ACF719 Financial Management

Transcription

1 ACF719 Financial Management Bonds and bond management Reading: BEF chapter 5 Topics Key features of bonds Bond valuation and yield Assessing risk 2 1

2 Key features of bonds Bonds are relevant to the financing decision: INVESTMENTS FINANCE Weighted average cost of capital (WACC) Market interest rates Market risk aversion Cost of debt Cost of equity Firm s business risk Firm s debt/equity mix 4 2

3 Bond outline How much will you pay me now for these promised payments? Timeline promised coupon payments expressed as a % of 1,000 + promised payment of 1,000 A 5% 10 year bond is a promise of an annual payment of 50 and 1,000 in 10 years time. A BOND is a financial instrument that is a standardized form of borrowing that is easily tradable (negotiable). Bond outline (cont.) The basic principle: How much will you pay me now for these promised payments? Timeline promised coupon payments as a % of 1,000 + promised payment of 1,000 Payment depends on the required return 5%, 10%, 25%? 3

4 Bond terminology Par value: the stated face value of the bond the amount the issuer will pay at the end of the life of the bond (its maturity date) Coupon rate: The amount that the issuer will pay on a regular basis before the maturity date (say, 5%) It is expressed as a percentage of the par value Current yield: The amount of the annual coupon divided by the current market price of the bond. The coupon is a fixed amount, so the current yield will fall if the bond price rises. Discount rate: The interest rate applied by the investor in valuing the bond (say, 15%) Also referred to as the yield to maturity (YTM) It is a similar concept to that of internal rate of return (IRR) 7 Bond valuation and yield 4

5 Bond prices Bond prices vary widely depending on the coupon rate, the current interest rate, the par value, the maturity and the issuer Here are a selection of government and corporate bond prices taken from the finance.yahoo.com website 9 Calculating the value of a bond The general principle of bond valuation is calculate the present value of a bond s cash flows and then add these up to yield a fair price of the bond. There are, therefore, three steps to valuing a bond Estimate the bonds cash flows. These comprise (a) the coupon payments and (b) the payment made at maturity Determine the appropriate discount rate based on the risk of the cash flows. Calculate the present value of the cash flows, and their sum 5

6 Simple example What is the value of a 10-year, 5% coupon bond if investors want a return of 15%? % V =? , ,000 V B = (1 + r d ) 1 (1 + r d ) N (1 + r d ) N = = (Alternatively, use PVIFA approach, Excel, or a financial calculator) 11 Calculating the value of a bond If we assume that the discount rate ( r) is the same for all horizons then for an n year bond that makes an annual coupon payment of c (the first of which is in exactly one period s time), and a maturity payment of F, the value (fair price) is given by P = C 1 + r + C (1 + r) C 1 + r n + F 1 + r n The present value of the whole stream of coupon payments can be obtained using the formula for an annuity, i.e. C * PVIFA(r %, n) where PVIFA(r%,n) = 1 1 (1+r) n /r What should be the value of r? For a Treasury bond, we require the risk free rate of interest for the discount rate For a corporate bond, we must add a risk premium to the risk free rate 6

7 Bond valuation using a spreadsheet Consider for instance a 3% coupon bond with 4 years to maturity and an interest rate (discount rate) of 7%. Suppose that today is October 2017, and that a coupon has just been paid. The fair price of this bond can be calculated in Excel as follows: The bond price can also be computed using Excel s PV function. Example: valuing a bond Jackson Corporation s bonds have 12 years remaining to maturity. Interest is paid annually, the bonds have a $1000 par value, and the coupon interest rate is 8%. The bonds have a yield to maturity of 9%. What is the current market price of these bonds? 7

8 The relationship between the coupon rate, discount rate and price relative to par value Note that to calculate the total return over the life of the bond (the holding period return), we must also include the interest generated by reinvesting the coupons that are paid, which is known as reinvestment income. It is typically assumed that the future coupons will be reinvested at the same rate of return that the bond currently offers in terms of current yield and capital gain yield. The total return on the bond can be defined as Total return = current yield + capital gain yield The relationship between the coupon rate, discount rate and price relative to par value (cont.) Valuing a Discount Bond with Annual Coupons Consider a bond with an annual coupon rate of 10%. 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? B = PV of annuity + PV of lump sum B = 100*PVIFA(11%,5) / (1.11)^5 =(100/0.11)*[1 1/(1.11)^5] = = Discount bond - bond sells at less than par 8

9 The relationship between the coupon rate, discount rate and price relative to par value (cont.) Valuing a Premium Bond with Annual Coupons Suppose 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? B = PV of annuity + PV of lump sum B = 100*PVIFA(8%,20) / (1.08)^20 = = Premium bond bond sells for more than its face. The relationship between the coupon rate, discount rate and price relative to par value (cont.) Consider a bond whose coupon rate = the discount rate. The price of this bond must be equal to its par value. This is because it will offer a current yield exactly equal to the YTM and zero capital gain. 9

