Intro To Corporate Finance and Investments Topic: Valuing Bonds

INTRO TO CORPORATE FINANCE AND INVESTMENTS
TOPIC: VALUING BONDS

Professor
M. Max Croce
SDA Bocconi Asia Center I Capital Markets

Outline
 Bonds
 How Bonds Are Priced and Quoted
 Term Structure of Interest rates
 Inflation Protected Bonds
 Why bonds are risky:

 Interest Rate Risk
 Risk and Term Structure
 Real rates and the capital market
 Inflation risk and monetary policy
 Risk of Default
 Corporate default
 Sovereign default

Bonds Valuation

Terminology
 Bond: Security that obligates the issuer to make specified payments to the bondholder.
 Face value (par value or principal value) - Payment at the maturity of the bond.
 Coupon - The interest payments made to the bondholder.
 Coupon rate - Annual interest payment, as a percentage of face value.
 Note on Coupon Rate:

 The coupon rate IS NOT the discount rate used in the present value calculations.
 The coupon rate merely tells us what cash flow the bond will produce
 Since the coupon rate is listed as a %, this misconception is quite common

Valuing a Bond
 The price of a bond is the present value of all cash flows generated by the bond (i.e. coupons and face value)
discounted at the required rate of return, i.e., yield to maturity
cpn cpn (cpn  par)

PV    .... 
(1  r ) (1  r )
1 2
(1  r ) t
 Note: “cpn” is commonly used as an abbreviation for “coupon”

 Note: given the market price of the bond and its cash-flow payment, the yield to maturity can be computed as the
internal rate of return (IRR)

Example - France
 In October 2014 you purchase 100 euros of bonds in France which pay a 4.25% coupon every year. If the
bond matures in 2018 and the YTM is 0.15%, what is the value of the bond?
4.25 4.25 4.25 104.25

PV    
1.0015 1.0015 2
1.0015 1.0015
3 4
 116.34 euros

An Alternative Pricing Equation
 PV(bond) = PV(annuity of coupons) + PV(principal)

 Previous example continued:
PV (bond)  (cpn  PVAF)  (final payment  discount factor)

 1 1  100
 4.25    4

 .0015 .00151  .0015  1  .0015
4
 116 .34

Example: Corporate Bonds and Terminology
 If today is October 1, 2015, what is the value of the following bond? An IBM Bond pays $115 every
September 30 for 5 years. In September 2020 it pays an additional $1000 and retires the bond. The bond
is rated AAA (WSJ AAA YTM is 7.5%)
115 115 115 115 1,115

PV     
1.075 1.075 2
1.075 1.075 1.075 5
3 4
 $1,161.84

How Bonds are Traded and Quoted
 Bonds prices are usually quoted as a % of the face value. For example, if the face value is 1000 and the price is 1100,
then the bond is quoted at 110%.
 If the current price is greater than the face value, the bond sells at a premium. Why? High coupons or safe asset
 If the current price is lower than the face value, the bond sells at a discount. Why? Low coupons or risky asset
 Bonds are usually traded Over-the-Counter not on exchanges. This means that buyers need to contact a dealer (big
intermediary). Retail-level buyers contact a broker who contacts the dealer.
 Since there is a 1-to-1 negative link between price of a bond and IRR, often only yields are quoted:
 Bloomberg indices for 10y gov. bonds: [here]
 Comparison across major countries: [here]
 Data on India [here]

How Bonds are Traded and Quoted (II)
 We saw before that some bonds may have a maturity shorter than one year (Bills)
 The US government pays coupon semiannually
 How do we think of the YTM in these cases?
 Rule: compute the YTM using the frequency of the cash-flow payments, then annualize it!
 Example: In November 2014 you purchase a 3 year US Government bond with Face value of 1000. The
bond has an annualized coupon rate of 4.25% (APR), paid semi-annually. If the annualized YTM is 0.965%
(APR), what is the price of the bond?
21.25 21.25 21.25 21.25 21.25 1021.25

PV      
1.004825 1.004825 2 1.004825 3 1.004825 4 1.004825 5 1.004825 6
 $1,096.90

Term Structure

Term Structure of Interest Rates
 Definition: a graph (or table) showing yields of bonds of different maturities measured at a given time
Maturity 1 2 5 10
1/1/2007 2 2.7 3 4
1/1/2017 0 0 2 5
Chart Title
6
0
1 2 5 10
1/1/2007 1/1/2017
 Updated data [here]

Short-Term Rates Change across Countries and over Time
 Central Banks and the Business Cycles are at work [From OECD here]

Long-Term Rates Change across Countries and over Time
 Long term rates are a reflection of long-run expected economic growth, inflation and uncertainty [From OECD here]

US Nominal Rates and Inflation
 Inflation is a common component: relevant for all maturities.

