Tài chính doanh nghiệp - Chapter 6: Interest rates and bond valuation

Interest Rates and Bond ValuationChapter 60Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerKey Concepts and SkillsKnow the important bond features and bond typesUnderstand bond values and why they fluctuateUnderstand bond ratings and what they meanUnderstand the impact of inflation on interest ratesUnderstand the term structure of interest rates and the determinants of bond yields1Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerChapter OutlineBonds and Bond ValuationMore on Bond FeaturesBond RatingsSome Different Types of BondsBond MarketsInflation and Interest RatesDeterminants of Bond Yields2Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerBond DefinitionsBondPar value (face value)Coupon rateCoupon paymentMaturity dateYield or Yield to maturity3Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerPV of Cash Flows as Rates ChangeBond Value = PV of coupons + PV of par valueBond Value = PV annuity + PV of lump sumRemember, as interest rates increase the PVs decreaseSo, as interest rates increase, bond prices decrease and vice versa4Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerValuing a Discount Bond with Annual CouponsConsider a bond with a coupon rate of 10% and coupons paid annually. The par value is $1000 and the bond has 5 years to maturity. The yield to maturity is 11%. What is the value of the bond?Using the formula:B = PV of annuity + PV of lump sumB = 100[1 – 1/(1.11)5] / .11 + 1000 / (1.11)5B = 369.59 + 593.45 = $963.04Using the calculator:N = 5; I/Y = 11; PMT = 100; FV = 1000CPT PV = -963.045Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerValuing a Premium Bond with Annual CouponsSuppose you are looking at a bond that has a 10% annual coupon and a face value of $1000. There are 20 years to maturity and the yield to maturity is 8%. What is the price of this bond?Using the formula:B = PV of annuity + PV of lump sumB = 100[1 – 1/(1.08)20] / .08 + 1000 / (1.08)20B = 981.81 + 214.55 = $1196.36Using the calculator:N = 20; I/Y = 8; PMT = 100; FV = 1000CPT PV = -1196.366Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerGraphical Relationship Between Price and YTM7Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerBond Prices: Relationship Between Coupon and YieldIf YTM = coupon rate, then par value = bond priceIf YTM > coupon rate, then par value > bond priceWhy?Selling at a discount, called a discount bondIf YTM < coupon rate, then par value < bond priceWhy?Selling at a premium, called a premium bond8Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerThe Bond-Pricing Equation9Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerExample 6.1Find present values based on the payment periodHow many coupon payments are there?What is the semiannual coupon payment?What is the semiannual yield?B = 70[1 – 1/(1.08)14] / .08 + 1000 / (1.08)14 = $917.56Or PMT = 70; N = 14; I/Y = 8; FV = 1000; CPT PV = -917.5610Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerInterest Rate RiskPrice RiskChange in price due to changes in interest ratesLong-term bonds have more price risk than short-term bondsReinvestment Rate RiskUncertainty concerning rates at which cash flows can be reinvestedShort-term bonds have more reinvestment rate risk than long-term bonds11Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerFigure 6.212Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerComputing YTMYield-to-maturity is the rate implied by the current bond priceFinding the YTM requires trial and error if you do not have a financial calculator, and is similar to the process for finding r with an annuityIf you have a financial calculator, enter N, PV, PMT and FV, remembering the sign convention (PMT and FV need to have the same sign, PV the opposite sign)13Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerYTM with Annual CouponsConsider a bond with a 10% annual coupon rate, 15 years to maturity and a par value of $1000. The current price is $928.09Will the yield be more or less than 10%?N = 15; PV = -928.09; FV = 1000; PMT = 100CPT I/Y = 11%14Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerYTM with Semiannual CouponsSuppose a bond with a 10% coupon rate and semiannual coupons, has a face value of $1000, 20 years to maturity and is selling for $1197.93Is the YTM more or less than 10%?What is the semiannual coupon payment?How many periods are there?N = 40; PV = -1197.93; PMT = 50; FV = 1000; CPT I/Y = 4% (Is this the YTM?)YTM = 4%*2 = 8%15Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerTable 6.116Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerSpreadsheet StrategiesThere is a specific formula for finding bond prices on a spreadsheetPRICE(Settlement,Maturity,Rate,Yld,Redemption,Frequency,Basis)YIELD(Settlement,Maturity,Rate,Pr,Redemption, Frequency,Basis)Settlement and maturity need to be actual datesThe redemption and Pr need to given as % of par valueDouble-click on the Excel icon for an example17Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerDifferences between Debt and EquityDebtNot an ownership interestCreditors do not have voting rightsInterest is considered a cost of doing business and is tax deductibleCreditors have legal recourse if interest or principal payments are missedExcess debt can lead to financial distress and bankruptcyEquityOwnership interestOrdinary shareholders vote for the board of directors and other issuesDividends are not considered a cost of doing business and are not tax deductibleDividends are not a liability of the firm and shareholders have no legal recourse if dividends are not paidAn all equity firm can not go bankrupt18Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerThe Bond Trust DeedContract between the company and the bondholders and includes:The basic terms of the bondsThe total amount of bonds issuedA description of property used as security, if applicableSinking fund provisionsCall provisionsDetails of protective