interest, kd

0
k Value

...
CF1 CF2 CFn

PV =

1 + k

CF1

1+ k

CF2

+ ... +

1 + k

CFn

The discount rate (ki) is the opportunity cost of capital, i.e., the rate that could be earned on alternative investments of equal risk.

ki = k* + IP + LP + MRP + DRP

Risk that issuer will not make interest or principal payments.

Increases required rate of return Bond ratings provide one measure of default risk Defaulting on bonds may result in bankruptcy and/or reorganization

0 10% V=?

10

...
100 100 100 + 1,000

VB

$100

1 + k d

+ . . . +

$100

1 + k d

10

$1,000

1+ k d

10

= $90.91 + = $1,000.

. . . + $38.55 + $385.54

INT M VB t N 1 kd 1 t 1 k d

Multiply years by 2 to get periods = 2n. Divide nominal rate by 2 to get periodic rate = kd/2. Divide annual INT by 2 to get PMT = INT/2.

INT / 2 M VB t 2N 1 kd / 2 1 t 1 k d / 2
10

2N

If coupon rate < kd, bond sells at a discount. If coupon rate > kd, bond sells at a premium. If coupon rate = kd, bond sells at its par value. If kd rises, price falls; if kd falls, price rises. At maturity, the value of a bond equals par.

11

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 kd remains constant.

12

Bond Value ($)

1,372 1,211

kd = 7%.

1,000

kd = 10%.

837
775
30 25 20 15 10

kd = 13%.

Years remaining to Maturity

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Yield-to-Maturity (YTM)
Effective Annual Return on Bond Yield-to-Call Current Yield

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YTM is the rate of return earned on a bond held to maturity, also called promised yield. It is the discount rate that equates the present value of the interest and principal payments to the price of the bond.
Annualized YTM = 2 x six-month yield Effective YTM = (1 + six-month yield)2 - 1

15

The effective annual return on a bond is equal to its current yield and capital gains yield.
Current yield Capital gains yield YTM = Current yield + Capital gains yield (1 + semiannual return)2 -1

Effective annual yield

16

Call Provision
Callable bonds Call premium Refunding operation

YTC is the average annual return an investor will receive if the bond is held until its expected call date.

17

Annual interest payment/Current value of bond Provides information about cash income on bond. Does not provide accurate measure of total expected return on bond.

18

Rising interest rates have an adverse effect on bond values. The longer the maturity of a bond, the greater the exposure to interest rate risk.

kd

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%
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Value
1,500 1,000 500

10-year 1-year

0 0%

5%

10%

15%

kd

20

The risk that CFs will have to be reinvested in the future at lower rates, reducing income. The shorter the maturity of the bond, the greater the risk of a decrease in interest rates.

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