MBF1223 Financial Management Prepared by Dr Khairul Anuar

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1 MBF1223 Financial Management Prepared by Dr Khairul Anuar L4 Bonds & Bonds Valuation

2 Bonds - Introduction A bond is a debt instrument issued by a borrower which has borrowed a sum of money (the principal) and promises to pay the principal and interest, on a specific date, to the holders of the bonds. Corporations issue bonds to finance capital expenditures such as real estate and equipment. In addition to corporations, governments and government agencies also issue bonds to raise funds to finance its capital expenditure and budget shortfall.

3 What is Bond Market? The bond market is a financial market where participants buy and sell debt securities, usually in the form of bonds. The bond market primarily includes: Government-issued securities. Corporate debt securities. 3

4 1. Application of the Time Value of Money Tool: Bond Pricing Bonds - Long-term debt instruments Provide periodic interest income annuity series Return of the principal amount at maturity future lump sum Prices can be calculated by using present value techniques i.e. discounting of future cash flows. Combination of present value of an annuity and of a lump sum 4

5 Types of Bond Treasury Bonds Treasury bonds are sometimes referred to as government bonds. They are issued by the government to finance its budget deficit. Since the probability of a government going bankrupt is almost zero, we can assume that this type of bonds are credit-risk free. However, when interest rates rises, the prices of treasury bonds will decline, and therefore they are not entirely free of all risks. In Malaysia, there are two types of treasury bonds. The conventional treasury bonds is referred to as Malaysian Government Securities (MGS) Islamic issues are referred to as Government Investment Issues (GII). 5

6 Types of Bond Domestic of Bonds Bonds issued in the country and currency in which they are traded. Unlike international bonds, domestic bonds are not subject to currency risk. They usually carry less risk, as the regulatory and taxation requirements are usually known to investors in domestic bonds, or at least to their brokers and accountants. 6

7 Types of Bond International Bond A bond issued in a country or currency other than that of the investor or broker. They include : Eurobonds, which are issued in a foreign currency, foreign bonds, which are issued by a foreign government or corporation in the domestic market, and global bonds, which are issued in both domestic and international markets. 7

8 Types of Bond Foreign Bonds A foreign bond is a bond issued in the domestic market by a foreign entity in the domestic market s currency to raise funds. For example, a ringgitdenominated bond issued by a China based company in Malaysia is a foreign bond. For illustration, in June 2016, Apple Inc., a US based company, issued $1.4 billion bonds in Australia. Foreign bonds are labelled based on the country in which it is issued Samurai bonds are bonds issued by non-japanese issuers in Japan, while Matilda bonds issued by non-australian issuers in Australia. Foreign bonds gives domestic investors the opportunity to add foreign investment into their portfolio without the added foreign currency exposure. Holders of foreign bonds are exposed to multiple risks, such as inflation risks, interest risks, and political risks. Since investing in foreign bonds entails multiple risks, compared to domestic bonds, foreign bonds typically have higher yields. 8

9 Corporate Bonds Types of Bond Corporate bonds are issued by corporations to raise financing for a number of reasons, such as capital expenditure, ongoing operations, business expansion, or mergers and acquisitions activities. Unlike the treasury bonds, corporations may be unable to pay the principal and interest payments, and hence holders of corporate bonds are exposed to default risk. Default risk is also referred to as credit risk. Default risk is determined by the characteristics of the issuer and the terms of the bond. The issuer will be required to pay a higher interest rate if its credit risk is high. 9

10 Municipal Bonds Types of Bond Municipal bonds are issued by states, local governments, or other government entities to finance day-to-day obligations and capital expenditures such as construction of schools, hospitals and highways. Municipal bonds are exempt from federal government taxes and local taxes. Since it is exempt from tax, the interest rate for municipal bonds is lower than other fixed income securities such as corporate bonds. Municipal bond issue is common in the United States of America and Europe. 10

