Tuesday, 4 August 2015

understanding bond valuation




 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.

    Market rate = coupon rate = market value of debt is @ par ($100)

     Market rate > coupon rate = market value of debt is @ discount (less than $100)

      Market rate < coupon rate = market value of debt is @ premium (greater than $100)

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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