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8/3/2019 Ch06 Ppt Brighamfm1ce
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PowerPoint Presentationprepared by
Traven ReedCanadore College
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chapter6Bonds, Bond Valuation,
and Interest Rates
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Copyright 2011 by Nelson Education Ltd. All rights reserved. 6-3
Corporate Valuation and Risk
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Topics in Chapter
Key features of bonds
Bond valuation
Measuring yield
Determining interest rate
Term structure
Assessing risk
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Bond Issuers
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 haveno default risk, they are not riskless.
Depending on th
e business,c
orporate bondsare exposed to default risk.
Foreign bonds have additional exchange raterisk. With C$ denominations, Maple bonds areappealing.
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Key Features of a Bond
Par value: Face amount; paid atmaturity. Assume $1,000.
Coupon interest rate: Statedinterest rate. Multiply by par value
to get dollars of interest. Generallyfixed, but can vary.
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Maturity: Years until bond must berepaid. Declines.
Issue date: Date when bond wasissued.
Default risk: Risk that issuer willnot make interest or principalpayments.
Key Features of a Bond (contd)
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Call Provision
Issuercan refund if interest ratesdecline. That helps the issuer but hurts
the investor. Therefore, borrowers are willing to pay
more, and lenders require more, oncallable bonds.
Most bonds have a deferred call and adeclining call premium. The Canadacall feature restricts the call price to acertain level.
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Retractable Bonds
Investors have the right to sell thebonds back before maturity to the
issuing company at a pre-set price.
Protect investors from the risinginterest rates or the event risk.
Copyright 2011 by Nelson Education Ltd. All rights reserved. 6-9
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Whats a sinking fund?
Provision to pay off a loan over itslife rather than all at maturity.
Similar to amortization on a termloan.
Reduces risk to investor, shortens
average maturity.
But not good for investors if ratesdecline after issuance.
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Sinking funds are generallyhandled in 2 ways
1. Call x% at par per year forsinking fund purposes.
2. Buy bonds on open market. Company would call if the going
market rate of interest (rd) is below
thecoupon rate and bond sells at apremium. Use open market
purchase if rd is above coupon rateand bond sells at a discount.
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Other Bond Features
Convertible bonds: convert intoshares ofcommon stock, at a fixed
price, at the bondholders discretion
Income bonds: pay interest onlywhen the issuercan afford.
Real return bonds: principal andinterests are indexed and protectedagainst inflation.
Copyright 2011 by Nelson Education Ltd. All rights reserved. 6-12
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PV =
INT
1+ rd
... +(INT+M)
1+rd1 2
1
INT
rdn
0 1 2 n
Rd%
INT INT +MINTValue
...
+ ++
Bond Valuation
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Copyright 2011 by Nelson Education Ltd. All rights reserved. 6-15
15 10 100 1000N I/YR PV PMT FV
-1,000
$ 760.61
239.39$1,000.00
PV annuity
PV maturity valueValue of bond
=
==
INPUTS
OUTPUT
The bond consists of a 15-year, 10% annuityof $100/year plus a $1,000 lump sum at t = 15:
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Zero-coupon Bond Prices
With no intern interest payments,the price of a zero is the present
value of the principal payment atmaturity.
Copyright 2011 by Nelson Education Ltd. All rights reserved. 6-16
N
d
zero
r
M
V)1(
!
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When rd rises, above the couponrate, the bonds value falls belowpar, so it sells at a discount.
15 15 100 1000
N I/YR PV PMT FV-707.63
INPUTS
OUTPUT
What would happen if going marketrate of interest r
d
= 15%?
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What would happen if rddeclined to 5%?
If coupon rate > rd, price risesabove par, and bond sells at apremium.
15 5 100 1000
N I/YR PV PMT FV-1,518.98
INPUTS
OUTPUT
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Whats yield-to-maturity?
YTM is the expected rate of total returnearned 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 andcannot be called.
YTM changes whenever market interestrates change.
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YTM on a 14-year, 10% annual coupon,$1,000 par value bond selling for $1,494.93
100 100100
0 1 13 14rd=?
1,000PV1..
.PV10PVM
1,494.93 Find rd that works!
...
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VINT
r
M
r
B
d
N
d
N!
