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Corporate Bonds - Bond Analysis and Valuation

Bond Analysis and Valuation

Corporate Bonds - They Are More Complex Than you Think

Jill Dougherty was hired as an investment analyst by A.M. Smith Inc. for the Cincinnati, Ohio office based on her sound academic credentials, which included an MBA from a top ranking university and a CFA designation. at the time of her recruitment she was told that one of her responsibilities would be to conduct educational seminars for current and prospective clients.

A.M. Smith Inc, a prestigious investment firm, with branches in 30 major metropolitan areas, had achieved most of its success due to its excellent client relations and focus on client support. The firm ranked among the very best in terms of the number of successful equity underwriting deals undertaken. Recently, a large utility company had hired it as the leading investment bankers, for a major corporate bond issue. Since most of its retail customers were more familiar with stock investments, John Sullivan, the branch Manager at the Cincinnati office, asked to prepare and present a seminar outlining the various implications of fixed income investments. About 60% of our investors are in the 55+ age group. Jill, so we should not have much trouble convincing them of the benefits of investing in bonds remarked John. " However, they may need clarifications regarding various terms and concept associated with fixed income investing. Your job is to convince them of the relative safety and income potential of corporate bonds" said John.

In preparation for the seminar, Jill called up a few of her best clients and queried them regarding their awareness of the risk and return potential associated with corporate bond investments. She realized that apart from a good knowledge about the current level and stability of interest rates and inflation, most customers were not very familiar about the finer aspects of bond investing Bond features like callability, convertibility, sinking fund provision, bond ratings, debentures, interest rate risk, were not well understood by most of the clients she interviewed. most of them seemed awfully interested in Knowing more about the opportunities offered by bond investing and Jill Knew that she would have a good turnover at the seminar. She decided to refer back to her finance textbook and dig out some definitions and examples that she could use in her Power Point presentation. She downloaded current data for outstanding bonds of various maturities, rating, and coupon rates( see table1) and started preparing her slides.

Table 1
Corporate Bond information

Issuer Face coupon Rating Quoted years Sinking Call
Value Rate price until Fund period
Maturity
ABC
Energy $1,000 5% AAA $703.1 20 yes 3 years
ABC
Energy 1,000 0% AAA 208.3 20 yes NA
Trans
Power 1,000 10% AA 1092.0 20 yes 5 years

Telco
Utilities 1,000 11% AA 1,206.4 30 no 5 years`

Questions:
1) How should Jill go about explaining the relationship between coupon rates and prices? Why do the coupon rates for the various bonds vary so much?

2) How are the ratings of these bonds determined? What happens when the bond rating get adjusted downwards?

3) During the presentation one of the clients is puzzled why some bonds sell for less than their face value while others sell for a premium. She asks whether the discount bonds are a bargain? How should Jill respond?

4) What does the term "yield to maturity" mean and how is it to be calculated?

5) What is the difference between the "nominal" and effective yields to maturity for each bond listed in table 1? Which one should the investor use when deciding between corporate bonds and other securities of similar risk? Please explain.

6) Jill Knows that the call period and its implications will be of particular concern to the audience. How should she go about explaining the effects of the call provision on bond risk and return potential.

Solution Preview

Questions:

1) How should Jill go about explaining the relationship between coupon rates and prices? Why do the coupon rates for the various bonds vary so much?

If the coupon rate is higher than the discount rate then the price of the bond would be higher than the face value.
If the coupon rate is lower than the discount rate then the price of the bond would be lower than the face value.

To arrive at the price of the bond the coupon payments and the redemption value are discounted at the discount rate.

Example:

Bond selling at discount:

Coupon rate= 8% is less than discount rate (YTM)=9%

Discount rate (YTM)= 9%
Coupon payment= 80 Annually
Term= 5 years
Redemption value= 1000

Year Cash flow Discount factor Cash flow X Discount factor
1 80 0.91743 73.39
2 80 0.84168 67.33
3 80 0.77218 61.77
4 80 0.70843 56.67
5 1080 0.64993 701.92
Price of bond= 961.08

Bond selling at premium

Coupon rate= 10% is more than discount rate (YTM)=9%

Coupon rate= 10%
Discount rate (YTM)= 9%
Coupon payment= 100 Annually
Term= 5 years
Redemption value / Face value= 1000

Year Cash flow Discount factor Cash flow X Discount factor
1 100 0.91743 91.74
2 100 0.84168 84.17
3 100 0.77218 77.22
4 100 0.70843 70.84
5 1100 0.64993 714.92
Price of bond= 1038.89

The coupon rates vary because of the following reasons:
Bonds are issued at different periods in time. The coupon rate reflect the maturity , risk , expected inflation rate.

1) The risk of bonds increases with the length of maturity. Investors therefore demand a higher return in interest as compensation for bonds with long maturity. Generally speaking, the longer the maturity of the bonds, the higher the interest rate and therefore the coupon rate.

2) Failure to pay interest to bond holders on time will constitute a default on the part of the issuer. Different bonds are issued by different entities and their risk varies. Investors may ...

Solution Summary

The solution gives steps to calculate the price of the bond and yield to maturity, and explains the effect of a call provision on the price of a bond and the difference between the "nominal" and effective yields to maturity. The solution consists of an attached word file that answers 6 questions.

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