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Bonds
A bond is a long-term debt instrument
A bond is an IOU a promise to pay both interest and
principal.
Issuance of bonds is a type of financing.
Interest (payment for the use of the principal) is
usually semiannual.
Principal (amount owed) is paid at maturity.
May be new issues or outstanding bonds/seasoned
issues.
4 main types of bonds, and they differ with respect to
expected return and degree of risk.
Kinds of Bonds
Zero coupon bonds bonds that are initially sold at a discount and on which
Common Bonds
Sample Problem:
You have the choice of choosing between a
one-year zero-coupon bond with a face value
of $1,000, which can be purchased for
$952.38 or a one-year 4% semi-annual coupon
bond trading at its face value of $1,000.
Which bond will you choose and why?
Par Value
Face value
Assume $1,000 (multiples of 1,000 also okay)
Maturity
Years until the bond has to be repaid.
Maturity declines
Original Maturity the number of years to maturity
at the time a bond is issued.
Issue Date
Date when the bond was issued.
Call Provisions
Allows the issuer to pay back the bond before maturity it allows them to
refinance the bonds
Call Premium amount that is paid by the issuer to the bondholder for the right to
call the bonds before maturity.
Issuers will call the bond, when interest rate is declining.
Subjects the bondholder to reinvestment risk.
Most bonds have a deferred call and a declining call premium.
Deferred call bonds cannot be called until after several years after issuance.
Declining call premium the value of call premium decreases as the bond nears
maturity.
Other Terms/Features
Warrant
Long-term option to buy a stated number of common stock at a specified price (Buy
when specified price is less than market price).
Putable Bond
Bondholders option to sell the bond back prior to maturity at a prearranged price (BH
put when interest rates are rising).
Indexed (Purchasing Power) Bond
Interest payments are based on an inflation index to protect the holder from inflation.
Interest paid rises automatically when inflation rate rises.
Eurobonds
Bonds sold outside of the country of issue but denominated in the currency of the
issuing company. (Issued in the Philippines, sold in Malaysia, but denominated in
pesos.
Other Features
Premium Bonds
A bond that is issued for more than its par value.
A bond that is currently trading for more than its
par value in the secondary market.
Bond Valuation
The value of any financial asset is the PV of
the cash flows it is expected to generate.
There are mainly two cash flows of a bond:
Principal and Interest
Bond Value = PV of interest + PV of principal
Pbond = INT (PVIFA) + M (PVIF)
...
Value
PV =
CF1
CF1
1+ r
CF2
CF2
1+ r
+ ... +
CFn
CFn
1+ r
Bond Terminology
Discount
Par
Premium
Price of
Sold for less Sold for
Sold for
Bond
than face
equal to face more than
value
value
face value
Investor
Higher
Equal to
Less return
Find the present value of a 4 year 10%, 1,000 bonds
Requirement return than coupon rate than coupon
with a discount rate of 10%, assuming semi-annual
rate
payments. coupon rate
Bond Terminology
Discount
Par
Premium
Price of
Sold for less Sold for
Sold for
Bond
than face
equal to face more than
value
value
face value
Investor
Higher
Equal to
Less return
Find the present value of a 4 year 10%, 1,000 bonds
Requirement return than coupon rate than coupon
with a discount rate of 10%, assuming semi-annual
rate
payments. coupon rate
Par Bonds
If expected inflation remains the same after 1 year.
Find the present value of a 3 year 10%, 1,000 bonds with a
discount rate of 10%, assuming semi-annual payments.
1
2
3
4
5
6
Interest paid
Interest expense
50.00
50.00
50.00
50.00
50.00
50.00
50.00
50.00
50.00
50.00
50.00
50.00
Amortization
-
Balance
1,000.00
1,000.00
1,000.00
1,000.00
1,000.00
1,000.00
1,000.00
Discount Bonds
If expected inflation rose by 2%, causing r = 12% after 1 year.
Find the present value of a 3 year 10%, 1,000 bonds with a
discount rate of 12%, assuming semi-annual payments.
1
2
3
4
5
6
Interest expense
(Increasing)
57.05
57.47
57.92
58.39
58.90
59.43
Interest paid
(Same)
50.00
50.00
50.00
50.00
50.00
50.00
Amortization
(Increasing)
7.05
7.47
7.92
8.39
8.90
9.43
Balance
950.78
957.82
965.29
973.21
981.60
990.50
999.93
Premium Bonds
If expected inflation fell by 2%, causing r = 8% after 1 year.
Find the present value of a 3 year 10%, 1,000 bonds with a
discount rate of 8%, assuming semi-annual payments.
1
2
3
4
5
6
Interest expense
(Decreasing)
42.10
41.78
41.45
41.11
40.75
40.38
Interest paid
50.00
50.00
50.00
50.00
50.00
50.00
Amortization
(Decreasing)
(7.90)
(8.22)
(8.55)
(8.89)
(9.25)
(9.62)
Balance
1,052.42
1,044.52
1,036.30
1,027.75
1,018.86
1,009.61
1,000.00
1052.42
kd = 10%.
1,000
kd = 12%.