India Nominal Rates and Inflation

The U.K.

Term Structure of Interest Rates: Sources
 Term Structures Change daily! Many countries [here].

Real Bonds (Inflation-Indexed Cash-Flows)

Term Structure of Real Interest Rates
 Treasury Inflation-Protected Securities (TIPS): provide insurance against inflation because the payments are
increased (or decreased) with inflation (with deflation). The US government commits not to decrease the face value
if cumulative inflation has been negative.
 Not all government offer inflation-indexed bonds, but both the US and the UK.
 Example 1: consider a zero-coupon real bond with maturity of 2 periods. Assume that FV=100 at time zero and that
Inflation is 1% in period one and 2% in period 2.
 The government pays a final face value of
max (100, 100*(1.01)*(1.02))
that is about 103.
 Example 2: consider a zero-coupon real bond with maturity of 2 periods. Assume that FV=100 at time zero and that
Inflation is 1% in period one and -2% in period 2.
 The government pays a final face value of
max(100, 100*(1.01)/(1.02)) = 100

Real vs Nominal Yields

Inflation: Recent Times
 Recent updates on inflation in different areas [From OECD]

Take-Aways So Far
 The yield curve tells us which discount rate is appropriate according to the duration of the cash-flow you are
discounting
 Use short-term yields for short-duration projects
 Use long-term yields for long-duration projects
 Use real yields for cash-flows that tend to adjusts with inflation (say, for example, gold or real estate)
 Yields curve data are available for many-many countries, which is important for international corporation
 Inflation is a major determinant of nominal yields over time: Why bother?

 As nominal yields change, the value of the bond changes as well and exposes us to financial risk (see next
slides!)
 As nominal yields change, the NPV of your projects changes as well

The Riskiness of Bonds

Bond Holding Returns
 Assume to buy today, t, a bond with maturity of n>1 periods at price P(t,n). Assume to sell the bond tomorrow, t+1.
Your holding return is:
 R(t+1,n)=P(t+1,n-1)/P(t,n) for zero-coupon bonds
 R(t+1,n)=(P(t+1,n-1) + C(t+1))/P(t,n) for regular bonds
 Example 1: you buy a 2-period bond with FV=100 at 100. You sell it after one period at 98 and cash a coupon of 3.
Your gross return is (98+3)/100=1.01 -> 1% net return.
 Example 2: you buy a 2-period zero-coupon bond with FV=100 with a yield of 5%. You sell it after one period knowing
that the new yield curve gives you a yield of 4% for 2-period ZCBonds and 1% for 1-period ZC-bonds.
 Let’s prove in class that your net return is about 10%.
 Big lesson: as the yields (rates) change according to market forces, your wealth invested in bonds changes as well!
There is risk unless (1) you hold the bond until maturity, and (2) the bond issuer does not default.

Maturity and Price Sensitivity (Risk!)
Different maturity bonds have different interest rate risk
2,500
Blue line: long-term bond

2,000
Orange line: short-term bond
Bond price ($)
1,500
1,000
500
4.5
8.5
0
0.5
1.5
2.5
3.5
5.5
6.5
7.5
9.5
10
Interest rate (%) = YTM

Duration: Definition and Formula
 Def: it is a measure of the timing of the cash-flow payed by the bond. A (short) long duration means that most of the
cash-flow is paid in the far (near) future.
1 PV (C1 ) 2  PV (C2 ) 3  PV (C3 ) T  PV (CT )

Duration     ... 
PV PV PV PV

Example on Duration with xlsx Spreadsheet
Proportion of Total Proportion of Total

Year Ct PV(C t ) at 5.0% Value [PV(C t )/V ] Value Time
1 100 95.24 0.084 0.084
2 100 90.7 0.08 0.16
3 1100 950.22 0.836 2.509
V = 1136.16 1 Duration= 2.753 years

