Transcript of Bond Analysis and Valuation

Bond Analysis and Valuation

- an investment firm likes to inform their clients about bonds

- Jill, having an MBA is going to explain it to them

Situation
How should Jill go about explaining the relationship between coupon rates and bond price?

During the presentation on of the clients is puzzled why some bonds sell for less than their face value while others sell a premium. She asks whether the discount bonds are a bargain. How should Jill respond?
What is the difference between the nominal and effective yields to maturity for each bond listed in Table 1? Which one should the investor use when deciding between corporate bonds and other securities of similar risk? Please explain.
- coupon rates over than market rates
then bond price will more than face value

- coupon rates less then market rates

the bond price will under the face value

Why do the coupon rates for the

various bonds very so much?
- depend on rating and the rules high risk high return

How are the ratings of these bonds determined? What happens when the bond ratings get adjusted downward?
Issuer

coupon rates

call period

coupon rate less than market rate

the coupon rate over than market rate.

What does the term yield to maturity mean and how it to be calculated ?
ABC Energy: 2.384%
ABC Energy: 8.160%
TransPower: 0.515%
Telco Utilities: 0.061%

The nominal yield to maturity on the bonds is calculated by multiplying the semi-annual yield by 2. The effective YTM is calculated by compounding the semi-annual yield for two periods.
Since it's only an estimation the nominal rate would be
good enough
How should Jill go about explaining the riskiness of each bond? Rank order the bonds in terms of their relative riskiness.
- ABC 5% -> AAA 5% > 0% => lower volatility
- ABC 0% -> AAA > AA
- TransPower -> 20 < 30 & Sinking Fund
- Telco Utilities -> long maturity,
no sinking fund
call period

One of Jills best clients poses the following question, If I buy 10 of each of these bonds, reinvest any coupons received at the rate of 5% per year and hold them until they mature, what will my realized return be on each bond investment? How should she
proceed?
Future Value of Reinvested Coupons:
PMT = -$25 (semiannual);
n = 40;
i = 2.5%; (reinvestment rate);
PV = 0;
CPT FV = $1,685.06
Realized Return = [{(1685.06+1000)/703.1}]1/40 1 = 3.41%*2= 6.82%
ABC 5% -> 6.82%