11 Characteristics of Bond Par Value The par value of a bond is the stated face value of the bond. It represents the amount of money the firm borrows and promises to repay on the maturity date. Par value is important for a bond or fixed-income instrument because it determines its maturity value as well as the dollar value of coupon payments. Generally, we assume par value to be $1,000, or the multiple of $1,000. Examples of fixed-income securities are treasury bonds, certificates of deposit and preferred stock with a stated dividend rate. 11

12 Characteristics of Bond Yield to maturity The YTM, book yield or redemption yield of a bond other fixed-interest security such as gilts, is the internal rate of return (IRR, overall interest rate) earned by an investor who buys the bond today at the market price, assuming that the bond will be held until maturity, and that all coupon and principal payments will be made on schedule. YTM is the discount rate at which the sum of all future cash flows from the bond (coupons and principal) is equal to the price of the bond. The YTM is often given in terms of Annual Percentage Rate (A.P.R.), but more often market convention is followed. 12

13 Characteristics of Bond Yield to maturity Calculating the Yield on a Bond Assume the market value of a RM100 bond with 5% p.a. coupon is at RM102. The bond is therefore said to be at 102. Let us now calculate the yield on this bond. Annual coupon on the bond = 5% x RM100 = RM5 Yield on bond = RM5 / RM102 x 100% = 4.90% 13

14 Coupon Interest Rate Characteristics of Bond Coupon interest rate is the interest paid on the principal borrowed by the corporation. Coupon may be paid annually, or semi-annually. If you hold a bond with a nominal value of RM100,000 and the coupon interest rate is 7%, then you will receive an annual coupon interest of RM7,000. If the coupon payment is semi-annual, i.e. every six months, you will receive RM3,500 every six months. There are also bonds issued with the coupon interest rate varying over time, and they are called floating rate bonds. The coupon interest rate may be adjusted over time on certain market rate, such as the KLIBOR (Kuala Lumpur Interbank Offered Rate) or the MGS (Malaysian Government Securities). 14

15 Characteristics of Bond Coupon Interest Rate (cont d) Corporations may also issue bonds which does not pay any coupon interest rate over the tenure of the bond. These are called zero-coupon bonds and the holders of the bonds will not receive any coupons during the life of the bond. To entice investors to invest in the zero-coupon, the zerocoupon bold will be sold at a discount, i.e. at a price lower than its par value. This will enable the investor to gain from the difference between the discount price and the par value when the bond matures. 15

16 Maturity Date Characteristics of Bond The maturity date of a bond is the date in the future on which the investors will be paid the par value. If you purchased a 20-year bond issued on January 4, 2010, it will mature on January 4, It is much easier to forecast a one year bond and therefore is less risky compared to a 20- year bond. We may conclude that the longer the maturity of a bond, the higher its coupon interest rate to compensate for the risks. 16

17 Characteristics of Bond Call Provisions or Redeemable Bonds A call provision entitles the issuer to repurchase or call the bond for redemption from their holders at a stated price within a predetermined period. Often the corporation must pay a premium over the par value of the bond if it is called. A call provision may be advantageous to the issuing corporation but may be detrimental to the investors. When the interest rate has increased significantly in the economy, the issuer will not call the bond, and consequently the investors will continue to receive the original coupon interest rate. 17

18 Sinking Fund Characteristics of Bond A corporation may issue a bond with sinking fund provision. In a sinking fund bond, the corporation is required to deposit a certain amount of funds with a trustee. This will facilitate in the orderly retirement of the bond when it matures. If the issuer fails to meet the sinking fund requirement, it will be deemed a default of the bond covenant. 18

19 Convertible Bonds Characteristics of Bond Convertible bonds give the holders a right to convert the bonds to a fixed number of the issuer s stock or shares during a period, and at a price agreed at the time of issuing the convertible bonds. Holders of the convertible bond have an opportunity to benefit from the upside if the issuer performs financially, and therefore are will to accept a lower coupon interest rate with convertible bonds compared to a non-convertible bond. 19

