Berlin, 04.01.2006Fußzeile1 Bonds and Valuing Bonds Professor Dr. Rainer Stachuletz Corporate...
-
Upload
judith-montgomery -
Category
Documents
-
view
216 -
download
0
Transcript of Berlin, 04.01.2006Fußzeile1 Bonds and Valuing Bonds Professor Dr. Rainer Stachuletz Corporate...
Berlin, 04.01.2006 Fußzeile 1
Bonds and Valuing Bonds
Professor Dr. Rainer Stachuletz
Corporate Finance
Berlin School of Economics
Berlin, 04.01.2006 Fußzeile 2
The Basic Valuation Model
)r +(1CF + . . . +
)r +(1
CF +
)r +(1
CF = P n
n2
21
10
• P0 = Price of asset at time 0 (today)
• CFt = Cash flow expected at time t
• r = Discount rate (reflecting asset’s risk)• n = Number of discounting periods (usually years)
This model can express the price of any asset at
t = 0 mathematically.Marginal benefit of owning the asset: right
to receive the cash flowsMarginal cost: opportunity cost of owning
the asset
Berlin, 04.01.2006 Fußzeile 3
Valuation Fundamentals: Example
Company issues a 5% coupon interest rate, 10‑year instrument with a $1,000 par value
Assume annual interest payments
Investors in company’s financial instrument receive the contractual rights- $50 coupon interest paid at the end of each
year - $1,000 principal at the end of the 10th year
000,1$ = P
Berlin, 04.01.2006 Fußzeile 4
Yield to Maturity (YTM)
Estimate of return investors earn if they buy
the bond at P0 and hold it until maturity
The YTM on a bond selling at par will always equal the coupon rate.
YTM is the discount rate that equates the
PV of a bond’s cash flows with its price.
Berlin, 04.01.2006 Fußzeile 5
Bond Premiums and Discounts
What happens to bond values if required return is not equal to the coupon rate?
The bond's price will differ from its par value
P0 < par valuer > Coupon Interest Rate DISCOUNT =
P0 > par valuer < Coupon Interest Rate PREMIUM =
Berlin, 04.01.2006 Fußzeile 6
Semi-Annual Interest Payments
Value a T-Bond
Par value = $1,000
Maturity = 2 years
Coupon rate = 4%
r = 4.4% per year
= $992.43
nr
FC
r
C
r
C
r
C
2321 )2
1(
2....)2
1(
2
)2
1(
2
)2
1(
2Price
Berlin, 04.01.2006 Fußzeile 7
Factors that Affect Bond Prices
Time to maturity: bond prices converge to par value (plus final coupon) with passage of time.
Interest rates: bond prices and interest rates move in opposite directions.
Changes in interest rates have larger impact on long-term bonds than on short-term bonds.
Berlin, 04.01.2006 Fußzeile 8
Interest Rate Risk
What does this tell you about the relationship between bond prices and yields for bonds with
different maturities?
Berlin, 04.01.2006 Fußzeile 9
Primary vs. Secondary Markets
Primary market: the initial sale of bonds by issuers to large investors or syndicates
Secondary market: the market in which investors trade with each other
Trades in the secondary market do not raise any capital for issuing firms.
Berlin, 04.01.2006 Fußzeile 10
Bonds by Issuer
Corporate Bonds
• Usually with par $1000 and semi-annual coupon
• Bonds if maturity > 10 years; notes if maturity < 10 years
Municipal Bonds
• Issued by local and state government
• Interest on municipal bonds tax-free
Treasury Bonds
• If maturity < 1 year: Treasury Bills
• If 1 year < maturity < 10 years: Treasury Notes
• Maturity > 10 years: Treasury Bonds
• Used to fund budget deficitsAgency Bonds
• Issued by government agencies: FHLB, FNMA (Fannie Mae), GNMA (Ginnie Mae), FHLMC (Freddie Mac)
Berlin, 04.01.2006 Fußzeile 11
Bonds by Features
Fixed vs. Floating Rates
• Floating-rate bonds: coupon tied to prime rate, LIBOR, Treasury rate or other interest rate
• Floating rate = benchmark rate + spread
• Floating rate can also be tied to the inflation rate: TIPS, for example
Secured vs.
Unsecured Bonds
• Unsecured bonds (debentures) are backed only by general faith and credit of issuer
• Secured bonds are backed by specific assets (collateral)
• Mortgage bonds, collateral trust bonds, equipment trust certificates
Berlin, 04.01.2006 Fußzeile 12
Bonds by Features (Continued)
Zero-Coupon Bonds
• Discount bonds or pure discount bonds
• Sell below par value• Treasury Bills (Tbills) • Treasury STRIPs
Convertible and
Exchangeable Bonds
• Convertible bonds, in addition to paying coupon, offers the right to convert the bond into common stock of the issuer of the bond
• Exchangeable bonds are convertible in shares of a company other than the issuer’s
Berlin, 04.01.2006 Fußzeile 13
Bonds by Features (Continued)
Callable and
Putable Bonds
• Callable bonds: bond issuer has the right to repurchase the bonds at a specified price (call price).
• Firms could retire and reissue debt if interest rates fall.
• Putable bonds: the investors have the right to sell the bonds to the issuer at the put price.
Protection from
Default Risk
• Sinking fund provisions: the issuer is required to gradually repurchase outstanding bonds.
• Protective covenants: requirements the bond issuer must meet
• Positive and negative covenants
Berlin, 04.01.2006 Fußzeile 14
U.S. Treasury Bond Quotations
RATEMATURITY
MO/YRBID ASKED CHG
ASK
YLD
Government Bonds & Notes
5.500 May 09n 107:13 107:14 3 3.83
Rate Coupon rate of 5.5%
Bid pricesAsk prices
(percentage of par value)
Bid price: the price traders receive if they sell a bond to the dealer.
Quoted in increments of 32nds of a dollar
Ask price: the price traders pay to the dealer to buy a bond
Bid-ask spread: difference between ask and bid prices.
Ask Yield Yield to maturity on the ask price
Berlin, 04.01.2006 Fußzeile 15
Bond Ratings
Bond ratings: grades assigned to bond issues based on degree of default risk
Investment-grade bonds
• Moody’s Aaa to Baa3 ratings
• S&P and Fitch AAA to BBB- ratings
Junk bonds • Moody’s Ba1 to Caa1 or lower
• S&P and Fitch BB to CCC+ or lower
Berlin, 04.01.2006 Fußzeile 16
Term Structure of Interest Rates
Relationship between yield and maturity is called the Term Structure of Interest Rates- Graphical depiction called a Yield Curve- Usually, yields on long-term securities are higher
than on short-term securities.- Generally look at risk-free Treasury debt
securities
Yield curves normally upwards-sloping - Long yields > short yields- Can be flat or even inverted during times of
financial stress
What do you think a Yield Curve would look like graphically?
Berlin, 04.01.2006 Fußzeile 17
Yield Curves U.S. Treasury Securities
2
4
6
8
10
12
14
16
5 10 15 20 30
Years to Maturity
Inte
res
t R
ate
%
August 1996
October 1993
May 1981
January 1995
1 3