What is debt?
– Debt securities are issued when a company (or government) wishes to borrow money from the public on a long-term basis.
– Bonds are issued by the government.
– Debentures are secured and issued by a corporation.
– Notes are unsecured corporate securities.
– Investor has claims to a fixed sequence of cash flows and the repayment of the face value on maturity
How do you value debt?
To value debt, you will need to determine the present value of future cash flows from the ownership of a debt security
- PMT= coupon interest payment to be received at end of period n
- n = the years to maturity
- FV = face value or par value to be received at end of period n
- rd = the investor’s required rate of return / yield to maturity (cost of debt)
- PV = bond price
What is Yield To Maturity?
The required rate of return that investors expect to receive from the bond investment (cost of debt)
The market interest rate that equates a bond’s present value of interest payments plus principal repayment with its price.
Note: There is an inverse relationship between market interest rates (YTM) and bond prices.
What is the relationship between coupon rate and yield to maturity?
If the coupon rate = YTM, the bond will sell for the face value
If the coupon rate > YTM, the bond will sell for a premium
If the coupon rate < YTM, the bond will sell for a discount
Why would two different bonds trading in the secondary market with the same term to maturity and the same required return on investment have different cash flows.
The Bonds were issued in the primary market at different time periods, and hence different prevailing coupon rates.
In an efficient market, if the term to maturity is the same, the return on investment should be the same.
What is interest rate risk?
Interest rate risk is the risk that arises for bond owners from changes in interest rates.
All other things being equal, the longer the time to maturity, the greater the interest rate risk.
All other things being equal, the lower the coupon rate, the greater the interest rate risk.
Bonds Questions
Question 1:
Suppose our firm decides to issue 20-year bonds with a par value of $1,000 and annual coupon payments. The return on other bonds of similar risk is 12%, so we decide to offer a 12% coupon interest rate.
Question 2:
Suppose now our firm decides to issue 20-year bonds with a par value of $1,000 and semi-annual coupon payments. We still offer a coupon rate of 12% but immediately after issue, interest rates rise to 14%
a) What happens to the price of these newly-issued bonds?
b) What would be a fair price for these bonds?
Question 3:
Bond A was issued in Oct 2001 – coupon rate 6.5%
Bond B was issued in Oct 1996 – coupon rate 4.0%
Interest is paid at the end of March and September for Bond A and Bond B. Both Bonds have a face value of $100 and mature in 2011. Today is October 2006. Similar risk bonds pay coupons of 5%
– What price would you pay for Bond A and Bond B?
Question 4:
Suppose that at the end of 2006 the following term structure of interest rates for securities is observed:
one year (maturity end 2007) – 15.0%
two years (maturity end 2008) – 12.5%
three years (maturity end 2009) – 11.5%
Calculate the interest rate on:
a) a one-year bond issued at the end of 2007
b) a one-year bond issued at the end of 2008
c) a two-year bond issued at the end of 2007