20 Bond with Warrants Characteritics of Bond Some corporations issue bonds with warrants. Warrants are options that that confers the right, but not the obligation, to buy or sell a stock or share at a fixed price. For investors holding the warrants, it is attractive to have the option to buy shares at preset prices, as they will gain if the price of the stock rises above the preset price. For the issuer, bonds with warrants allow the issuer to first raise money through the sale of the bonds and later, when the warrants are exercised, money is again raised in purchasing the shares at the preset price. As with convertibles, bonds with warrants have lower coupon rates than straight bonds. 20

21 Characteristics of Bond Secured and unsecured bonds When a corporation issues a secured bond, the settlement of the principal and interest of the secured bonds are secured by a pledge of the corporation s assets, such as land, building or shares. If the issuer defaults on the payment of principal or interest, the investors would have a claim on the pledged assets. Conversely, unsecured loans are bonds not backed by any collateral. In the event of a default, the bondholders would have a general claim on the issuing company. Due to its higher risk factor, unsecured loans offer higher interest rates than secured bonds. 21

22 Guaranteed bonds Characteristics of Bond Guaranteed bonds are guaranteed for full debt repayment by a guarantor, which could be the parent company or one or more financial institutions. The safety of the bond therefore depends on the financial capability of the issuer and the guarantor to satisfy the terms of the guarantee. 22

23 Deutsche Telekom Global Bond The largest corporate global bond issue to date is the $14.6 billion Deutsche Telekom multicurrency offering (year 2000). The issue includes three U.S. dollar tranches with 5-, 10-, and 30-year maturities totaling $9.5 billion, two euro tranches with 5- and 10-year maturities totaling 3 billion, two British pound sterling tranches with 5- and 30- year maturities totaling 950 million, and one 5-year Japanese yen tranche of 90 billion

24 Table 1: Bond Information August 1,

Coupon: Regular interest payment received by holder per year.

25 1. (A) Key Components of a Bond Figure 1: Merrill Lynch corporate bond. Par value : Typically $1000 Coupon rate: Annual rate of interest paid. Coupon: Regular interest payment received by holder per year. Maturity date: Expiration date of bond when par value is paid back. Yield to maturity: Expected rate of return based on price of bond 25

35 15- Jun-2010 15.438 6.94 B Price = 91.5% of $1000$915; Annual coupon = 6.35% *1000 $63.

26 1. (A) Key Components of a Bond Example 1: Key components of a corporate bond Let s say you see the following price quote for a corporate bond: Issue Price Coupon(%) Maturity YTM% Current Yld. Rating Hertz Corp Jun B Price = 91.5% of $1000$915; Annual coupon = 6.35% *1000 $63.50 Maturity date = June 15, 2010; If bought and held to maturityyield = % Current Yield = $ Coupon/Price = $63.5/$ % 26

27 1. (B) Pricing a Bond in Steps Since bonds involve a combination of an annuity (coupons) and a lump sum (par value) its price is best calculated by using the following steps: Figure 2: How to price a bond. 27

28 1. (B) Pricing a Bond in Steps (continued) Example 2: Calculating the price of a corporate bond. Calculate the price of an AA-rated, 20-year, 8% coupon (paid annually) corporate bond (Par value = $1,000) which is expected to earn a yield to maturity of 10%. Year $80 $80 Annual coupon = Coupon rate * Par value =.08 * $1,000 = $80 = PMT YTM = r = 10% Maturity = n = 20 Price of bond = Present Value of coupons + Present Value of par value $80 $80 $80 $80 $1,000 28

29 1. (B) Pricing a Bond in Steps (continued) Example 2: Calculating the price of a corporate bond Present value of coupons = 1 PMT 1 1 r r n = 1 $ Present Value of Par Value = Present Value of Par Value = = $80 x = $ FV 1 r $1,000 n Present Value of Par Value = $1,000 x = $ Price of bond = $ $ = $

