Semester 1

2019

BSNS 114
FINANCIAL
DECISION MAKING
TOPIC 4
Bonds

1
Financing Decision in the big picture

Maximize value of the business (firm)

The Financing
The Investment Working Capital
Decision:
Decision Management
• Debt
(Capital Budgeting) Decision
• Equity

2
Financing decision revisited. Choices of
financing. Bank loan
Corporate firm Debt:
• Contractual obligation between
Debt lender and borrower
• Has fixed life (maturity)

Assets Debt financing options:

1. Bank debt
Ø can be used for borrowing small amounts
Equity of money
Ø can be used if company is not well known
Ø can be source of both short and long term
borrowing
Ø can offer to meet unanticipated or
seasonal financing needs
2. Bonds
3
Financing decision revisited. Choices of
financing. Bonds

Corporate firm Bond - is a security that is issued in connection

with borrowing agreement between company
(bond issuer) and investor (bond holder).
Debt Ø Usually carry more favorable financing terms than
an equivalent bank loan
Ø Might provide chance for the issuer to add on
special features that could not be added on to a
Assets
bank loan
Whenever company issues bonds it creates a contract
- Bond Indenture.
Equity 1. Bond indenture is the contract between the bond
issuer and an investor
2. Bond indenture protects the bondholders
(investors). It provides legal recourse if interest or
principal payments are missed

4
Bonds may be classified as to…

1. Level of Security
– Collateralized: secured by a physical asset
– Debentures: unsecured, but secured by law

2. Level of Seniority
– Senior (takes priority over more "junior" debt owed by the
issuer)
– Junior
– Subordinated class

5
Bond Issuers

Governments (to finance deficits)

¤ NZ
Local government (municipal)
¤ Detroit, Auckland Council ko thu thuế

Companies (to finance investment)

¤ Large multinationals (Facebook) and smaller national
companies (Spark)
¤ Banks and financial institutions

Famous Individuals
¤ Bowie Bonds
6
 Interest only loan revisited. Coupon bond

Interest only loan is a loan where interest is paid periodically and the principal is repaid
at maturity
YTM, yield to maturity
t=0 t=1 t=2 t=3
t, time
Bond price, P Coupon Coupon Coupon payment, C
payment, C payment, C +
Principal (Face value), FV
FV: Principal (face value) is the cash flow bond holders are promised to receive at maturity
t: Maturity is the date when the issuer pays back the face value of the bonds
r: Coupon rate is a proportion of a principal
P: Bond price = PV coupon pmts (ordinary annuity) + PV principal (lump sum)
YTM (Yield to Maturity): market interest rate used to discount coupon and principal
payments to give current bond price

! % '(
P = "#$ × 1 − %&"#$ ! + (%&"#$)"
7
Example 1. Bond components and price

Coca Cola would like to borrow $2,000,000 from the general public to
finance its new project. To meet its objective Coca Cola issues bonds with a
$1,000 of face value. Bonds pay 5% annual coupon rate and mature in 3
years. Current market interest rate (YTM) is 5% p.a.
(i) How many bonds does Coca Cola have to issue to meet its objective?
(ii) Determine annual coupon payment (C) to be received by bondholders.
(iii) Determine current bond price (P).
Coupon payment = 1,000 x 5% = 50

8
Bond coupon payment frequencies

Coupon payments are typically made:

1. Annually
2. Semi-annually
3. Quarterly
Caution:
Ensure coupon rates and YTM quoted annually are adjusted to match the
frequencies of coupon payments before calculating bond price.
Year 1 Year 2 Year 3
t, time Annually
t=0 t=1 t=2 t=3

C C C+FV
Year 1 Year 2 Year 3
t, time Semi -annually
t=0 t=1 t=2 t=3

C C C C C C+FV
9
Example 2. Price of a semi-annual bond

A General Electric bond carries a coupon rate of 8% p.a., has 9

years to maturity and sells at a yield to maturity of 7% p.a.
The bond has a face value of $1000 and pays coupon to
bondholders every 6 months (semi-annually).
i. What coupon payments do bondholders receive every 6
months?
ii. At what price does the bond sell?

a) CP = 8%/2 x 1000 = 40

b) P0 = 40/3.5% x ((1 - 1/(1+3.5%)^18)) + 1000/(1+3.5%)^18 = 615

10
 Bonds differ in…
1. Conditions of borrowing vary between
corporations therefore the pricing specifics BNZ bank Bond ASB bank Bond
are different: YTM= YTM=
Ø Years to maturity Coupon rate= Coupon rate=
Ø Coupon rate and frequency of payments Frequency of coupon Frequency of coupon
Ø Yield to maturity pmts= pmts=
2. Coupon rate: Years to maturity= Years to maturity=
Ø fixed
Ø floating-rate (interest pmts tied to some
measure of current market rate)
3. Interest and non-interest paying bonds:
Ø Coupon bond (pays fixed interest pmt)
Ø Pure discount bonds
§ Do not pay a series of coupon
payments
§ Only expect a repayment of
principal at future maturity date
§ Trade at a discount to par today

