CHAPTER FOURTEEN
BOND ANALYSIS
CAPITALIZATION OF INCOME METHOD
PROMISED YIELD-TO-MATURITY
•
In equation formwhere P=the current market price of bond n=the number of years to maturity Ct=the annual coupon payment
y=the prevailing yield to maturity
n
t t
t
y P c
1 (1 )
CAPITALIZATION OF INCOME METHOD
INTRINSIC VALUE
•
In equation form
nt t
t
y V c
1
( 1 )
CAPITALIZATION OF INCOME METHOD
SOLVING FOR V,
•
Given the current market price (P), the investment decision is
if V is the intrinsic value andV>P buy the bond
V<P don’t buy
CAPITALIZATION OF INCOME METHOD
ALTERNATIVELY
•
SOLVING FOR y*y
*>y bond overprice
y
*<y bond underpriced
BOND ATTRIBUTES
SIX ATTRIBUTES that affect a bonds value
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LENGTH OF TIME TO MATURITY•
COUPON RATE•
CALL PROVISIONS•
TAX STATUS•
MARKETABILITY•
LIKELIHOOD OF DEFAULTLENGTH OF TIME TO MATURITY
COUPON RATE AND LENGTH TO MATURITY
•
these attributes determine size and timing of cash flow•
yield-to-maturityCALL PROVISIONS
CALL PROVISIONS
•
DEFINITION: a provision in some bond indentures that permits an issuer to retire some or all of the bonds in a particularissue prior to maturity date stated
CALL PROVISIONS
CALL PROVISIONS
•
Issuer may find it advantageous to call existing bond
if market interest rate is lower
replace existing bonds with lower rate bondsTAX STRUCTURE
TAX STRUCTURE
•
Taxation affects bond prices and yields
low-coupon bonds selling at a discount provide return in– coupon payments
– gains from price appreciations
taxes on appreciations may be deferred until bond sale or maturity
discount bonds have a tax advantageTAX STRUCTURE
TAX STRUCTURE
•
Taxation affects bond prices and yields
because of tax effect, discount bonds should have a slightly lower before-tax yield
low-coupon bonds will have a slightly higher intrinsic valueMARKETABILITY
MARKETABILITY
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refers to the ability of the investor to resellMARKETABILITY
MARKETABILITY
•
bid-ask spread is one indicator of marketability
the higher the spread, the less marketable
the lower the spread, the more marketable•
bonds that are actively traded should have a lower YTM and a higher VMARKETABILITY
MARKETABILITY
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bonds that are actively traded should have a lower YTM and a higher VLIKELIHOOD OF DEFAULT
LIKELILHOOD OF DEFAULT
•
Bond ratings provided by professional services.LIKELIHOOD OF DEFAULT
LIKELILHOOD OF DEFAULT
•
Two most famous include
Moody’s Investors Services, Inc.
Standard & Poor’s Corporate ratingsLIKELIHOOD OF DEFAULT
LIKELILHOOD OF DEFAULT
•
Categories
investment grade usually the bonds in the top four ratings
speculative
often called junk bondsLIKELIHOOD OF DEFAULT
LIKELILHOOD OF DEFAULT
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Bond ratings provided by professional services.
better ratings are generally associated with– larger financial leverage
– larger firm size
– larger and steadier profits
– large cash flows
– lack of subordination to other debt series