Modified Duration and Risk
 The elasticity (% variation) of the price of a bond w.r.t. the interest rate is equal to the modified duration
duration
Modified duration  volatility (%) 
1  yield
Bond price, percent
Interest rate, percent

Example on Modified Duration
 Calculate the modified duration of a 6 7/8% bond with a maturity of 5 periods @ 4.9% YTM
Year CF PV@YTM% of Total PV % × Year

1 68.75 65.54 .060 0.060
2 68.75 62.48 .058 0.115
3 68.75 59.56 .055 0.165
4 68.75 56.78 .052 0.209
5 1068.75 841.39 .775 3.875
1085.74 1.00 Duration 4.424
 Modified duration: 4.42/(1.049)= 4.21. What should the price be if the YTM goes to 5.9%?
Back to the Term Structure (I)
 Terminology:
 Spot Rate - The actual interest rate today (t = 0)
 Forward Rate - The interest rate, fixed today, on a loan made in the future at a fixed time
 Future Rate - The spot rate that is expected in the future
 Forward rates can be recovered from the yield curve recursively by no-arbitrage:
 Example: y(t,2) = 4% and y(t,1) = 2% implies a forward rate FR(t+1,1) = 4%*2-2% = 6% (approximately)
 Forward rates in the data are not identical to the expected future short-term rates because of uncertainty!
 In a forward contract we commit to a future interest rate before knowing whether it is convenient according to
future market forces

Back to the Term Structure (II)
 Assume to face an upward sloping term structure, here is what could be going on in the background:
 Expected future real rate are higher than the current ones
 Expected future inflation is higher than the current one
 Future uncertainty is higher than present one (on either real rate or inflation)
 Long-term bonds are less liquid than others and hence there is a liquidity premium
 Given these claims,

what do you think of this figure on US data?

A Simple Way to Think About Term Structure Risks

The Real and the Nominal Rates
 Nominal yields can always be thought as the sum of two components:

nominal yield = real interest rate + expected inflation
 Real rate:
 determined by the equilibrium of the capital markets
 Nominal rate:
 Once we know what is happening to the real real rate, we just need to think about forecasting inflation
 Think of the production costs (businesses set prices of goods and services)
 Think of the reaction of the Central Bank (Monetary Policy)

The Capital Market
Fixed Assets | Liabilities

Financial vs Real Investment: What is the difference?
Example 1
 Mary and friends decide to start their own company. To start their business, they need $5M to:
 Build a new commercial space
 Buy new office furniture, equipment and software
 Mary and friends have only $4M. They put this money down as equity. Joe lends $1M by buying a corporate bond issued by
Mary’s company.
 Is there financial volume? Is there real investment?
Example 2
 Joe suddenly needs cash and decides to sell his bond issued by Mary’s company. Ravi buys it, as he thinks that this bond is a
convenient investment vehicle.
 Is there financial investment? Is there real investment?

Whatever is produced but not
consumed is saved. The supply
A Chart for the Capital Markets of savings determines
investment.
Investment is a sizeable
component of GDP (15% in the
US) and is the key device to
accumulate capital
stock/infrastructures.
Consumers/Investors
Resources for Savings
Investment
Firms
Financial (Capital) market

Cost of Capital Capital Income

National Accounting and Capital Markets
 In National Accounting, the following holds:

Stot = Spvt + Sgovt = I + NX
 In the Global Economy, NX=0 (at the world level all net exports cancel with net imports), and the capital market clear
when:
Stot = I
 What makes sure that the market clears?

 The real risk free rate adjusts!

