LONG TERM SOURCES FINANCE (understanding bond valuation)
If we take a look at the statement of financial
position equation (A= L+E), we could infer that asset column which represents
investment is finance by liability and equity. However, in finance we don’t
call it liability, the term used is debt. Hence, an entity is finance via debt
and or equity.
Focusing on debt which can be structure in a
variety of ways in particular reference to need it has to meet. The primary
types of debt are
·
Irredeemable
·
Redeemable
The term redeemable means debt will be repaid
back at a pre-specified future date e g 10% redeemable debt 2016. Means the
debt will pay 10% interest annually until the bullet payment of the principal
together with the interest on repayment date (year 2016), meaning the debt has
a maturity period of five years commencing from 2012. While irredeemable means
the debt has no pre-specified future repayment date.
Other forms of debt:
Zero coupons
A zero coupon debt is a debt that does not pay
annual coupon throughout the life of the debt. It will however pay accrued
interest and principal at the redemption date. The accrued interest is
calculated based on an effective rate e g treasury bill
Convertible debt
A convertible debt is an option like hybrid
security that has both debt and equity instrument in it. The holder has the
right but not an obligation to convert the debt to equity when the condition is
favourable within a specific period, if this period expires and the holder do
not convert it will be redeemed. The right the holder owns come with a cost
which is in form of a lower coupon rate in relative to a redeemable (straight)
debt.
Deep discount
A deep discount debt is a structured financial
obligation issued at high discount than would otherwise have been issue if the
company had been known in the market. This is done in order to avoid
under-subscription of debt.
Debt can be raised from the bank or from the
market. Debt raised from the bank is called loan while the one raised from the
capital market are called bonds.
What are bonds?
In its simplest form, bond is a financial
obligation of an entity that promises to pay specified sum of money at specific
future dates. The entity that promises to make the payment is called the issuer
of the security. The promised payment that the issuer agrees to make at the
specified dates consist of two components: interest and principal (principal
represents repayment of funds borrowed) payments.
BASIC BOND
FEATURES
Maturity
The term maturity of a bond is the number of
years the debt is outstanding or the number of years remaining prior to final
principal payment. There are three reasons why the term to maturity of a bond
is important:
·
Term
to maturity indicates the time period which the bondholder can expect to
receive interest payments and the number of years before the principal will be
paid in full.
·
The
yield/market rate offered on a bond depends on the term to maturity. The
relationship between the yield and maturity is called the yield curve.
·
The
price of a bond will fluctuate over the life as interest rates in the market
change.
Par value
In this course we will assume a unit of bond id
quoted at $100.
Coupon rate
Also called the nominal rate is the interest
rate that the issuer agrees to pay each year. The annual amount of the interest
payment made to bondholders during the term of the bond is called the coupon.
Coupon = coupon rate X par value
Market rate
Market rate is also known as market yield and
cost of debt. This is the rate the market is asking for based on the risk inherent
on the source of repayment of the loan i e the cash flows that will repay the
debt.
At the inception of raising a bond the market
rate determines the coupon rate that the company will issue its bond, the
company does this in order to raise the bond at the par value and for its full
subscription. However, as time elapse the market rate will defer from the
coupon rate and making the market value of debt to defer from the par value.
The following is the relationship between coupon rate, market rate and the
market value of debt.
Factors that determine the market rate:
1. The term structure
of interest rate
·
Pure
expectation theory
states that the short term interest and inflation determines the long term
interest for example, an investors that wants to invest in 2 year maturity bond
has two options. One is to invest in 2 years bond directly or invest in 1 year
bond and at the expiration invest the principal and accrued interest in another
1 year. To attract investor to the 2
year bond the total return on either option should be the same if not and
arbitrage will set in which will bring the value to zero.
·
Liquidity
preference theory
states that in addition to the short term interest rate and inflation that
determine long-term rate, investors will demand a premium to compensate for the
not holding cash for a longer period of time. The longer the maturity the
higher the liquidity premium investors will demand.
·
Market
segmentation theory
states that each maturity bond is treated as a segment in the market. That is 7
year maturity has a separate segment from a 5 year maturity and the supply and
demand and a segment will determine the interest rate in each segment of the
market. If the demand in 5 year maturity bond is higher and the yield offered
in this segment of the market is attractive than the 7 years maturity,
investors in other segment of the market will move the funds to the five year
maturity to earn a higher yield. This explains the reason why in practice yield
curve are not upward sloping as stated in the biased theories.
2. Economic
condition: if the economy is booming CB tends to increase discount rate and cut
rate when the economy is in recession.
3. Monetary policy:
see the reading below on central bank
4. Inflation:
investors will want to be compensating for increase inflation so as not erode
their purchasing power and their value of the bond.
5. Credit risk: the
credit risk of the company entails default risk, which is the ability of the
company to fulfil its financial obligation on its interest and principal
repayment as when due. Downgrade risk, risk that the credit rating of the
company will be downgraded as well as the credit spread risk, risk that the
credit spread will widen.
6. Collateral: is the
bond secured on any specific non-current assets such as land and building which
lower the interest rate or unsecured which will increase its interest rate? The
subsequent performance of the security will affect the subsequent market rate
after the issue of the bond.
Market value of the bond
The market value of the bond is the computed by
discounting the future contractual cash inflow of the bond by the market
rate/cost of debt.
The following are factors that influence the
market value of traded bond as represented in the bond valuation:
I.
Coupon
payment:
the market value of a traded bond will increase as the coupon paid on the bond
increases, as the return offered of owning the bond becomes more attractive.
II.
Market
rate/cost of debt:
the rate of return required by the investor heavily influences the present
value of coupon payment. The higher the required rate of return, the lower the
value of a traded bond and vice versa.
III.
Redemption
value:
the higher the redemption value of a bond the higher the market value of a
traded bond.
IV.
Redemption
period:
the market value of traded bonds is affected by the period of redemption,
either because the capital payment becomes more distant in time or because the
number of interest payments increases.
V.
Frequency
of coupon payments:
if coupon payment is more frequent, say quarterly or bi-annually than every
year, then the present value of the interest payments increases and hence so
does the market value.
VI.
Embedded
options:
embedded options like convertibility which entail option to convert to equity.
The market price will be influenced by the likelihood of the future conversion
and the expected conversion value, which is dependent on the current share
price, the future share price growth rate and the conversion ratio.
VII.
Collateral: the quality of
the collateral at any point in the life of the bond affects the market value of
the bond.
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