ABC 0% -> 8.00%

TransPower -> 7.06%

Telco Utilities -> 6.61%

2. How are the ratings of these bonds determined? What happens when the bondratings
get adjusted downwards?
The ratings are determined by professional rating agencies such as Standard &
Poors andMoodys. Each of these rating agencies has a committee that evaluates
the risk level of acompanys bond issue and accordingly assigns a rating ranging
from AAA or Aaa (bestrating) down to D (default). The ratings are periodically re-
evaluated whenever there isany significant development in a companys capital
structure or earnings performance.When ratings get adjusted downward, the bond
becomes less attractive and therefore itsrequired rate of return goes up, reducing its
price.
3. During the presentation one of the clients is puzzled why some bonds sell for lessthan
their face value while others sell for a premium. She asks whether the discountbonds are
a bargain? How should Jill respond?
Jill should explain that bonds can be issued at a discount, at par, or even at a
premiumfrom face value, depending on the firms preference for the coupon rate
that will be paid.The vast majority of bonds are sold at par ($1000) with the
coupon rate being set equal tothe yield that is commensurate with its rating and
maturity. After being issued, however,the yields demanded by investors will
change based on economic and company-specificfactors, but the coupon rate
is fixed. Thus, the price has to vary in line with theconsensus yield demanded
by investors. If the yield exceeds the coupon rate, investorsare demanding a higher
rate of return than what the company is currently paying via thecoupon payment,
leading to a drop in price and vice-versa. Thus, as long as the yields area true
reflection of the risk level of the bond (which would happen in efficient
markets), bond prices, whether at a discount or a premium from face value, would
be just rightand not really a bargain or overpriced.
4. What does the term yield to maturity mean and how is it to be calculated?
The yield to maturity (YTM) of a bond is the rate of return that an investor
expects toearn when he or she buys the bond at its current price, reinvests the
coupons, and receivesthe face value when it matures. The YTM of a bond is also
known as its promised yield.To calculate a bonds YTM we must use the following
inputs:For example: ABC Energy, 5%, 20 year, Face Value = $1000, Price
= $703.1 (semi-annual coupons)
PV = -$703.1; FV = $1000; N = 40; PMT = $25; CPT I = 8.03%
2
Issuer Face Value Coupon Rate RatingQuotedPrice Years
untilmaturitySinkingFund Yield tomaturity
ABC Energy $1,000 5% AAA $703.10 20 Yes 8.0310% ABC
Energy $1,000 0% AAA $208.30 20 Yes 8.1597%TransPower $1,000 10% AA $1,092.0
0 20 Yes 8.9927%Telco Utilities $1,000 11% AA $1,206.40 30 No 8.9923%
5. What is the difference between the nominal and effective yields to maturity foreach
bond listed in Table 1? Which one should the investor use when decidingbetween
corporate bonds and other securities of similar risk? Please explain.
Issuer Face Value Coupon Rate RatingQuoted Price Years
untilmaturitySinkingFundCallPeriodNominal Yield
tomaturityEffective YTM
ABCEnergy $1,000 5% AAA $703.10 20 Yes 3 Years 8.0001% 8.1601% ABCEnergy $
1,000 0% AAA $208.30 20 Yes NA 7.9997% 8.1597%TransPower $1,000 10% AA $1,0
92.00 20 Yes 5 Years 9.0001% 9.2026%TelcoUtilities $1,000 11% AA $1,206.40 30 No
5 Years 8.9998% 9.2023%
The nominal yield to maturity on the bonds is calculated by multiplying the semi-
annualyield by 2. The effective YTM is calculated by compounding the semi-
annual yield for two periods. For exampleOn the ABC Energy 5%, 20 year
bond, the semi-annual YTM is 4.00%. The
effectiveannual YTM would be calculated as ((1+.04)
2
)-1 = .0816 or 8.16%. Since the YTM ismerely a promised yield with the actual
yield being dependent on the reinvestment ratethat each investor is able to earn, it
is best to compare similar risk bonds on the basis of their nominal YTMs.
6. Jill knows that the call period and its implications will be of particular concern tothe
audience. How should she go about explaining the effects of the call provisionon bond
risk and return potential.
Jill should explain to the audience that call provisions are attached to bonds so as
to allowcompanies to refinance their debt at lower rates when interest
rates drop. Thus, theexistence of a call provision presents a risk to the bond
investor that their investmenthorizon on that bond may be prematurely
ended. Moreover, there is reinvestment risk associated with callable bonds, since
the bonds are called when rates are low. Thecompany does pay a premium
(typically equal to one extra coupon) when the bond iscalled. Furthermore, there
is generally a deferred call period of about 5 years, duringwhich the bond cannot
be called. In the case of callable bonds, investors should calculatethe yield to first
call of the bonds and decide accordingly. For this calculation, the future3
value is set equal to $1000 + 1 years coupon, and the maturity is assumed to be
thenumber of years until the bond becomes freely callable.
7. How should Jill go about explaining the riskiness of each bond? Rank order thebonds
in terms of their relative riskiness.
Issuer FaceValueCouponRate RatingQuotedPrice Years
untilmaturitySinkingFundCallPeriodNominal Yield tomaturityEffective YTMRisk
Rank(1=low)
ABC Energy 1000 5% AAA 703.1 20 Yes 3 Years 8.0001% 8.1601% 1 ABC
Energy 1000 0% AAA 208.3 20 Yes NA 7.9997% 8.1597% 2TransPower 1000 10% AA
1092
20 Yes 5 Years 9.0001% 9.2026% 3Telco Utilities 1000 11% AA 1206.4 30 No 5 Years
8.9998% 9.2023% 4
The bond ratings provide a general guide as to the credit risk associated with each
bond.Within each rating though, investors need to be aware of call risk,
reinvestment risk,maturity risk, and the sinking fund provisions effect
on risk. Callability makes a bondhave higher reinvestment risk. Among the AAA
bonds, the zero coupon bond has no callrisk, no reinvestment risk, but the
highest price risk. Among the AA bonds, TelcoUtilities bond has a longer
maturity and no sinking fund making it the riskiest of the lot.
8. One of Jills best clients poses the following question, If I buy 10 of each of thesebonds
, reinvest any coupons received at the rate of 5% per year and hold them untilthey
mature, what will my realized return be on each bond investment? Howshould she
proceed?
Realized Return = [{Future Value of reinvested coupons + Face Value}/Price of Bond ]
1/n
-1
Issuer Face ValueCouponRateQuotedPrice Years
untilmaturityCallPeriodNominal Yield tomaturityFV of CouponFV of Coupon+Face
VaueRealizedReturn
ABC Energy 1000 5% 703.1 20 3 Years 8.0001% $1,685.06 $2,685.06 6.82% ABC
Energy 1000 0% 208.3 20 NA 7.9997% $0.00 $1,000.00 8.00%TransPower 1000 10%
1092 20 5 Years 9.0001% $3,370.13 $4,370.13 7.06%Telco Utilities 1000 11% 1206.4
30 5 Years 8.9998% $7,479.54 $8,479.54 6.61%
In the case of the ABC Energy, 5% coupon bond the realized return is calculated as
follows:Future Value of Reinvested Coupons: PMT = -$25 (semiannual); n = 40;
i/y = 2.5%;(reinvestment rate); PV = 0; CPT FV = $1,685.06Realized Return =
[{(1685.06+1000)/703.1}]
1/40
1 = 3.41%*2= 6.82%
Note: The number of bonds purchased does not affect the realized return