11
Example 3. Pure discount (zero coupon)
bond price
Suppose Coca-Cola issued a 5 year bond which pays
$1,000 at maturity (t=5)? Assume yield to maturity of
8% compounded semi-annually. What is the price of
the Coca-Cola bond today?

P0= 1000/(1+8%/2)^10 = 675.564

12
Bonds revisited…

What’s so special about bonds?

¨ Follows basic principles of valuation: future cash
flows are discounted to present time
¨ Cash flows are fixed

¨ Cash flows are finite

¨ Known maturity

¨ Only downside with respect to likelihood of

receiving promised cash flow

13
In the meantime at the bond market…

¨ Extremely large number of bond issues, but generally low

daily volume in single issues.
¨ Transactions of bonds are with dealers connected
electronically in a banking system.
¨ Getting up-to-date prices is difficult (lack of transparency),
particularly on small company or municipal issues.

14
In the meantime at the bond market…Continued

1. At issuance, bond is usually priced at par value ($1000).

This reflects the original amount corporations borrow
2. Coupon cash flows are predetermined and remain the same
until maturity:
q Coupon rate is fixed

q Face/par value at maturity is fixed

3. As time goes on, price changes in response to the

following:
q Time rolls forward, the life of the bond reduces as the
maturity date approaches – calendar turn
q Interest rate (ΔYTM) changes with news information in the
market – market shifts
15
Bond Price and Interest rate (YTM)
Relationship
Recall that present value and interest rates have inverse relationship
( r Ç => PV È )
When interest rate (YTM) rises, the
Bond
Price (P)
present value of the bond’s CFs
declines and the bond is worth less
Interest
rate
(YTM, r)

Bond
When interest rate (YTM) declines,
Price (P) the present value of the bond’s CFs
Interest rises and the bond is worth more
rate
(YTM, r)
Bond theorem I. Bond price movements inversely related to interest rate
movements.
16
Example 4. Bond price and interest rate
(YTM)
Suppose Apple issues a bond with 10 years until
maturity. It pays annual coupons with a coupon rate of
8% p.a. Apple will pay $1000 to the bondholders in 10
years. One year later you decide to sell this bond. If the
interest rate in the market has risen to 10%, what will
the bond worth today?

17
Bond Price and Interest rate (YTM)
Relationship. Continued
Coupon rate of a bond is fixed; but YTM (interest rate)
fluctuates throughout the lifetime of a bond.

If YTM = coupon rate: Bonds trade at par (i.e. face value); these bonds are
called Par-value Bonds
If YTM > coupon rate: Bonds trade at a discount to par; these bonds are
called Discount Bonds
If YTM < coupon rate: Bonds trade at a premium to par; these bonds are
called Premium Bonds

18
Example 5. Par, discount and premium
bonds
A bond issued by Air New Zealand has a coupon rate of 10% per annum, pays annual
coupons and matures in 3 years. How much would you pay for $1,000 face value of
this bond if:
i. the yield to maturity (YTM) is 10% per annum?
"!! "!! "!!$"!!!
𝑃! = + +
("$!.")! ("$!.")" ("$!.")#

i. the yield to maturity (YTM) is 5% per annum?

"!! "!! "!!$"!!!
𝑃! = + +
("$!.!')! ("$!.!')" ("$!.!')#

ii. the yield to maturity (YTM) is 20% per annum?

"!! "!! "!!$"!!!

𝑃! = + +
("$!.()! ("$!.()" ("$!.()#

19
 Bond price and interest rate relationship for a
10% coupon rate bond
$1,300.00

PREMIUM to
Bond price PAR
$1,200.00

P= $1136
$1,100.00

$1,000.00 P=$1,000 (PAR) Bond A

$900.00
DISCOUNT
from PAR
$800.00
P=$789

$700.00
0% 5% 10% 15% 20% 25%

Market interest rate, YTM

Example 5. Par value, discount and
premium bonds. Revisited
A bond issued by Air New Zealand has a coupon rate of 10% per annum, pays annual
coupons and matures in 3 years. Initial yield to maturity is 10%. What is the rate of
change of the bond price if:
(i) the yield to maturity (YTM) is 10% per annum?
𝑃" − 𝑃!
∆𝑃 =
𝑃!
(ii) the yield to maturity (YTM) is 5% per annum?
𝑃" − 𝑃!
∆𝑃 =
𝑃!
(iii) the yield to maturity (YTM) is 20% per annum?
𝑃" − 𝑃!
∆𝑃 =
𝑃!

