The International University, VNU-HCM

School of Business

Financial Management
MBA program sem 2 (2015-2016)
Lecturer: Dr. Linh Nguyen
Email: [email protected]

Tutor: Mr. Le Ngoc Anh Khoa (MSc)

Email: [email protected]

The International University, VNU-HCM

School of Business

Lecture 4
Bond Analysis and
Evaluation

KEY CONCEPTS AND SKILLS

Know the important bond features and bond types

Understand bond values and why they fluctuate
Understand bond ratings and what they mean

Understand the term structure of interest rates

and the determinants of bond yields

7-3

DIFFERENCES BETWEEN
DEBT AND EQUITY
Debt

Not an ownership interest

Creditors do not have voting
rights
Interest is considered a cost
of doing business and is tax
deductible
Creditors have legal
recourse if interest or
principal payments are
missed
Excess debt can lead to
financial distress and
bankruptcy

Equity

Ownership interest
Common stockholders vote
for the board of directors
and other issues
Dividends are not
considered a cost of doing
business and are not tax
deductible
Dividends are not a liability
of the firm, and stockholders
have no legal recourse if
dividends are not paid
An all equity firm can not go
bankrupt merely due to debt
since it has no debt

7-4

The

most common type of fixed-income security

Promises

to make a series of interest payments in

fixed amount and to repay the principal amount at
maturity

Par value/face value/principal value

The face value of a bond, which the borrower repays

at maturity.
Maturity Date

The date when a bonds life ends and the borrower

must make the final interest payment and repay the
principal / par value.
Coupon payments

A fixed amount of interest that a bond promises to

pay investors each period.
Coupon interest rate

The rate derived by dividing the bonds annual

coupon payment by its par value.

Asked price

The price that investors need to pay to buy the bond

Bid price

The price at which an investor who already owns the

bond and wishes to sell it would receive
Yield to maturity

The return to investors if they buy the bond at the

asked price and hold it to maturity.

CASH FLOWS OF A TYPICAL BOND

Coupon & Face Value

Coupon

Year

2015

- Price

2016

Coupon

2017

2018

THE BOND INDENTURE

Contract between the company and the

bondholders that includes

The basic terms of the bonds
The total amount of bonds issued
A description of property used as security, if applicable
Sinking fund provisions:

Sinking fund : an account managed by the bond trustee for early bond
redemption

Call provisions
Details of protective covenants

7-10

BOND CLASSIFICATIONS
Registered vs. Bearer Forms

Security: secured versus unsecured

Collateral secured by financial securities
Mortgage secured by real property, normally land or
buildings
Debentures unsecured
Notes unsecured debt with original maturity less than
10 years
Seniority ranking: a bonds priority of claims to the

issuers assets and cash flows

7-11

BOND CHARACTERISTICS AND REQUIRED RETURNS

The coupon rate depends on the risk characteristics

of the bond when issued

Which bonds will have the higher coupon, all else
equal?
Secured debt versus a debenture
Subordinated debenture versus senior debt
A bond with a sinking fund versus one without
A callable bond versus a non-callable bond

7-12

BOND RATINGS INVESTMENT QUALITY

High Grade

Moodys Aaa and S&P AAA capacity to pay is extremely

strong
Moodys Aa and S&P AA capacity to pay is very strong

Medium Grade

Moodys A and S&P A capacity to pay is strong, but more

susceptible to changes in circumstances
Moodys Baa and S&P BBB capacity to pay is adequate,
adverse conditions will have more impact on the firms ability
to pay

7-13

BOND RATINGS - SPECULATIVE

Low Grade

Moodys Ba and B
S&P BB and B
Considered possible that the capacity to pay will degenerate.

Very Low Grade

Moodys C (and below) and S&P C (and below)

income bonds with no interest being paid, or
in default with principal and interest in arrears

7-14

GOVERNMENT BONDS
Treasury Securities
Federal government debt
T-bills pure discount bonds with original maturity of one
year or less
T-notes coupon debt with original maturity between one
and ten years
T-bonds coupon debt with original maturity greater than

ten years
Municipal Securities
Debt of state and local governments
Varying degrees of default risk, rated similar to corporate
debt
Interest received is tax-exempt at the federal level

7-15

CORPORATE BONDS AND THE RISK OF DEFAULT

16

When investing in bonds, there is always the risk that the issuer may
default.