1 1
1... +
INT
1+ rd
1494.93 100
1
1,000
11 14 14!
r rd d+
100
1+ rd
++
++
++++
Solving for the unknown rd is tedious.Need a financial calculator.
...
Find rd
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Callable Bonds and Yield to Call
A 10-year, 10% annual coupon,$1,000 par value bond is selling for
$1,494.93 with an 5% yield-to-maturity.It can be called after 1 year at
$1,100
N
d
N
tt
d
CALLr
callprice
r
INTV
)1()1(1
!!
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9 -1494.93 100 1100N I/YR PV PMT FV
4.21=YTC
INPUTS
OUTPUT
Yield to Call (YTC)
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If you bought bonds, would you bemore likely to earn YTM or YTC?
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 payonly $42.1/year.
Investors should expect a call,hence YTC = 4.21%, not YTM = 5%
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Current yield
Current yield =
= 0.0669 = 6.69%
$100$1,494.93
10% coupon, 14-year bond, P =$1,494.93, and YTM = 5.0%
Current yield =Annual coupon pmt
Current price
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Cap gains yield = YTM - Current yield
= 5.00% - 6.69%= - 1.69%
Capital gains yield
Cap gains yield= Change in price/beginning price= -25.25/1494.93 = - 1.69%
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M
1,495
1,000
714
0 1 2 3 14 15
Premium bond
Discount bond
rd = 10% (par bond)
Changes in Bond Values ($)Over Time
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At maturity, the value of any bondmust equal its par value.
The value of a premium bond woulddecrease to $1,000
The value of a discount bond would
inc
rease to $1,000 A par bond stays at $1,000 if rdremains constant.
Changes in Bond Values ($)Over Time (contd)
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Ifcoupon rate < rd, bond sells at adiscount.
Ifcoupon rate = rd, bond sells at itspar value.
Ifcoupon rate > rd, bond sells at a
premium. If r d rises, price falls.
Price = par at maturity.
Changes in Bond Values ($)Over Time (contd)
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Semiannual Bonds
1. Multiply years by 2 to get periods = 2n.
2. Divide nominal rate by 2 to get periodicrate = rd/2.
3. Divide annual INT by 2 to get PMT =INT/2.
2n rd/2 OK INT/2 OK
N I/YR PV PMT FV
INPUTS
OUTPUT
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2(15) 5/2 100/230 2.5 50 1000N I/YR PV PMT FV
-1523.26
INPUTS
OUTPUT
Value of 15-year, 10% coupon,semiannual bond if r
d
= 5%
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Market Interest Rate
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.
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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-termgovernment of Canada T-bills in aninflation-free world
R* is not static, changing over time
Copyright 2011 by Nelson Education Ltd. All rights reserved. 6-35
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Inflation Premium (IP)
Inflation erodes the purchasingpower of money.
The IP for a particular lengthmaturity can be approximated asthe difference between the yield on
a non-indexed security of t
hatmaturity minus the yield on a
default-free government bond ofthat maturity.
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What is the nominal risk-free rate?
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-termgovernment bonds.
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Default Risk Premium (DRP)
Investors want to be compensated forthe chance that interest or principal
will not be paid on the due date and inthe promised amount
The greater the default risk, the higher
th
e bonds DRP While Canada bonds is default free,default risk can be substantial forcorporate bonds
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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
Copyright 2011 by Nelson Education Ltd. All rights reserved. 6-39
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Bond Ratings ProvideOne Measure of Default Risk
Investment Grade Junk Bonds
Moodys Aaa Aa A Baa Ba B Caa C
S&P AAA AA A BBB BB B CCC D
DBRS AAA AA A BBB BB B CCC D
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What factors affect defaultrisk and bond ratings?
Financial performance Debt ratio
Coverage ratios, such as interest coverage ratioor EBITDA coverage ratio
Current ratios
Other factors
Earnings stability Regulatory environment
Potential product liability
Accounting policies
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Bond Ratings and BondSpreads (Canadian Fixed Income, 2008)
Long-term Bonds (5 yr) Example Yield Spread
Government of Canada(Reference)
3.01%
AAA-rated Can. Savings Bond 3.01% --
AA-rated BOM 4.68% 1.67%
A-rated Telus Corp 4.88% 1.87%
BBB-rated Loblaws 5.61% 2.60%
BB-rated Sherritt International 7.47% 4.46%
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Liquidity Premium (LP)
A liquid asset can be convertedinto cash quickly and at a fair
market price. Liquidity is also known as
marketability
Financial assets are generally moreliquid than real assets
Often difficult to accurately measure
Copyright 2011 by Nelson Education Ltd. All rights reserved. 6-43
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Bond Spreads, the DRP, andthe LP
A bond spread is often calculated asthe difference between a corporate
bonds yield and a Government ofCanada bonds yield of the samematurity. Therefore:
Spread = DRP + LP.