21
Bond price changes and interest rate risk

q The direction and magnitude of interest rate movement is

difficult to predict
q The potential changes in bond prices as interest rates fluctuate
result in gains or losses to a bondholder. This is called interest
rate risk
q The degree in the rate of change of a bond price as a
response to interest rate change is called interest rate
sensitivity
q Bonds that are highly sensitive to interest rate change are
therefore referred to as having high interest rate risk

22
The effect of interest rate changes on bond
prices will vary from bond to bond
Effect of interest rate change on bond price will
depend upon a number of characteristics of the bond:
¨ The maturity of the bond (holding coupon rate
constant, increasing the maturity of a bond will
usually increase its sensitivity to interest rate
changes)
¨ The coupon rate of the bond (holding maturity
constant, increasing the coupon rate of a bond will
decrease its sensitivity to interest rate changes)

23
Impact of maturity on bond price:
intuition
Consider three 6% coupon bonds:
Coupon rate Yield to Price of 5- Price of 10-
Maturity Year Bond Year Bond
6% 5% 104.3294 107.7217
6% 6% 100 100
6% 7% 95.8998 92.9764

Conclusion:

24
Impact of coupon rate on interest rate
sensitivity bond price: intuition
Consider three 10-year bonds:
Coupon Bond price Bond price % Price Bond price % Price
rate at yield at yield change at 4% change
5% 6% yield

0% $613.91 $558.39 $675.56

5% $1000.00 $926.40 $1081.11
10% $1386.00 $1294.40 $1486.65

Conclusion:

25
 Past Midterm Question 1

Bonds A and B both have a face value of $1,000. Bond A has a 6%

coupon; Bond B has an 8% coupon. If the YTM on Bond A is 5%
and the YTM on Bond B is 10% which statement is TRUE?
a. Bond A trades at a premium, Bond B trades at a discount.
b. Bond A trades at a discount, Bond B trades at a premium.
c. Both bonds trade at a premium.
d. Both bonds trade at a discount.
e. Both bonds trade at par value.

26
Past Midterm Question 2

Ruth Jones wants to invest in 4-year zero coupon bond

with a face value of $1000 that are currently (t=0)
priced at $772.89. Assume semi-annual compounding.
What is the current market yield on this bond?

27
Other risks in bonds

¨ If you buy a conventional bond, you are promised fixed

payments (coupons) in the future and the principal of the bond
at the maturity.
¨ You face three risks while you hold the bond:
— Interest rate risk, where changes in market interest rate

affect the value of your fixed payment

— Inflation risk, where a high rate of inflation lowers the real

value of the interest you earn

— Default risk, where the entity that promised the fixed

payments is unable to deliver

28
Bonds and inflation risk. What is
inflation?
Rising prices….
¨ In most modern economies, prices tend to rise over
time. This phenomenon is known as inflation
¨ Change in real purchasing power of $1 over time

¨ Different from time-value of money (how?)

¨ For some countries, inflation is extremely

problematic
¨ How to quantify its effects?

29
Bonds and inflation risk. Real versus
nominal interest rates
¨ Recall that nominal interest rate (𝒓𝒏𝒐𝒎𝒊𝒏𝒂𝒍 ) ingredients are: time
preference, inflation premium, risk premium.
¨ Real interest rate (adjusted for inflation, 𝒓𝒓𝒆𝒂𝒍 ) ingredients are: time
preference, risk premium. Real interest rate is important to investors
because it represents how much purchasing power has changed.

𝑟1234 ≈ 𝑟5678534 − 𝑖𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛 => This is just an approximated 𝒓𝒓𝒆𝒂𝒍

(1 + 𝑟5678534 ) = (1 + 𝑟1234 ) × (1 + 𝑖𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛)

(9:5!"#$!%& )
Solve for r9:;< you get: r5678 = − 1 => Precise 𝒓𝒓𝒆𝒂𝒍
(9:;<=>?@;A< )

30
The effect of inflation on bonds’ return

¨ Inflation decreases the purchasing power of a dollar over long

periods of time.
¨ Inflation decreases real wealth if it is not invested to earn

interest.
¨ And if it is invested, inflation reduces the bonds’ coupon rate

to a lower, real interest rate.

Example 6. Suppose you have invested $10,000 in an Auckland
International Airport bonds. These bonds pays an annual coupon
rate of 5.5%. Assume inflation per annum is 1%. What is your
annual real rate of return?