A Way to think about Consumption/Saving Decisions
Ct = C(Yt-Tt, Yf - Tf, Wealth, risk, credit, r)

+ + + - + -
 Ct = current demand of real consumption goods and services
 Yt –Tt = current real income after taxes
 Yf –Tf = expected real future income after taxes
 Wealth = real value of wealth
 Risk = related to health, unemployment, natural disasters,…
 Credit = available credit in the financial sector
 r = real interest rate
 Substitution Effect (SE): r↑→more incentive to save, C↓

Total Savings in a Graph
SLOPE What shifts the
curve to the left?
r r↑→savings↑, as C t ↓ r Yt↓, G t↑, Y F↑, Wealth ↑, risk↓
Total Savings Total Savings

Desired Investment
 Desired investment is:

I = I( r, pK , MPKf , t, credit conditions)
 r is the interest rate:

 Capital Budget rules: As r↑→Net Present Value (NPV)↓→I↓
 pK is the price of equipment goods (initial cost of the project);
 MPKf is the expected future productivity of new capital (expected cash-flows);
 t is a measure of Effective Tax Rate on capital (ETR)

 sum of all taxes and shields affecting capital expressed in equivalents of corporate income tax ( t)

Investment in a Graph
Id = I( r, pK , MPKf , t corp, credit)
- - + - +
What shifts the curve to the right?

SLOPE: r↓→NPV ↑ → I↑
pk↓, t↓, MPKf ↑ , credit ↑
r r
Investment Investment

The Equilibrium
Total Savings
Investment
S, I

Example: Better Health Care
 Think about Rural China: Chinese saving rate is expected to fall as soon as the country
will introduce better health insurance in the country side (where most of the savings
come from!)
Total Savings
Investment
S, I

Example: Increase in Government Deficit
 If G = government expenditure increases, there is crowding out of private investment.
Total Savings
Investment
S, I

Example: A Positive productivity Shock
 Think about the IT revolution: expected future productivity increases
Total Savings
Investment
S, I

Monetary Policy

Money Demand
 Demand of Money: comes from a portfolio allocation problem
 Trade-off: Given a certain amount of wealth, households have to decide how much cash to hold versus other
financial assets:
 BENEFITS OF CASH: liquidity services;
 COST of CASH: nominal interest rate i.

Supply of Money: the role of the Central Bank
 The Central Bank directly controls the monetary base, i.e., the currency component of M1
 The Central Bank changes the money supply through Open-Market Operations (OMO)
• Central bank purchases financial assets (e.g. government bonds) => Ms
• Central bank sells financial assets => Ms
 In practice, transmission of monetary policy is a bit more complicated and based on REPO rates
 (beyond the scope of our class)

Money (left) and Bonds (right) Market
Bonds
i
Money P of Available
Supply bond
1
i1
1
P1
Money Bond Face Value

Expansionary OMO
i
Money P of
Supply Bonds
bond Available
1
i1 2
P2
2 1
i2 P1
Money Bond Face Value
Rember that P. of bond  when i  and viceversa.

Transmission Mechanism of Monetary Policy
 Prices of goods and services are somewhat sticky, i.e., they adjust with delay:
 Over the short run it is possible to have more (less) money growth without additional inflation adjustments, i.e.,
the real rate moves 1:1 with the nominal rate:
↑↓r = ↑↓i - inflation
 Over the short-run, controlling the nominal interest rate is equivalent to control the real rate, i.e., the main
determinant of consumption (C) and corporate investment (I).
 High rates, low demand of C+I
 Low rates, high demand of C+I

Objective of Monetary Policy
1. Stabilize GDP growth around its trend=potential/natural growth.

How?
 Avoid excessive growth by increasing the rates
 Avoid cyclical recessions by reducing the rates
 Output gap = Current GDP - Potential GDP
→ The central bank needs to stabilize the output gap
2. Stabilize inflation around target
 Avoid excessive inflation by increasing the rates
 Avoid deflation by reducing the rates

RBI and inflation
Global Great
Recession
Ordinary RBI Mon.

Pol. is back
SDA Bocconi
Copyright Asia Center
© 2017 McGraw-Hill I Capital
Education. Markets
All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Conventional vs Unconventional Monetary Policy
 Conventional:
 Move the short-term rates
 Unconventional Policies (Quantitative Easing):

 US ZLB: Dec 2008
 US QE 1 [Nov 2008 - March 2010]: lower long-term mortgage rate.
 US QE 2 [Nov 2010 – Dec 2013]: Buy 85 Bil.s of 10y Treasury Bonds every month.
 EU QE 1 [June 2012]: Buy Treasuries from PIGS [politically tricky]

 EU ZLB: June 2014
 EU QE 2 [Oct 2014]: Buy private long-term securities
 Tapering – beginning of exit strategy from QE, the Central Bank slowly reduces the injection of cash
 US: Dec 2013 – Oct 2014
 EU: promised to start in mid 2019

Why QE May Have Helped the Economy?
 EXAMPLE. Consider a project requiring an investment of $1 and paying $2 over 10 years.