10 Examples: yield to maturity and current yield You just purchased a bond that matures in five years. The bond has a face value of 1000 and has an 8% annual coupon. The bond has a current yield of 8.21%. What is the bond s yield to maturity? Changes in bond value over time Before maturity, the price of a bond may be above par (if the coupon rate is higher than the interest rate), or below par (if the coupon rate is lower than the interest rate) As the bond reaches maturity its price will converge to par value P High coupon bond Par 10 10% coupon rate Lower coupon bond Years to Maturity

11 Semi-annual coupon payments So far we have assumed that a bond makes annual coupon payments In practice, however, most bonds pay coupons twice a year. If a bond makes semi-annual coupon payments then the fair price is calculated as P = c/2 (1 + r/2) + c/2 (1 + r/2) c/2 1 + r/2 2n + F (1 + r/2) 2n By convention, the semi-annual yield is converted to an annual yield simply by multiplying it by two. Semi-annual coupon payments (cont.) With semi-annual coupon payments, for the bond example in slide 13, we would have 11

12 Zero coupon bonds A zero coupon bond has only a single payment at maturity (i.e. the par value) So its price is simply the present value of the par value of the bond: P = F (1+r/2) 2n Note that, by convention, we write the price of a zero coupon bond as if coupons were paid semi-annually (even though no coupons are paid) Bond equivalent yields Suppose that Bond A has a semi-annual coupon and trades at a YTM of 6.25% Bond B has an annual coupon and trades at a YTM of 6.30% The YTMs of these two bonds are not directly comparable. Solution: Convert the YTM of the annual coupon bond to a semi-annual bond equivalent yield (BEY) as follows BEY (semi-annual) =[(1 + annual YTM) 0.5 1]*2 = [( ) 0.5 1]*2 = Bond B has a BEY of 6.2% This is lower than the YTM of Bond A. 12

13 Assessing risk Credit risk and bond ratings Determinate of yield: credit risk The debt ratings are an assessment of the creditworthiness of the corporate issuer. The definitions of creditworthiness used by Moody's and S&P (credit rating agencies) are based on how likely the firm is to default and the protection creditors have in the event of a default. Credit ratings are important because defaults really do occur, and when they do, investors can lose heavily. 13

14 Bond ratings (cont.) What factors affect default risk and bond ratings? Financial ratios Debt ratio; Coverage ratios, such as interest coverage ratio or EBITDA coverage ratio; Profitability ratios; Current ratios Median Ratios of companies with bond ratings (S&P) Interest coverage Return on capital Debt to capital AAA % 12.4% AA % 28.3% A % 37.5% BBB % 42.5% BB % 53.7% B % 75.9% CCC % 113.5% 28 14

15 Other factors that affect bond ratings Provisions in the bond contract Secured versus unsecured debt Senior versus subordinated debt Guarantee provisions Sinking fund provisions Debt maturity Other factors Earnings stability Regulatory environment Potential product liability Accounting policies 29 Interest rate risk and Duration Bonds have many differing maturities, ranging from short term to long term. A bond with long maturity is more sensitive to changes in interest rates than a short maturity bond The measure of sensitivity to interest rate changes is called duration. It takes into account years to maturity, also the yield and coupon rate. 15

16 Interest rate (or price) risk for 1-year and 10-year 10% bonds Interest rate risk: r d change causes bond prices to fall at different rates 1-Year 10-Year r d Price Change Price Change 5.0% 1,048 1, % 38.6% 10.0% 1,000 1, % 33.5% 15.0% Reinvestment rate risk What is reinvestment rate risk? The risk that cash flows from a bond will have to be reinvested in the future at lower rates, reducing income. Illustration: Suppose you just won $500,000 playing the lottery. You ll invest the money and live off the interest. You buy a 1-year bond with a YTM of 10%. Year 1 income = $50,000. At year-end you get back $500,000 to reinvest. If rates then fall to 3%: Your next year s income will drop from $50,000 to $15,000! Had you bought 30-year bonds, income would have remained constant

17 Reinvestment rate risk (cont.) One interpretation of the YTM is that it is the rate of return on the bond, assuming that the bond is held until maturity and assuming that all coupons are reinvested at this rate until the maturity of the bond In practice, however, we do not know the rate of interest that will be earned on reinvested coupons and so the YTM does not in general tell us the rate of return on the bond If the return in reinvested coupons is lower than the YTM then clearly the return on the bond will also be lower than the YTM. Reinvestment risk is determined by: 1. The coupon rate the higher the coupon rate, the more coupons there are to be reinvested 2. The bond maturity the longer the bond maturity, the higher the fraction of the bond return that is due to reinvested coupons The Maturity Risk Premium 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! How to decide whether to borrow using short term debt, or long term debt? Financial managers can consider the term structure of interest rates: the relationship between interest rates (or yields) and maturities. A graph of the term structure is called the yield curve. Yields on longer term bonds usually are greater than on shorter term bonds (see yield curve). Typically the curve slopes upward: longer investments offer the market higher interest rates per year In times of uncertainty this may not be true: investors may be more optimistic about the longer term than the present 34 17

18 Yield curve: U.K. Government bonds source: Bank of England website What to do next Read BEF Chapter 5 to reinforce your understanding of this topic 18