Valuation involves an estimation of the intrinsic value of an organisation or its stock. The present value theory forms the basis of valuation. Generally, the worth of an organisation could be determined using two major valuation methods.
These include debt valuation and equity valuation. An effective measurement of the value of a security requires information on its discount rate, expected future pay-offs over the security’s life, among others.
Discussions in this feature would lay strong emphasis on the debt valuation method. It is hoped a higher understanding of the debt valuation method would ease our understanding of the equity valuation method.
Definition of bond/
A bond is an investment debt in which an institution, government or corporate borrows financial resources (usually money) from individual or group of investors at a predetermined premium (coupon or interest) rate over a stated period of time.
A completed bond agreement indicates the coupon or premium rate and the principal amount to be returned to the investor at the maturity date. Further, it states when premium or coupon payments (monthly, semi-annually or annually) would be made to the investor. A bondholder is an investor who has loaned funds to an issuer, commonly called bond issuer. A bond may be negotiated at a later date. That is, the bondholder may decide to transfer ownership of his or her bond to a third party in the secondary market.
Types of bonds
A bond may be issued in different forms to meet varying financial needs of government and various corporate institutions. Examples include government or treasury bonds, municipal bonds, corporate bonds, savings bonds, zero-coupon bonds, convertible bonds, callable bonds, term bonds, amortised bonds, adjustment bonds, junk or high-yield bonds, emerging market bonds and angel bonds. The following section presents a discussion on each of the aforementioned bond types.
Government or Treasury Bonds: It is one of the safest investments in the bond market. It is safe in that it assures the holder of “prompt” payment at the maturity date; it assures the holder of payment prior to maturity date, often at a penalty – the holder forfeits part of the accumulated premium should he or she decide to redeem the bond prior to the agreed maturity date. Premium payments on the bond could be fixed or variable; payments could be effected semi-annually or annually.
Treasury bonds could be issued for a medium- (three to four years) or long-term (five years and above) or both. Treasury Notes are securities issued by the government to raise funds for duration of one and two years. Treasury bonds are often issued by governments to raise funds for socio-economic development; funds raised through debt aid in the provision of good schools and hospitals; provision of potable water and extended electrification projects, and construction of highways and overpass. Strategically, the government may issue a long-term bond and use the proceeds to settle current debts. Thus, it enables the government to transform a current liability into a long-term liability. This provides the government with some economic respite in terms of early debt settlement. Generally, treasury bonds attract lower coupon rate than corporate bonds due to lack of default risk in holding of the former.
Municipal Bonds: Depending on the jurisdiction and type of governance system, municipal bonds may be issued by local government bodies (district assemblies), cities (metropolitan or municipal) and states (regions) to raise funds for specific socio-economic development activities. Risk associated with a municipal bond is higher than a Government bond, but less than a corporate bond.
A municipal bond is sometimes called “munis.” Premium accumulated on municipal bonds is tax-free, that is, it is not taxable at the national and local levels. Generally, municipal bonds offer lower pre-tax yields than taxable securities.
This renders municipal bonds a safe investment “haven” for individuals in higher income bracket than those in lower income bracket. All else held constant, individuals with higher incomes could invest more in municipal bonds to earn, cumulatively, higher pre-tax yields than individuals with lower incomes.
Corporate bonds: Sometimes, commercial banks may be reluctant to lend money to corporate bodies due to myriad of factors, including high non-performing loan amounts on the banks’ books. Such a decision could have strong negative implications for the development and growth of corporate bodies in a given jurisdiction. For instance, in 2016, the non-performing loans amount recorded by banks in Ghana was estimated at GH¢6.2 billion.
This was an increase over the GH¢4.2 billion recorded in 2015. In percentage terms, the increase (GH¢2 billion) in 2016 over the preceding year translates into about 47.6191 per cent. To avert such negative tendencies and assure a stream of cash flows for its operations and expansionary projects, a corporate body may issue corporate bonds in the bond market. Corporate bonds serve as an alternative source of funding to equity and commercial banks’ lending.