Default risk: The risk that a bond issuer may default on

his bonds.

Companies compensate investors for bearing this added risk in

the form of higher interest rates on their bonds.

Default premium: The additional yield on a bond that

investors require for bearing default risk.

Usually the difference between the promised yield on a

corporate bond and the yield on a U.S. Treasury bond with the
same coupon and maturity.

17

Bond Price = PV of coupons + PV of face value/principal

Assuming annual interest:

P0 =

C
C
C
F
+
+
.
.
.
+
+
(1+ r )1 (1+ r )2
(1+ r )n (1+ r )n

C
1
F
P0 =
1
+
r
1 r n (1+ r )n

Where:
C: annual coupon payment
n: number of years of bonds life
r: annual interest rate

Example

What is the price of a 5.5 % annual coupon bond, with a $1,000

face value, which matures in 3 years? Assume a required
return of 3.5%p.a.

1
1,000
1 (1 0.035) 3 (1. 0.035) 3

PV $1,056.03
55
PV
0.035

18

19

Example (continued)
What is the price of the bond if the required rate of return
is 5.5%?
55
PV
0.055

1
1,000
1 (1 0.055) 3 (1. 0.055) 3

PV $1,000

Example (continued)
What is the price of the bond if the required rate of return is
15 %?

55
1
1,000
PV
1

3
0.15
(1 0.15) (1. 0.15) 3

PV $783.09

20

What happens to bond values if the required return is not equal to

the coupon rate?
The bond's price will differ from its par value.

R > Coupon Interest

Rate

P0 < par value

DISCOUNT

R< Coupon Interest

Rate

P0 > par value

PREMIUM

R = Coupon Interest
Rate

P0 = par value

PAR VALUE

Bond prices move inversely to yields (interest rates)

6% coupon rate
for both

21

22

Bond prices converge to par value (plus final coupon) with

passage of time
1,080

Price path for Premium

Bond

1,060
1,040

Bond Price

1,020
1,000
980
960
940

Price path for Discount

Bond

920

Maturity

Today

900
880
0

10

15

Time to Maturity

20

25

30

23

Example:

Determine the price of a 5.5 % annual coupon bond, with a $1,000

face value, which matures in 3 years?
What is the price of the bond if the required rate of return is 3.5%
AND the coupons are paid semi-annually?

27.50
27.50
27.50
1,027.50
PV

...

1
2
5
(1.0175)
(1.0175)
(1.0175)
(1.0175) 6
PV $1,056.49

24

Zero coupon bond: is the bond that does not pay interests
during the bonds life.

Bond Price = PV of coupons + PV of principal

Assuming annual interest:
P0 =

0
0
0
F
+
+
.
.
.
+
+
(1+ r )1 (1+ r )2
(1+ r )n (1+ r )n

F
P0 =
(1+ r )n

25

YT
M
P0

YTM is the interest rate for which the present

value of the bonds coupon payments and
principal equal the bond price.

C
C
(C F )

....

(1 YTM )1 (1 YTM ) 2
(1 YTM ) n

YT
M

Economic meaning: YTM is the rate of return

investors earn if they buy at P0 and hold it
until maturity

26

Calculating Yield to Maturity (YTM=r)

If you are given the price of a bond (PV) and the coupon
rate, the yield to maturity can be found by solving for r or
YTM.
Example
What is the YTM of a 5.5 % annual coupon bond, with a
$1,000 face value, which matures in 3 years? The market price
of the bond is $1,056.03.

55
1
1,000
1

YTM
(1 YTM ) 3
(1 YTM ) 3

PV $1,056.03
PV

27

Current
Yield
The amount obtained by dividing the bonds
coupon by its current market price (which
does not always equal its par value).

EXAMPLES
28

1. Staind, Inc., has 7.5 percent coupon bonds on the

market that have 10 years left to maturity. The bonds
make annual payments. If the YTM on these bonds is
8.75 percent, what is the current bond price? Assuming
the par value of Staind, Inc. bonds is $1,000.
Solution:
The price of the bond will be:
1
1
$1,000
10
1.0875
= $75
+
= $918.89
10
0.0875
1.0875

EXAMPLES
29

2. Ashes Divide Corporation has bonds on the market

with 14.5 years to maturity, a YTM of 6.8 percent, and a

current price of $924. The bonds make semiannual
payments. What must the coupon rate be on these

bonds, assuming the par value of Ashes Divide

Corporation bonds is $1,000?