 Assume the short-term rate over 1-year is equal to 1%, and a 10-year yield of 9%: NPV = -1 + 2/(1.09)^10 = -0.16
 Assume the short-term rate over 1-year is equal to 0%, and a 10-year yield of 8%: NPV = -1 + 2/(1.08)^10 =
-0.074
 Assume the central bank reduces the 10-year yield to 7%: NPV = -1 + 2/(1.07)^10 = +0.0167 → investment
increases by $1.
 Long-story-short: at the zero-lower-bound, central banks manipulate the entire yield curve!

Key Factors for the Yield Curve in India
 The article ``Factors causing movements of yield curve in India” by Kakali Kanjilal (IMI), published in Economic
Modeling:
 The article identifies principal reasons underlying the movements of yield curve for government debt market in
India for the period Jul '97 to Dec '11. […]
 99% of the movements in yield curves in India are explained by three factors which are ‘level’ (long-term factor),
‘Slope’ (short-term factor) and ‘Curvature’ (medium-term factor) with ‘level’ contributing more than 90% of its
variations.
This implies that in more than 90% of cases, the yield curves move parallel either in upward or in downward
direction bringing similar effects to all maturity spectrums. This means that yield curve movements in India mainly
reflect the monetary policy changes of central bank. […]
 [ADVANCED TOPIC:] This finding also suggests that a simple ‘duration and convexity’ hedging strategy should be
appropriate to cover maximum risk exposure of government debt market investors in India.

Default Risk

Definitions
 Default or Credit Risk - The risk that a bond issuer may default on its bonds
 Default premium - The additional yield on a bond that investors require for bearing credit risk
 Investment grade - Bonds rated Baa or above by Moody’s or BBB or above by Standard & Poor’s
 Junk bonds - Bond with a rating below Baa or BBB

Definitions (II)
Standard
Moody' s & Poor's Safety
Aaa AAA The strongest rating; ability to repay interest and principal
is very strong.
Aa AA Very strong likelihood that interest and principal will be
repaid
A A Strong ability to repay, but some vulnerability to changes in
circumstances
Baa BBB Adequate capacity to repay; more vulnerability to changes
in economic circumstances
Ba BB Considerable uncertainty about ability to repay.
B B Likelihood of interest and principal payments over
sustained periods is questionable.
Caa CCC Bonds in the Caa/CCC and Ca/CC classes may already be
Ca CC in default or in danger of imminent default
C C C-rated bonds offer little prospect for interest or principal
on the debt ever to be repaid.
SDA Bocconi
Copyright Asia Center
© 2017 McGraw-Hill I Capital
Education. Markets
All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Prices and Yields of Corporate Bonds

Credit Rating and Risk in India
 The article “Modelling Credit Risk in Indian Bond Markets” by Varma (IIM) and Raghunathan (IIM) on the Journal of
Applied Finance.
 […] In this paper therefore, we analyse credit rating migrations in Indian corporate bond market to bring about
greater understanding of its credit risk.
 Probability of an upgrade within a quarter: 1%-4%

 Probability of being upgraded by one notch: 80% (very rare 2 notches at the time)
 Probability of a downgrade within a quarter: 2%-8%

 Probability of being upgraded by one notch: 40% (2 notches at the time is frequent)
 Why do we care? Assume that you have a AAA bond with a yield of 5%. Assume that it may migrate to BBB and pay a
yield of 7% with probability 50%. What is your expected loss? Let’s do it in class!

Yield Spread
Yield Spreads between Corporate and 10-year Treasury Bonds

Corporate Credit Spread in India
 The Article “The impact of monetary policy on corporate bonds in India” by Sensarma (IIM) and Bhattacharyya (RBI)
published in Journal of Policy Modeling:
 [They] analyse the impact of monetary policy on the shape of the corporate yield curve and credit spread using
a macro-finance approach. […] we use market proxies of level, slope and curvature of the corporate yield curve
and credit spread.
 The results demonstrate that while monetary policy has the dominant impact among macroeconomic variables
on the entire term structure, it is particularly strong at the short end and on credit spreads.
 When RBI tightens monetary policy, the entire corporate yield curve shifts up for 8 months. The shifts is almost
parallel, but stronger on the short-term yields.
 Monetary policy tightening increases the corporate yields through 2 channels: it increases government yields,
but it also increases the credit spread with a delay of about 6 months.
 Monetary Policy explains most of the movements of the corporate yield curve as well, but with a delay of 6
months.

