likelihood of default

CHAPTER
FOURTEEN
BOND ANALYSIS
CAPITALIZATION OF
INCOME METHOD

PROMISED YIELD-TO-MATURITY
• In equation form
n
ct
P  
t
(
1

y
)
t1
where 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
CAPITALIZATION OF
INCOME METHOD

INTRINSIC VALUE
• In equation form
V 
n

t 1
ct
t
(1  y )
CAPITALIZATION OF
INCOME METHOD

SOLVING FOR V,
• Given the current market price (P), the
investment decision is
if V is the intrinsic value and
V>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
• LENGTH OF TIME TO MATURITY
• COUPON RATE
• CALL PROVISIONS
• TAX STATUS
• MARKETABILITY
• LIKELIHOOD OF DEFAULT
LENGTH OF TIME TO
MATURITY

COUPON RATE AND LENGTH TO
MATURITY
• these attributes determine size and timing
of cash flow
• yield-to-maturity
CALL PROVISIONS

CALL PROVISIONS
• DEFINITION:
a provision in some bond
indentures that permits an issuer to retire
some or all of the bonds in a particular
issue 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 bonds
TAX 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 advantage
TAX 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 value
MARKETABILITY

MARKETABILITY
• refers to the ability of the investor to resell
MARKETABILITY

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 V
MARKETABILITY

MARKETABILITY
• bonds that are actively traded should have
a lower YTM and a higher V
LIKELIHOOD 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 ratings
LIKELIHOOD OF DEFAULT

LIKELILHOOD OF DEFAULT
• Categories
investment grade usually the bonds in the top
four ratings
speculative
often called junk bonds
LIKELIHOOD OF DEFAULT

LIKELILHOOD OF DEFAULT
• 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
END OF CHAPTER 14