- Information
- AI Chat
Lecture 8 Bond valuation
BUSINESS FINANCE (MAN2089)
University of Surrey
Recommended for you
Preview text
Bond valuation Bond: is a type of loan. When a company wishes to borrow money from the public (not from banks) on a long-term basis, it does so by selling (issuing) debt securities called bonds.
A typical bond has a fairly simple structure ● The investor loan a company some money ● The company pays you interest every period ● The company repays the amount it borrowed at end of loan ● Usually bonds have an active secondary market
A typical bond structure: The company issues a £1,000 bond. The investors loan the company £1,000 and receive interest of £80 each year. After 10 years, the company repays the £1, borrowed.
Key features/ Terms Coupon: The stated interest payment made on a bond. Typically paid on an annual or semi-annual basis. Face Value: The principal amount of a bond that is repaid at the end of the term. Also called par value or maturity value. Coupon Rate: The annual coupon divided by the face value of a bond
Maturity: The specified date on which the principal amount of a bond is paid. Yield to Maturity (YTM): The rate required in the market on a bond. Note: YTM or current market interest rates are used as the discount rate in bond valuation calculations Current yield: Annual coupon / price, one year out, what is the next or the first coupon payment? What is the value today? Gives approximation of yields and maturity
Security: Security is where an asset is allocated to the bond as security against non-payment. Bonds are normally unsecured. (Unlike bank borrowings that are often secured on assets such as property.) e. asset, building or mortgage The Call Provision: A clause that gives the company the option to repurchase (or “call”) part or all of the bond issue at stated prices over a specific time. Sinking fund: An account managed by the bond by the bond trustee for early bond redemption. Protective covenant: Limits certain actions that might be taken during the term of a bond to protect the investor’s interests.
Summary of indenture agreement
● t is the number of periods to maturity ● r is the YTM or yield or current market interest rate for a period
Example 1: Bond value on issue date Pixie Plc. plan to issue a £1,000 10-year annual coupon 8% bond with 10 years to maturity. Similar bonds have a yield to maturity of 8%. Required: 1. What are the bond cash flows? 2. What would this bond sell for?
Step 1: Draw a timeline
Step 2: Use the bond formula to calculate bond value
Answer: The bond price is £1,000. This is the same as face value, so the bond is trading at ‘par
More terms Par Bond: A bond that is selling at face value (coupon is the same as yield) Discount Bond: A bond that is selling at a price below its face value. Premium Bond: A bond that is selling at a price more than its face value
Lecture example 2: Semi-Annual Bond Value Bond value after issue date and where coupons are paid semi-annually rather than annually. Company Q has issued a 10 year £1,000 semi- annual 6% bond that now has 2 years left to maturity. The bond is trading at 8% (that is, its yield to maturity, or ‘quoted yield’ is 8%.
Required: 1. What are the bond cash flows? 2. What would this bond sell for?
Link between interest rates and bond value There us an inverse relationship between interest rates and bond value. The sensitivity of the bond price to interest rate changes is known as interest rate risk.
Link between interest rates and bond value
If YTM = coupon rate, then bond price= face value If YTM > coupon rate, then bond price < face value ● Bond is trading at a “discount” If YTM < coupon rate, then bond price > face value
● Bond is trading at a “premium” Interest rate risk The sensitivity of the bond value to interest rates is called interest rate risk. If you invest in a bond and interest rates rise, your bond will fall in value.
This graph shows the impact of time to maturity on interest rate risk. Longer time to maturity (that is, remaining life) => greater interest rate risk
Note that the 30-year bond had greater interest rate risk that the 1-year bond. This is because the further away the cash flows, the greater the impact on the PV calculations of a change in interest rates because the current market interest rate is used as the discount rate. The longer the remaining maturity of the bond, the greater the interest risk, (assuming the coupon and face value are the same)
Explanation of Clean and Dirty price
Accrued interest ● When the bond is sold between coupon payment dates,part of the next coupon payment belongs to the seller ● This is known as the accrued interest Clean Price ● The price of a bond net of accrued interest ● This is the price that is typically quoted Dirty Price ● The price of a bond including accrued interest , also known as the full or invoice price ● This is the price the buyer actually pays
Credit Rating To be successful, a bond issue must be rated by credit rating agencies prior to issue. The ratings are an assessment of the creditworthiness of the issuer and help set the yield at which the bond is issued. Investors will pay more for a bond with a higher rating. Bonds are normally issued at or close to par (face value), so bonds with a higher credit rating can be issued at par at a lower coupon rate that bonds with a lower credit rating.
Bond details, including ratings
How inflation/other factors affect bond price/yield Key terms: Nominal Rate: ● Interest rate or rate of return that has not been adjusted for inflation ● The percentage (%) change in the amount of cash you have Real rate ● Interest rate or rate of return that has been adjusted for inflation ● The percentage (%) change in your buying power
The term structure of interest rates represents the combined effect of the: Real rate of Interest: The compensation that investors demand for forgoing the use of their money Inflation Premium: The portion of a nominal interest rate that represents compensation for expected future inflation Interest rate risk premium: The compensation that investors demand for bearing interest rate risk
Bond yields represent the combined effect of: ● Real rate of interest/Expected future inflation/Interest rate risk premium (as before)
Lecture 8 Bond valuation
Module: BUSINESS FINANCE (MAN2089)
University: University of Surrey
- Discover more from:
