MOD004491 Corporate FinanceDebt Valuation Bonds

MOD004491 Corporate Finance

Debt Valuation Bonds

Anglia Ruskin University

Dr Handy Tan
handy.tan@anglia.ac.uk

27 March 2017

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MOD004491 Corporate FinanceDebt Valuation Bonds

Highlights

1 Understand bond cash flows, prices and yields.

2 Illustrate the idea of zero-coupon bonds.
3 Illustrate the idea of coupon bonds.
4 Illustrate the idea of generic bonds.
5 Understand the effect of time on bond prices.
6 Understand the effect of interest rates on bond prices.
7 Understand bond replication between zero coupon bonds and coupon bonds.
8 Observe cases of corporate bonds and sovereign bonds.
Reading: BKM chapter 9

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The law of one price

The law of one price states that identical goods should sell for the same price in two
separate markets when there are no transaction costs and no differential taxes applied
in the two markets.
This law is commonly associated with the purchasing power parity (PPP).
As we will see today why the law of one price is very important in bond valuation.

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Bond cash flows, prices and yields

Whether we are talking about corporate, government or sovereign bonds, typically

bonds come with their own contracts, the so-called bond indentures.
In the bond indentures, the specifications (terms) about the bonds are usually stated.
The specifications refer to the bonds maturity date, face value and coupon rate terms.
The maturity date refers to the final repayment date in which the bond holder returns
the bond to the issuer.
The coupons are interest payments of a bond that are paid periodically (e.g. annu-
ally, semi-annually, etc.) until the bond matures (NB: Coupons to bonds are akin to
dividends to stocks).
The face value of the bond is the notional amount we use to compute the interest
payments. Usually, it is repaid at maturity and may consist of increments, e.g. 1,000.
A bond with 1,000 face value is often referred to as a 1,000 bond.

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Coupons

The coupon rate is set by the bond issuer and stated on the bond indenture. By
convention, the coupon rate is expressed as an APR, so that the coupon is given by:
CR F
C= (1)
number of coupon payments per year

where CR is the coupon rate, F is the face value.

For example, a 1,000 bond with a 10% coupon rate and semi-annual payments will
pay 50 every six months.

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Zero-Coupon Bonds (ZCBs)

The simplest type of bond is a zero-coupon bond, which does not make coupon pay-
ments. The only cash payment the investor receives is the face value of the bond on
the maturity date.
Treasury bills with maturity up to one year are zero-coupon bonds.
For example, a one-year, risk-free, zero-coupon bond with a 100,000 face value has
an initial price of 96,618.36.
If you bought this bond today, in one years time, the value of the bond will be
100,000.

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Yield to maturity (YTM)

What is YTM?
Recall that the IRR of an investment opportunity is the discount rate at which the
NPV of the cash flows of the investment opportunity is equal to zero.
So, the IRR of an investment in a zero-coupon bond is the rate of return that investors
will earn on their money if they buy the bond at its current price and hold it until
maturity.
The IRR of an investment in a bond is given a special name, the yield to maturity
(YTM) or just the yield:
The yield of maturity of a bond is the discount rate that sets the present value of the
promised bond payments equal to the current market price of the bond.

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YTM one period example

Using previous example, the YTM for one period is simply given by:
100, 000
96, 618.36 =
1 + YTM
YTM = 3.5%

Because the bond is risk free, investing in this bond and holding it to maturity is like
earning 3.5% interest on your initial investment. Thus, by the Law of One Price, the
competitive market risk-free interest rate is 3.5%, meaning that all one-year risk-free
investments must earn 3.5%, otherwise there will be arbitrage opportunities.

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Generalising the one-period to n-period

We can then write the above expression as:

FV
P=
(1 + YTMn )n
!1/n
FV
YTMn = 1
P

so the yield to maturity here is the per-period rate of return for holding the bond from
today until maturity on date n.
Note how similar the above equation is to the capital gains portion of the holding
P1
period return, i.e. CG = 1. This is because both are measures of investment
P0
returns without their interests (i.e. coupons and/or dividends).