Bonds of large, strong companies oftenhave very small LPs. Bonds of smallcompanies often have LPs as high as2%.
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Maturity Risk Premium
(MRP) All bonds, including Government of
Canada bonds, are exposed to two
extra risks: interest rate (price) riskand reinvestment risk.
MRP is the net effect of these two
sources of risk on a bonds yield
Copyright 2011 by Nelson Education Ltd. All rights reserved. 6-45
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Interest rate (or price) risk for 1-year and 10-year 10% bonds
rd 1-year Change 10-yearChange
5% $1,048 $1,386
10% 1,000 4.8% 1,000 38.6%
15% 956 4.4% 749 25.1%
Interest rate risk: Rising rd causes
bonds price to fall.
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0
500
1,000
1,500
0% 5% 10% 15%
1-year
10-year
rd
Value
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What is reinvestment rate risk?
The risk that CFs will have to bereinvested 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 of10%.
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Year 1 income = $50,000. At year-end get back $500,000 to reinvest.
If rates fall to 3%, income will dropfrom $50,000 to $15,000. Had you
bought 30-year bonds, incomewould have remained constant.
What is reinvestment raterisk? (contd)
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Remarks of MRP
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, sothe MRP is more affected by interest raterisk than by reinvestment rate risk.
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Term Structureand Yield Curve
Term structure of interest rates: therelationship between interest rates
(or yields) and maturities. A graph of the term structure iscalled the yield curve.
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Hypothetical Govt of CanadaYield Curve
0%
2%
4%
6%
8%10%
12%
14%
1 3 5 7 911 13 15 17 19
Years to Maturity
Interest
Ra
te
MRP
IP
r*
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Relationship Between Govt ofCanada Yields and Corporate Yields
Corporate yield curves are higherthan that of the Govt of Canada
bond. However, corporate yieldcurves are not necessarily parallelto the Govt of Canada curve.
Th
e spread between ac
orporateyield curve and the Govt of Canadacurve widens as the corporate bondrating decreases.
H h i l G f C d
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Hypothetical Govt of Canadaand Corporate Yield Curves
6.0%5.9%5.2%
0.0%
2.0%
4.0%
6.0%
8.0%
10.0%
12.0%
1 10 20
Years to Maturity
Interest
R
ate
BB Bond
AAA Bond
Gov't of Canada
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Junk Bonds
Belong to the non-investmentgrades (with a BB or lower in the
S&P and DBRS rating or a Ba orworse in the Moodys)
Also called as high-yield or low-
grade bonds Junk bonds are risky because their
default rates are high
Copyright 2011 by Nelson Education Ltd. All rights reserved. 6-55
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Bankruptcy
Two main chapters of FederalBankruptcy Act:
Bankruptcy and Insolvency,bankruptcy
Companies Creditors Arrangement,reorganization
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Ifcompany cant meet its obligations, itfiles under CRA. That stops creditors
from foreclosing, taking assets, andshutting down the business.
Company has 120 days to file areorganization plan.
Court appoints a trustee to supervisereorganization.
Management usually stays in control.
Bankruptcy (contd)
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Company must demonstrate in itsreorganization plan that it is worth
more alive than dead. Otherwise, judge will order
liquidation under the Bankruptcy
and Insolvency Act.
Bankruptcy (contd)
If th i li id t d
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If the company is liquidated,heres the payment priority:
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 underWorkers Compensation
Other unsecured creditors Preferred stock Common stock
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In a liquidation, unsecured creditorsgenerally get zero. This makes themmore willing to participate inreorganization even though theirclaimsare greatly scaled back.
Various groups ofcreditors vote on thereorganization plan. If both the majority
of the creditors and the judge approve,company emerges from bankruptcywith lower debts, reduced interestcharges, and a chance for success.
If the company is liquidated, heresthe payment priority: (contd)