30 1. (B) Pricing a Bond in Steps (continued) Method 2. Using a financial calculator Mode: P/Y=1; C/Y = 1 Input: N I/Y PV PMT FV Key: 20 10? Output

31 2. Semiannual Bonds and Zero-Coupon Bonds Most corporate and government bonds pay coupons on a semiannual basis. Some companies issue zero-coupon bonds by selling them at a deep discount. For computing price of these bonds, the values of the inputs have to be adjusted according to the frequency of the coupons (or absence thereof). For example, for semi-annual bonds, the annual coupon is divided by 2, the number of years is multiplied by 2, and the YTM is divided by 2. The price of the bond can then be calculated by using the TVM equation, a financial calculator, or a spreadsheet. 31

32 2. Semiannual Bonds and Zero-Coupon Bonds Figure 4: Coca-Cola semiannual corporate bond. 32

33 2. Semiannual Bonds and Zero-Coupon Bonds Figure 5: Future cash flow of the Coca-Cola bond. Using TVM Equation Using Financial Calculator 33

34 2. Semiannual Bonds and Zero-Coupon Bonds 34

2. (A) Pricing Bonds after Original Issue The price of a bond is a function of the remaining cash flows (i.e. coupons and par value) that would be paid on it until expiration.

35 2. (A) Pricing Bonds after Original Issue The price of a bond is a function of the remaining cash flows (i.e. coupons and par value) that would be paid on it until expiration. As of August, 2008 the 8.5%, 2022 Coca-Cola bond has only 27 coupons left to be paid on it until it matures on Feb. 1, 2022 Figure 6.6 Remaining cash flow of the Coca-Cola bond. 35

36 2. (A) Pricing Bonds after Original Issue Example 3: Pricing a semi-annual coupon bond after original issue: Four years ago, the XYZ Corporation issued an 8% coupon (paid semiannually), 20-year, AA-rated bond at its par value of $1000. Currently, the yield to maturity on these bonds is 10%. Calculate the price of the bond today. Remaining number of semi-annual coupons = (20-4)*2 = 32 coupons = n Semi-annual coupon = (.08*1000)/2 = $40 Par value = $1000 Annual YTM = 10% YTM/25% = r 36

37 2. (A) Pricing Bonds after Original Issue Method 1: Using TVM equations Bond Price = Bond Price = Par Value $1, r n 1 Coupon 1 $ r r 1 n Bond Price = $1000 x $40 x Bond Price = $ $ Bond Price = $

38 2. (A) Pricing Bonds after Original Issue Method 2: Using a financial calculator Mode: P/Y=2; C/Y = 2 Input: N I/Y PV PMT FV Key: 32 10? Output

39 2. (B) Zero-Coupon Bonds Known as pure discount bonds and sold at a discount from face value Do not pay any interest over the life of the bond. At maturity, the investor receives the par value, usually $1000. Price of a zero-coupon bond is calculated by merely discounting its par value at the prevailing discount rate or yield to maturity. 39

2. (C) Amortization of a Zero-Coupon Bond Table 2: Amortized Interest on a Zero-Coupon Bond The discount on a zero-coupon bond is amortized over its life.

40 2. (C) Amortization of a Zero-Coupon Bond Table 2: Amortized Interest on a Zero-Coupon Bond The discount on a zero-coupon bond is amortized over its life. Interest earned is calculated for each 6-month period. for example.04*790.31=$31.62 Interest is added to price to compute ending price. Zero-coupon bond investors have to pay tax on annual price appreciation even though no cash is received. 40

41 2. (C) Amortization of a Zero-Coupon Bond Example 4: Price of and taxes due on a zero-coupon bond: John wants to buy a 20-year, AAA-rated, $1000 par value, zero-coupon bond being sold by Diversified Industries Plc. The yield to maturity on similar bonds is estimated to be 9%. a) How much would he have to pay for it? b) How much will he be taxed on the investment after 1 year, if his marginal tax rate is 30%? 41

045) 40 Bond Price = $1000 *.1719287 = $171.