EXAMPLES
30

Ashes Divide Corporation has bonds on the market with 14.5 years to
maturity, a YTM of 6.8 percent, and a current price of $924. The bonds make
semiannual payments. What must the coupon rate be on these bonds,
assuming the par value of Ashes Divide Corporation bonds is $1,000?
Solution:
We have:
1
$1,000
29
1.034
= $924 =
+
0.034
1.03429
Solving for the coupon payment, we get:
C = $29.84
Since this is the semiannual payment, the annual coupon
payment is:
2 $29.84 = $59.68
And the coupon rate is the annual coupon payment divided by
par value, so:
Coupon rate = $59.68 / $1,000 = 0.0597 or 5.97%
1

EXAMPLES
31

A five-year, 4.50% semiannual coupon payment government bond

is priced at 98 per 100 of par value.
a. Calculate the annual yield-to-maturity stated on a semiannual
bond basis, rounded to the nearest basis point.
b. Convert that annual yield to: an annual rate that can be used
for direct comparison with otherwise comparable bonds that
make quarterly coupon payments

EXAMPLES
32

Solution:

33

Bonds Rate of Return: total Income per period per dollar

invested
CouponIncome Pr iceChange
r
Initial Investment

Nominal return
The stated return offered by an investment and have
not adjusted for the effects of inflation.
Real return

Approximately, the difference between an investments

stated or nominal return and the inflation rate.

34

Suppose you purchased 8% coupon, 10-year bonds

for $1,324.4 when they were yielding 4% ( we

assume annual coupon payments). One year later
you receive the annual coupon payment of 80$, but
the YTM has risen to 6%. Confirm that the rate of
return on your bond over the year is less than the
original 4% YTM

35

Price in one year later (using YTM = 6%): P1 = 1136.03

Rate of return over the last year
= [80 + (1136.03- 1,324.4)]/1324.4 = -.082 or -8.2%
Interest rates (YTM) rise Rate of return < YTM
Interest rates (YTM) fall Rate of return > YTM
Interest rates (YTM) remain unchanged during the
period Rate of return = YTM

CLEAN VS. DIRTY PRICES

Clean price (flat price): quoted price
Dirty price (full price): price actually paid = quoted price +

accrued interest
Example: Consider a T-bond with a 4% semiannual yield and

a clean price of $1,282.50, assuming that the coupon dates

are May 15 and Nov.15, the settlement date: July 15.

Number of days since last coupon = 61 = 16 + 30 + 15

Number of days in the coupon period = 184 = 16 + 30 + 31 + 31 + 30 +
31 + 15
Accrued interest = (61/184)(.04*1000) = $13.26
Dirty price = $1,282.50 + $13.26 = $1,295.76

So, you would actually pay $ 1,295.76 for the bond

7-36

37

Interest rate risk: the risk of a decline in bonds value

(bond price) due to an increase in interest rate.

Duration: is used as a measure of a bonds interest rate
risk or sensitivity of a bonds full price to a change in its
yield
Was first introduced by Frederick Macaulay Macaulay
duration
There are also other measures of interest rate risk:
modified duration, effective duration

38

Reinvestment rate risk: the risk of decline in

income from a bond portfolio (e.g. Proceeds from

coupon) due to the decrease in interest rate.

TERM STRUCTURE OF INTEREST RATES

Term structure is the relationship between time to

maturity and yields, all else equal

It is important to recognize that we pull out the effect of
default risk, different coupons, etc.
Yield curve graphical representation of the term
structure

Normal upward-sloping; long-term yields are higher than shortterm yields

Inverted downward-sloping; long-term yields are lower than
short-term yields

7-39

Upward-Sloping Yield Curve

7-40

Downward-Sloping Yield Curve

7-41

FACTORS AFFECTING BOND YIELDS

Default risk premium bond ratings

Taxability premium municipal versus taxable

Liquidity premium bonds that have more

frequent trading will generally have lower

required returns
Anything else that affects the risk of the cash
flows to the bondholders will affect the required
returns

7-42

THANK YOU
43

Exercises:
Chapter 7 (pp. 226-230) : 3,7,8,10, 18,19, 20,
22