Bond Values
Objectives
Understand basic concept of valuing an asset.
Apply the valuation technique to determine the value of selected financial instruments.
Study the concept of duration.
Bond Types
Debentures
A certificate issued by a corporation that states the amount of a loan, the interest to be paid and the time for repayment. It is backed only by the corporation's reputation and good word, but not by collateral.
Subordinated Debenture
A debt security that will be paid off after the issuer first pays off debt to senior creditors in the event of insolvency.
Mortgage Bonds
Debt issues secured by a mortgage on the issuer's property, such as buildings or equipment.
Bond Types
Zero Coupon Bonds
A bond sold at a deep discount. It does not pay periodic interest payments to investors; instead, investors receive their return on investment at maturity. The return is equal to the difference between the bond's price at issuance and its face value.
Junk Bonds
High-yield bonds that credit-rating agencies consider speculative. The bonds typically offer higher yields and carry higher risk than bonds with investment-grade ratings.
Eurobonds
Bonds issued by a borrower outside its own country. The bonds are denominated in a currency foreign to the borrower or the purchaser or both.
Definitions of Value
Book Value is the value of an asset shown on the firm’s balance sheet which is determined by its historical cost rather than its current worth.
Liquidation Value is the amount that could be realized if an asset is sold individually and not as a part of a going concern.
Market Value is the observed value of an asset in the market place where buyers and sellers determine the price of the asset.
Determinants of Value
The value of any asset is measured by the present value of the benefits it generates.
Identical streams of benefits must sell for the same price.
Investors will not pay for benefits that they can duplicate for themselves at no cost.
Investors will demand returns on investments sufficient to compensate them for the risk borne.
Valuation: An Overview
Asset Characteristics
Amount of Cash Flows
Timing of Cash Flows
Risk of Cash Flows
Investor Attributes
Investor’s assessment of
of Cash Flow risks
Investor’s willingness
to bear risk
Investor’s required rate
of return (RRR)
Asset Value = Present Value of
expected Cash Flows
discounted using the
investor’s RRR
Basic Valuation Model
where Ct = cash flow at date t V0 = the present value of the asset r = the investor’s required rate of return
What is a Bond?
A bond is a long-term promissory note that commits the firm to pay the bondholder a fixed amount of interest each year until maturity and the principal at maturity.
Bond Terminology
A bond's Par Value is the amount that will be repaid by the firm when the bond matures.
The bond has a Maturity Date, at which time the borrowing firm is committed to repay the loan principal.
The bond’s contractual agreement specifies a Coupon Rate that is expressed either as a percent of the par value or as a flat amount of interest which the borrowing firm promises to pay the bondholder each year.
Bond Terminology
Call Provision - A provision in a bond contract that gives the issuer the right to “recall” the bond and pay it off under specified terms prior to the stated maturity date.
Bond Valuation
The value of a bond with semi-annual interest payments is the present value of the interest payment stream plus the present value of the face value. Letting It = rc FV be the interest payment per period, T be the maturity, FV be the face value (par value) and rb be the rate of interest, the bond value B may be expressed as
Relationships in Bond Valuation
A decrease in interest rates will cause the value of a bond to increase; an interest rate increase will cause a decrease in value. The change in value caused by changing interest rates is called interest rate risk.
If the bondholder's required rate of return (current interest rate) equals the coupon interest rate, the bond will sell at par, or maturity value.
If the current interest rate exceeds the bond's coupon rate, the bond will sell below par value, or at a discount.
If the current interest rate is less than the bond's coupon rate, the bond will sell above par value, or at a premium.
Relationships in Bond Valuation
Regardless of whether a bond is selling below or above par value, the value of the bond will gradually approach par value as the bond matures.
A bondholder owning a long-term bond is exposed to greater interest rate risk than when owning a short-term bond.
In understanding a bond's sensitivity to interest rate changes, we must consider not only the time to maturity, but also the time pattern of interim cash flows, or its duration.
Interest Rate Risk
Consider the value of a coupon bearing bond at various dates as the interest rate changes from 5% to 15%. Suppose the coupon rate is 10% and the maturity initially is 30 years.
Interest Rate Risk
Consider the value of a zero coupon bond with an initial maturity of 30 years as the interest rate changes from 1% to 15%
Yield To Maturity
YTM is the average rate of return earned on a bond if it is held to maturity.
John Kooti
John Kooti
John Kooti
John Kooti
John Kooti
John Kooti