31
Bonds and default risk

Fixed income securities have promised payoffs of fixed amount at fixed times.
Excluding government bonds, other fixed-income securities, such as corporate
bonds, carry the risk of failing to pay off as promised.
Default risk (credit risk) refers to the risk that a debt issuer fails to make the
promised payments (interest or principal).
Determinants of default risk:
¨ Capacity to generate cash flows: The larger the cash flows that a firm
generate from operations, the lower its default risk should be
¨ Volatility in these cash flows: The more predictable a firm’s cash flows
are, the lower its default risk should be
¨ Fixed Commitments: The larger a firm’s commitments (interest and
principal payments) relative to its cash flows, the greater is its default risk

32
Measuring bond default risk. Rating
agencies
¨ A default is when a debt issuer fails to make a promised payment
(interest or principal)
¨ Rating agencies (e.g., Moody's and S&P) provide credit ratings which are
an indications of the risk of default by each issuer.
¨ Default (credit) spread – difference between the interest rate on a bond
with default risk and a default-free government bond

33
Past Midterm Question

Fitch (a US bond rating agency), S&P and Moody’s all provide debt ratings
services to corporate and government issuers. These ratings provide the
market with the following:

a. Information about the yield to maturity on a firm’s debt.

b. A measure of the expected volatility in the price of the bond during the next
year.
c. An indication of the effect that inflationary pressures on the bond price.
d. Information about the amount of exposure the debt has to interest rate risk.
e. A measure of default risk and the protection creditors have in the event of a
default.

34
Decomposition of corporate bond yield

Default risk premium

Interest rate risk

(term) premium
Risk-free rate Inflation risk premium
(default free)
Real rate
(Time preference)

Real rate (time preference) = reward for delayed consumption

Inflation risk premium = compensation for expected future inflation. Higher anticipated inflation
leads to higher required compensation
Interest rate risk premium = compensation for bearing interest rate risk. Longer term bond has
higher risk compare to short term bond and thus requires higher compensation
Default risk premium = compensation for possibility of default. The higher the default risk, the
higher the default premium
35
Term structure of interest rates

Bonds of different maturity usually have different yields.

The Term Structure is the relationship between maturity

and yields, all else equal.

The Yield Curve is the graph of the term structure

¤ Normal – upward-sloping, long-term yields are higher
than short-term yields
¤ Inverted – downward-sloping, long-term yields are
lower than short-term yields
¤ Other shapes – e.g.,humped.

36
Upward-Sloping (Govt) Yield Curve

Risk (default)
Free Rate

Risk free rate – theoretical rate of return on zero default risk

investment 37
Downward-Sloping (Govt) Yield Curve

Risk Free Rate

38
Walt Disney Co.'s Sleeping Beauty
Bonds

39
Walt Disney Co.'s Sleeping Beauty
Bonds. Continued
Walt Disney company was founded in October, 1923.
The company is best known for the products of its film studio.
In July 1993 the Walt Disney Company issued $300,000,000 in senior
debentures. The debentures carried a coupon of 7.75%, payable semi-annually,
and were priced at par.
They are due to be repaid in July 15, 2093, a full 100 years after the date of
issue. However, at the company’s option, the debentures could be repaid (in
whole or in part) at any time after July 15, 2023 (in 30 years) after the issue
date.

1. Why did Disney issued 100-year bonds?

2. What are the risks of issuing 100-year bond from Disney’s perspective?
3. What are the risks of buying 100-year bond from the investor
(bondholder) perspective?
4. Why did the Disney bonds have a higher yield than 30-year U.S. Treasury
bonds? 40
Key insight

1. Conventional bonds are financial claims with promised cash flows of

known fixed amount paid at fixed dates
2. The essential features of most fixed-interest securities are that:
the interest rate, which is the price of the loan of the funds to the borrower, is
set at the start of the loan period and the face value (the principal) is fixed
4. Price of a bond is the present value of expected cash flows:
a) Coupon bonds: PV of annuity + PV lump sum
b) Zero coupon bonds: PV lump sum

5. When market yields decline (rise), fixed coupon bonds rise (decline) in
price because investors are attracted (not attracted) to the higher coupons
compared to new bonds
6. Treasury yield is used as a benchmark rate to reflect expected inflation and
term premium
7. Interest rates for corporate bonds compensate investors on uncertainties due
to: Interest rate risk being higher for longer-term bonds, Inflation outlook,
Bankruptcy probabilities
8. Corporate yield is quoted higher than an equivalent treasury yield at the
same maturity because of default likelihood for corporate businesses 41