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Coupon bonds

Like zero coupon bonds, coupon bonds pay investors their face value at maturity. In
addition, these bonds make regular coupon interest payments.
Gilts are examples of coupon bonds that pay coupons until perpetuity.
In general, if the time period is fixed, then the price of the bond is given as:
T
X C
P= (2)
(1 + r )t
t=1

One might need to adjust (2) for higher compounding frequencies by changing T
nT , r r /n and t nt where n is the compounding frequency.
If the coupon bonds are perpetual, then it is simply given by:
C
P= (3)
r
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General bond pricing

In the general case, bonds have finite terms and come with both the face value and
the coupons.
The general formula for this type of bond is given as:
T
XC F
P= t
+ (4)
(1 + r ) (1 + r )T
t=1
" #
C 1 F
P= 1 T
+ (5)
r (1 + r ) (1 + r )T

Again, as before, T , t and r will need to be adjusted of the compounding frequency

(n) increases.

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Dynamic behaviour of bond prices

Bonds traded in the market may sell at a discount, par or premium.

If a bond trades at a discount, an investor who buys the bond will earn a return both
from receiving the coupons and from receiving a face value that exceeds the price paid
for the bond. In this case, its yield to maturity will exceed its coupon rate.
If a bond trades at a premium, the investors return from the coupons is diminished
by receiving a face value less than the price paid for the bond. Thus, a bond trades at
a premium whenever its yield to maturity is less than its coupon rate.
When a bond trades at a price equal to its face value, it is said to trade at par. A
bond trades at par when its coupon rate is equal to its yield to maturity.

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Time and bond prices

Suppose that you purchase a 30-year zero-coupon bond with a yield to maturity of
100
5%. For a face value of 100, the bond will initially trade for = 23.14.
1.0530
Five years later, with 25 years remaining and assuming that the YTM is still at 5%,
100
the bond price in five years will be: = 29.53.
1.0525
Note that the bond price is higher, and hence the discount from its face value is smaller,
when there is less time to maturity. The discount shrinks because the yield has not
changed, but there is less time until the face value will be received.
If you purchased the bond for 23.14 and sell it 5 years later, the IRR of your investment
!1/5
29.53
will be 1 = 5.0%. That is, your return is the same as the YTM of the
23.14
bond.
If a bonds yield to maturity has not changed, then the IRR of an investment in the
bond equals to its yield to maturity even if you sell the bond early.
We will do some examples in the seminar with more general cases for coupon bonds.
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Time and bond prices

If the YTM remains constant, between coupon payments, the prices of all bonds rise
at a rate equal to the YTM as the remaining cash flows of the bond become closer.
But as each coupon is paid, the price of the bond drops by the amount of the coupon.
When the bond is trading at a premium, the price drop when a coupon is paid will be
larger than the price increase between coupons, so that the bonds premium will tend
to decline as time passes.
If the bond is trading at a discount, the price increase between coupons will exceed
the drop when the coupon is paid, so the bonds price will rise and its discount will
decline at time passes.

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Interest rate changes and bond prices

Lets evaluate the effect of fluctuations in a bonds yield to maturity and its price.
If you have a 30-year, zero-coupon bond with the YTM of 5% and face value of 100,
100
the bond will initially trade for P = = 23.14.
1.0530
If interest rates suddenly rise so that investors demand a 6% yield to maturity before
100
they will invest in this bond, then the bond price will be P = = 17.41.
1.0630
Relative to the initial price, the bond price changes by -24.8%, a substantial price drop.
This example illustrates a general phenomenon. A higher YTM implies a higher dis-
count rate for a bonds remaining cash flows, reducing their present value and hence
the bonds price. Therefore, as interest rates and bond yields rise, bond prices will fall,
and vice versa.
The sensitivity of a bonds price to changes in interest rates is measured by the bonds
duration. Bonds with high duration are highly sensitive to interest rate changes.
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The yield curve and bond arbitrage

Thus far, we have only focused on the relationship between the price of an individual
bond and its yield to maturity.
We can also explore the relationship between the prices and yields of different bonds.
Using the Law of One Price, we show that given the spot interest rates, which are the
yields of default-free zero-coupon bonds, we can determine the price and yield of any
other default-free bond. As a result, the yield curve provides sufficient information to
evaluate all such bonds.
For example, we can replicate a three-year, $1,000 bond that pays 10% annual coupons
using three zero-coupon bonds as follows:

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The yield curve and bond arbitrage (cont...)