covenants19Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerBond ClassificationsRegistered vs. Bearer FormsSecurityCollateral – secured by financial securitiesMortgage – secured by real property, normally land or buildingsNotes – unsecured debt usually with original maturity less than 10 yearsSeniority20Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerBond Characteristics and Required ReturnsThe coupon rate depends on the risk characteristics of the bond when issuedWhich bonds will have the higher coupon, all else equal?Secured debt versus a noteSubordinated note versus senior debtA bond with a sinking fund versus one withoutA callable bond versus a non-callable bond21Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerBond Ratings – Investment QualityHigh GradeMoody’s Aaa and S&P AAA – capacity to pay is extremely strongMoody’s Aa and S&P AA – capacity to pay is very strongMedium GradeMoody’s A and S&P A – capacity to pay is strong, but more susceptible to changes in circumstancesMoody’s Baa and S&P BBB – capacity to pay is adequate, adverse conditions will have more impact on the firm’s ability to pay22Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerBond Ratings – SpeculativeLow GradeMoody’s Ba, B, Caa and CaS&P BB, B, CCC, CCConsidered speculative with respect to capacity to pay. The “B” ratings are the lowest degree of speculationVery Low GradeMoody’s C and S&P C – income bonds with no interest being paidMoody’s D and S&P D – in default with principal and interest in arrears23Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerDebt securitiesTreasury SecuritiesGovernment bonds (debt)Bank bills – pure discount debt with original maturity of one year or lessState Government SecuritiesDebt of state and local governmentsVarying degrees of default risk, rated similar to corporate debt24Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerZero Coupon BondsMake no periodic interest payments (coupon rate = 0%)The entire yield-to-maturity comes from the difference between the purchase price and the face valueCannot sell for more than face valueSometimes called zeroes, or deep discount bondsBank Bills are good examples of zeroes25Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerFloating Rate BondsCoupon rate floats depending on some index valueExamples – adjustable rate mortgages and inflation-linked bondsThere is less price risk with floating rate bondsThe coupon floats, so it is less likely to differ substantially from the yield-to-maturityCoupons may have a “collar” – the rate cannot go above a specified “ceiling” or below a specified “floor”26Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerOther Bond TypesDisaster bondsIncome bondsConvertible bondsPut bondThere are many other types of provisions that can be added to a bond and many bonds have several provisions – it is important to recognise how these provisions affect required returns27Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerBond MarketsPrimarily over-the-counter transactions with dealers connected electronicallyExtremely large number of bond issues, but generally low daily volume in single issuesMakes getting up-to-date prices difficult, particularly on small company bondsGovernment bonds are an exception28Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerWork the Web ExampleBond quotes are available onlineOne good site is Bloomberg.comGo to Bloomberg’s web site Follow the bond searchSearch a bond issue and see what you can find!29Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerInflation and Interest RatesReal rate of interest – change in purchasing powerNominal rate of interest – quoted rate of interest, change in purchasing power and inflationThe ex ante nominal rate of interest includes our desired real rate of return plus an adjustment for expected inflation30Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerThe Fisher EffectThe Fisher Effect defines the relationship between real rates, nominal rates and inflation(1 + R) = (1 + r)(1 + h), whereR = nominal rater = real rateh = expected inflation rateApproximationR = r + h31Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerExample 6.6If we require a 10% real return and we expect inflation to be 8%, what is the nominal rate?R = (1.1)(1.08) – 1 = .188 = 18.8%Approximation: R = 10% + 8% = 18%Because the real return and expected inflation are relatively high, there is significant difference between the actual Fisher Effect and the approximation32Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerTerm Structure of Interest RatesTerm structure is the relationship between time to maturity and yields, all else equalIt is important to recognise that we pull out the effect of default risk, different coupons, etcYield curve – graphical representation of the term structureNormal – upward-sloping, long-term yields are higher than short-term yieldsInverted – downward-sloping, long-term yields are lower than short-term yields33Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerFigure 6.6 – Upward-Sloping Yield Curve34Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerFigure 6.6 – Downward-Sloping Yield Curve35Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerExample of Yield Curve36Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerFactors Affecting Required ReturnDefault risk premium – remember bond ratingsLiquidity premium – bonds that have more frequent trading will generally have lower required returnsAnything else that affects the risk of the cash flows to the bondholders, will affect the required returns37Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerQuick QuizHow do you find the value of a bond and why do bond prices change?What is a bond trust deed and what are some of the important features?What are bond ratings and why are they important?How does inflation affect interest rates?What is the term structure of interest rates?What factors determine the required return on bonds? 38Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan Trayler