Sovereign Default Risk
 Government may default as well!

 `Developed’ Countries like Greece may default because they run our of fiscal capacity
 `Emerging Economies’ may default because:
 They feature poor economic growth
 Lack of fiscal capacity
 They have (``cheaper’’) debt in foreign currency and their domestic currency become too weak
 Other forms of default:

 Pay debt by issuing more money and have excessive inflation (real return to bond investors declines).
 Pay local currency denominated debt but after having devaluated the local currency

Relevance of the Problem [here]
 Sovereign external debt, 1800-2008: Percentage of countries in external default or restructuring weighted by their share of
world Production
45
Share of Countries in Default
40
35
As percentage of World Income
30
25
20
15
10
 Let’s see who-is-who [Europe and Latin America] [Africa and Asia]

THANKS YOU

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INTRO TO CORPORATE FINANCE AND INVESTMENTS

TOPIC: VALUING BONDS

SDA Bocconi Asia Center I Capital Markets

 Why bonds are risky:

SDA Bocconi Asia Center I Capital Markets

SDA Bocconi Asia Center I Capital Markets

 Note on Coupon Rate:

SDA Bocconi Asia Center I Capital Markets

cpn cpn (cpn  par)

 Note: “cpn” is commonly used as an abbreviation for “coupon”

SDA Bocconi Asia Center I Capital Markets

4.25 4.25 4.25 104.25

SDA Bocconi Asia Center I Capital Markets

 PV(bond) = PV(annuity of coupons) + PV(principal)

PV (bond)  (cpn  PVAF)  (final payment  discount factor)

SDA Bocconi Asia Center I Capital Markets

115 115 115 115 1,115

SDA Bocconi Asia Center I Capital Markets

SDA Bocconi Asia Center I Capital Markets

21.25 21.25 21.25 21.25 21.25 1021.25

SDA Bocconi Asia Center I Capital Markets

SDA Bocconi Asia Center I Capital Markets

 Updated data [here]

SDA Bocconi Asia Center I Capital Markets

SDA Bocconi Asia Center I Capital Markets

SDA Bocconi Asia Center I Capital Markets

 Inflation is a common component: relevant for all maturities.

SDA Bocconi Asia Center I Capital Markets

SDA Bocconi Asia Center I Capital Markets

SDA Bocconi Asia Center I Capital Markets

SDA Bocconi Asia Center I Capital Markets

SDA Bocconi Asia Center I Capital Markets

SDA Bocconi Asia Center I Capital Markets

SDA Bocconi Asia Center I Capital Markets

SDA Bocconi Asia Center I Capital Markets

 Inflation is a major determinant of nominal yields over time: Why bother?

SDA Bocconi Asia Center I Capital Markets

SDA Bocconi Asia Center I Capital Markets

SDA Bocconi Asia Center I Capital Markets

Blue line: long-term bond

SDA Bocconi Asia Center I Capital Markets

1 PV (C1 ) 2  PV (C2 ) 3  PV (C3 ) T  PV (CT )

SDA Bocconi Asia Center I Capital Markets

Proportion of Total Proportion of Total

SDA Bocconi Asia Center I Capital Markets

Bond price, percent

Interest rate, percent

Year CF PV@YTM% of Total PV % × Year

SDA Bocconi Asia Center I Capital Markets

 Given these claims,

SDA Bocconi Asia Center I Capital Markets

SDA Bocconi Asia Center I Capital Markets

 Nominal yields can always be thought as the sum of two components:

SDA Bocconi Asia Center I Capital Markets

Fixed Assets | Liabilities

SDA Bocconi Asia Center I Capital Markets

 Is there financial volume? Is there real investment?

 Is there financial investment? Is there real investment?

SDA Bocconi Asia Center I Capital Markets

Financial (Capital) market

SDA Bocconi Asia Center I Capital Markets

 In National Accounting, the following holds:

 What makes sure that the market clears?