950.78
Bond Yields
Yield to Maturity (YTM) or Redemption Yield
The rate of return earned on a bond if it is held to maturity.
The discount rate which forces the PV of all the cash flows to equal the
price paid for the bond
Solving for k (or for the i)
Equal to ERR only if
The probability of default is zero
The bond cannot be called.
Yield to Maturity
Suppose your 7% $1,000 par value bond is
selling for $950 and it matures in 4 years.
What is the YTM?
a. 6%; b. 6.5%; c. 7%; d. 8%; e. 8.5%
PMT (1+YTM)^-1 + PMT (1+YTM)^-2.. + PMT (1+YTM)^-n
Par(1+YTM)^-n = PV
70 (1+YTM)^-1 + 70 (1+YTM)^-2 + 70 (1+YTM)^-3 + 70
(1+YTM)^-4 + 1,000 (1+YTM)^-4 = 950
YTM will never be A,B,C because it is sold at a discount. So
you have to do trial and error to get YTM.
Yield to Call
A 2-year, 10% semiannual coupon, $1,000 par
value bond is selling for $1,135.90 with a
2.95% YTM. It can be called after 1 year at
$1,050. Compute its YTC.
a. 1.27% b. 5.17% c. 10.15% d. 12.3% e. 14.24%
YTC: N = 4; I = ?; PV = 1135.90; PMT = 50; FV = 1050
PMT (1+YTC/2)^-1 + PMT (1+YTC/2)^-2.. + PMT (1+YTC/2)^-n
FV(1+YTC/2)^-n = PV
50 (1+YTC/2)^-1 + 50 (1+YTC/2)^-2 + 50 (1+YTC/2)^-3 + 50
(1+YTC/2)^-4 + 1050 (1+YTC/2)^-4 = 1,135.90
i
0
.
1
0
N
o
m
E
F
F
%
1
0
.
2
5
%
.
2
CONCLUSION
Long-term bonds = high interest rate risk, low reinvestment risk
Short-term bonds = low interest rate risk, high reinvestment risk
Default Risk
A big factor in corporate bonds
The higher the probability of default, the lower the price of the bond, the
higher the required yield.
Default risk will depend on the type of the bond issued.
Mortgage Bonds
Have a specific asset pledged as collateral.
Lower required yields.
Debentures
Unsecured bonds
No lien or claim against specific property
Higher required yields.
Subordinated debentures has claims on assets only after senior debt has
been paid off in times of bankruptcy.
Stronger companies can easily issue debentures. They dont need to pledge
specific property because they already established their reputation and
have gained the confidence of investors; but definitely not small
companies.
Is measured by bond ratings, such as Moodys, S&P, and Fitch Investors Service
Bonds can be rated as Investment Grade or Junk.
Investment Grade
Moodys/
Mergent's
S&P
Junk Bonds
Aaa
Aa
Baa
Ba
Caa
Ca
AAA
AA
BBB
BB
CCC
Financial performance
Debt ratio
TIE, FCC ratios (fixed charged coverage ratio)
Current ratios
Provisions in the bond contract
Secured vs. unsecured debt
Senior vs. subordinated debt
Sinking fund provisions
Debt maturity
Other factors
Earnings stability
Regulatory environment
Potential product liability
Accounting policies
Bond Ratings
Changes in ratings will have large impact on
bond prices.
Higher ratings = higher prices = lower yields.
Cheaper to raise capital
Downgrades have the opposite effect
Junk bonds= low ratings
Exercises:
A bond matures in 12 years and pays an 8
percent annual coupon. The bond has a face
value of $1,000 and currently sells for $985.
What is the bonds current yield and yield to
maturity?
Exercises:
The current price of a 10-year, $1,000 par
value bond is $1,158.91. Interest on this bond
is paid every six months, and the nominal
annual yield is 14 percent. Given these facts,
what is the annual coupon rate on this bond?
Exercises:
Motwani Inc. issued 20 year noncallable 7.8%
annual coupon bonds at their par value of
P1,000 one year ago. Today, the market
interest rate on these bonds is 5.5%. What is
the current price of the bonds, given that they
now have 19 years to maturity?
Exercises:
Matteo Toys has bonds outstanding that have
a 9 percent annual coupon and a face value of
$1,000. The bonds will mature in 10 years,
although they can be called before maturity at
a call price of $1,050. The bonds have a yield
to call of 6.5 percent and a yield to maturity of
7.4 percent. How long until these bonds may
first be called?
Exercises:
Recently, Ohio Hospitals Inc. filed for bankruptcy. The firm
was reorganized as American Hospitals Inc., and the court
permitted a new indenture on an outstanding bond issue to
be put into effect. The issue has 10 years to maturity and a
coupon rate of 10 percent, paid annually. The new
agreement allows the firm to pay no interest for 5 years.
Then, interest payments will be resumed for the next 5
years. Finally, at maturity (Year 10), the principal plus the
interest that was not paid during the first 5 years will be
paid. However, no interest will be paid on the deferred
interest. If the required annual return is 20 percent, what
should the bonds sell for in the market today?