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VALUING BONDS

Investment in new plant and equipment requires money often a lot of money. Sometimes firms may be able to save enough out of previous earnings to cover the cost of investments, but often they need to raise cash from investors. In broad terms, we can think of two ways to raise new money from investors: borrow the cash or sell additional shares of common stock. If companies need the money only for a short while, they may borrow it from a bank; if they need it to make long-term investments, they generally issue bonds, which are simply long-term loans. When companies issue bonds, they promise to make a series of fixed interest payments and then to repay the debt. As long as the company generates sufficient cash, the payments on a bond are certain. In this case bond valuation involves straightforward time-value-of-money computations. But there is some chance that even the most blue-chip company will fall on hard times and will not be able to repay its debts. Investors take this default risk into account when they price the bonds and demand a higher interest rate to compensate.

In the first part of this material we sidestep the issue of default risk and we focus on U.S. Treasury bonds. We show how bond prices are determined by market interest rates and how those prices respond to changes in rates. We also consider the yield to maturity and discuss why a bond s yield may vary with its time to maturity. Later in the material we look at corporate bonds where there is also a possibility of default. We will see how bond ratings provide a guide to the default risk and how low grade bonds offer higher promised yields.

Later we will look in more detail at the securities that companies issue and we will see that there are many variations on bond design. But for now, we keep our focus on garden-variety bonds and general principles of bond valuation.

After studying this material you should be able to

_ Distinguish among the bond s coupon rate, current yield, and yield to maturity.

_ Find the market price of a bond given its yield to maturity, find a bond s yield given its price, and demonstrate why prices and yields vary inversely.

_ Show why bonds exhibit interest rate risk.

_ Understand why investors pay attention to bond ratings and demand a higher interest rate for bonds with low ratings.

Bond Characteristics

Governments and corporations borrow money by selling bonds to investors. The money they collect when the bond is issued, or sold to the public, is the amount of the loan. In return, they agree to make specified payments to the bondholders, who are the lenders. When you own a bond, you generally receive a fixed interest payment each year until the bond matures. This payment is known as the coupon because most bonds used to have coupons that the investors clipped off and mailed to the bond issuer to claim the interest payment. At maturity, the debt is repaid: the borrower pays the bondholder the bond s face value (equivalently, its par value).

How do bonds work? Consider a U.S. Treasury bond as an example. Several years ago, the U.S. Treasury raised money by selling 6 percent coupon, 2002 maturity, Treasury bonds. Each bond has a face value of $1,000. Because the coupon rate is 6 percent, the government makes coupon payments of 6 percent of $1,000, or $60 each year.1 When the bond matures in July 2002, the government must pay the face value of the

bond, $1,000, in addition to the final coupon payment.

Suppose that in 1999 you decided to buy the 6s of 2002, that is, the 6 percent coupon bonds maturing in 2002. If you planned to hold the bond until maturity, you would then have looked forward to the cash flows depicted in Figure 3.1. The initial cash flow is negative and equal to the price you have to pay for the bond. Thereafter, the cash flows equal the annual coupon payment, until the maturity date in 2002, when you receive the face value of the bond, $1,000, in addition to the final coupon payment.