Corporate bonds ease pressure on the costs of funding in organisations. Corporate bonds may be issued for a short-term (from one to four years), medium-term (five to twelve years), and long-term (thirteen years and beyond). Some organisations have the tendency to default in payment to corporate bondholders. As a result, corporate bonds often attract a higher coupon rate than Treasury and municipal bonds. Organisations with strong financial performance and effective bond repayment records often negotiate for a lower coupon rate.
The implication is organisations are making the necessary efforts to reduce costs associated with funding their operations and expansionary projects through corporate bonds. Small and medium-scale enterprises (SMEs) constitute about 90 per cent of the world’s corporate establishments. Companies willing to expand and have financial reputation as well as strong operational performance are able to borrow from both domestic and international bond markets.
Savings bonds: The principal investment amount in savings bonds has government backing. That is, the principal is often guaranteed not to lose value. To this end, savings bonds are described as the safest investment in the bonds market. These bonds are commonly issued in the bonds market in the United States of America. Coupon interests accumulated on savings bonds do not attract taxes at the local and state levels.
At the federal level, proceeds from savings bonds used to finance education do not attract taxes. In spite of its attractive “package,” buying and selling savings bond are not easy, compared with other investment types. Stated differently, liquidity of savings bonds is quite challenging; it is equally challenging to cash savings bonds within one year of contract signing while a three-month interest penalty is charged when the holder decides to cash within the first five years of contract signing.
Zero-coupon bonds: In some cases, a bond may be issued at a discounted rate or below its par value. However, the bondholder is assured of collection of an amount at least equivalent to the bond’s par value at the maturity date. Thus, at maturity, a zero-coupon bondholder receives the principal investment plus imputed interest.
Zero-coupon bonds allow investors to set aside a relatively small investment and derive higher returns in addition to the principal at the maturity date. Issuers of other types of bonds may effect semi-annual or annual coupon payments to bondholders. However, issuers of zero-coupon bonds do not pay cash coupons; holders of zero-coupon bonds are expected to receive one-time payment at the maturity date; this one-time payment comprises the principal investment plus imputed interest.
The imputed interest usually includes predetermined yield compounded semi-annually. The implication is issuers of zero-coupon bonds credit holders, regularly, with premium, but this premium credit is not paid until the bond matures. A zero-coupon bond may be issued for a minimum of 10 years. This enables the investor to engage in long-term investment planning. To illustrate, Mensean Corporation issues a 15-year bond with a face value of $15,000, and a yield of 5 per cent. An investor pays $5,520 for the bond. At the maturity date, the investor would receive $15,000.
The difference ($9,480) between $15,000 and $5,520 is the premium that compounds semi-annually until the maturity date. Zero-coupon bonds may be issued by governments, corporate bodies, and government agencies. Investment in zero-coupon bonds allows corporate bodies to release their excess capital requirements into other productive sectors of the economy over a considerable period of time.
Convertible Bonds: These bonds are often referred to as “CVs.” They are bonds with an underlying clause permitting holders to exchange them for stock or shares in the issuing corporation at a later date. Convertible bonds allow investors or creditors to transform their original investment status into shareholders.
Convertible bonds enable holders to have voting rights in the issuing company when the holder decides to convert the value into shares.
Generally, the underlying clause of the bond agreement gives the holder the exclusive right to decide on the conversion.
Convertible bonds may be issued to boost investor confidence in the issuing organisation; and to minimise any negative perception investors might have formed about the organisation and its operations.
Callable Bonds: Certain bond agreements allow the bond issuer to call the bond prior to its maturity date.
Bonds in this category are described as callable or redeemable bonds. Coupon payments on callable bonds are computed and paid to the holder when the bond is called.
The underpinning objective of the issuing organisation is to raise capital at the least cost; the issuing firm may be interested in paying lower coupon rate on the bonds.
Due to the foregoing, the issuer may call the bonds when there is a general decline in interest rates in the financial market.
Suppose Amishadai Corporation issued a 10-year bond with a face value of $30,000, and a yield-to-maturity of 10 per cent.
Reports obtained from the financial market reveal a decline in the interest rate from 10 per cent to 6 per cent over a two-year period.
Since Amishadai is interested in minimising its cost of capital, the 10 per cent bond would be called and reissued at the prevailing lower market rate of six per cent.
Author: EBENEZER M. ASHLEY (PHD)