We match each coupon payment to a zero-coupon bond with a face value equal to the
coupon payment and a term equal to the time remaining to the coupon date.
Similarly, we match the final bond payment (final coupon plus the face value) in three
years to a three-year, zero-coupon bond with a corresponding face value of $1,100.
Because the coupon bond cash flows are identical to the cash flows of the portfolio
of zero-coupon bonds, the Law of One Price states that the price of the portfolio of
zero-coupon bonds must be the same as the price of the coupon bond, otherwise there
is arbitrage opportunity.
If the price of the coupon bond were higher, you could earn arbitrage profit by selling
the coupon bond and buying the zero-coupon bond portfolio. If the price of the coupon
bond were lower, you could earn an arbitrage profit by buying the coupon bond and
short selling the zero-coupon bonds.

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Corporate Bonds

Corporate bonds, that is, bonds issued by corporations, have a higher risk of default
than government bonds.
The risk of default, which is known as credit risk of the bond, means that the bonds
cash flows are not known with certainty.
Because of this, corporate bondholders often expect to receive amounts less than what
was promised in the cash flows.
Because the YTM for a bond is calculated using the promised cash flows, the yields
of bonds with credit risk will be higher than that of otherwise identical default-free
bonds.

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Corporate Bonds (cont...)

Suppose that the one-year, zero-coupon Treasury bill has a yield to maturity of 4%.
What are the price and yield of a one-year, 1000, zero-coupon bond issued by ABC
Corporation?
If, at the beginning, that there is no risk of default for this corporation, then the Law of
One Price dictates that the corporate bond should have the same yield as the one-year
1000
zero-coupon T-bill, which means P = = 961.54.
1.04
If, however, bondholders of ABC Corporation will only receive 900 with certainty, then
900
P= = 865.38. The prospect of default lowers the cash flow investors expect to
1.04
receive and hence the price they are willing to pay.
FV 1000
The YTM for this will be YTM = 1= 1 = 15.56%.
P 865.38

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Bond Ratings
It would be both difficult and inefficient for every investor to privately investigate the
default risk of every bond.
Consequently, several companies rate the creditworthiness of bonds and make this
information available to investors. By consulting these ratings, investors can assess
the credit worthiness of a particular bond issue.
These ratings therefore encourage widespread investor participation and relatively liquid
market.
Looking at the table below, bonds in the top four categories are referred to as
investment-grade bonds because of their low default risk.
Bonds in the bottom five categories are often called speculative bonds, junk bonds, or
high yield bonds because of their likelihood of default is high.
The rating depends on the risk of bankruptcy as well as the bondholders ability to lay
claim to the firms assets in the event of such a bankruptcy. Thus, debt issues with
a low-priority claim in bankruptcy will have a lower rating than issues from the same
company that have a high-priority claim in bankruptcy or that are backed by a specific
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Bond Ratings (cont...)

Tab. 1. Moodys Ratings

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Corporate yield curves

The difference between the yields of the corporate bonds and the Treasury yields is
the default spread or credit spread.
Credit spreads fluctuate as perceptions regarding the probability of default change.
Note that the credit spread is high for bonds with low ratings and therefore a greater
likelihood of default.

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Sovereign bonds

Sovereign bonds are bonds issued by national governments.

Whilst some government bonds are considered default free, not all government bonds
are default free.
Similar to the corporate bonds, we can also look at the credit spread for various
government bonds to see which country(ies) is/are likely to default by the distance of
the spread.

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Sovereign bonds spread against Germany

Fig. 2. 10-Year Spread of Various Nations 24 / 25

MOD004491 Corporate FinanceDebt Valuation Bonds

Summary

Understand bond cash flows, prices and yields.

Illustrate the idea of zero-coupon bonds.
Illustrate the idea of coupon bonds.
Illustrate the idea of generic bonds.
Understand the effect of time on bond prices.
Understand the effect of interest rates on bond prices.
Understand bond replication between zero coupon bonds and coupon bonds.
Observe cases of corporate bonds and sovereign bonds.

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