42 2. (C) Amortization of a Zero-Coupon Bond Example 4 Answer Method 1: Using TVM equation Bond Price = Par Value * [1/(1+r) n ] Bond Price = $1000*(1/(1.045) 40 Bond Price = $1000 * = $ Method 2: Using a financial calculator Mode: P/Y=2; C/Y = 2 Input: N I/Y PV PMT FV Key: 40 9? Output

43 2. (C) Amortization of a Zero-Coupon Bond Example 4 (Answer) (continued) Calculate the price of the bond at the end of 1 year. Mode:P/Y=2; C/Y = 2 Input: N I/Y PV PMT FV Key: 38 9? Output Taxable income = $ $ = $15.82 Taxes due = Tax rate * Taxable income = 0.30*$15.82 = $

44 2. (C) Amortization of a Zero-Coupon Bond Example 4 (Answer) (continued) Alternately, we can calculate the semi-annual interest earned, for each of the two semi-annual periods during the year. $ *.045 = $7.736 Price after 6 months $ = $ $ *.045=$8.084 Price at end of year $ = $ Total interest income for 1 year = $7.736+$8.084 $15.82 Tax due = 0.30 * $15.82 = $

45 3. Yields and Coupon Rates A bond s coupon rate differs from its yield to maturity (YTM). Coupon rate - set by the company at the time of issue and is fixed (except for newer innovations which have variable coupon rates) YTM is dependent on market, economic, and companyspecific factors and is therefore variable. 45

46 3. (A) The First Interest Rate: Yield to Maturity Expected rate of return on a bond if held to maturity. The price that willing buyers and sellers settle at determines a bond s YTM at any given point. Changes in economic conditions and risk factors will cause bond prices and their corresponding YTMs to change. YTM can be calculated by entering the coupon amount (PMT), price (PV), remaining number of coupons (n), and par value (FV) into the TVM equation, financial calculator, or spreadsheet. 46

47 3. (B) The Other Interest Rate: Coupon Rate The coupon rate on a bond is set by the issuing company at the time of issue It represents the annual rate of interest that the firm is committed to pay over the life of the bond. If the rate is set at 7%, the firm is committing to pay.07*$1000 = $70 per year on each bond, It is paid either in a single check or two checks of $35 paid six months apart. 47

48 6. U.S. Government Bonds Include bills, notes, and bonds sold by the Department of the Treasury State bonds, issued by state governments Municipal bonds issued by county, city, or local government agencies. Treasury bills, are zero-coupon, pure discount securities with maturities ranging from 1-, 3-, and 6-months up to 1 year. Treasury notes have between two to 10 year maturities. Treasury bonds have greater than 10-year maturities, when first issued. 48

49 4. Bond Ratings Ratings are produced by Moody s, Standard and Poor s, and Fitch Range from AAA (top-rated) to C (lowest-rated) or D (default). Help investors gauge likelihood of default by issuer. Assist issuing companies establish a yield on newly-issued bonds. Junk bonds: is the label given to bonds that are rated below BBB. These bonds are considered to be speculative in nature and carry higher yields than those rated BBB or above (investment grade). Fallen angels: is the label given to bonds that have had their ratings lowered from investment to speculative grade. 49

50 Table 4: Bond Ratings 50

51 Rating Criteria Profitability Capital Structure Business Model Management Quality of earnings EBITDA margins Interest coverage indicators Volatility of earnings Cost Management Indebtedness ratios Distribution of debt maturities Effects of concentrated ownership on funding capabilities Barriers to entry Competitive environment Market position Diversification: Clients, Products, Geographic Management Structure Strategy and Objectives Performance Record 51

MBF1223 Financial Management Prepared by Dr Khairul Anuar

MBF1223 Financial Management Prepared by Dr Khairul Anuar L4 Bonds & Bonds Valuation www.notes638.wordpress.com Bonds - Introduction A bond is a debt instrument issued by a borrower which has borrowed