. Who issues bonds
. Characteristics of bonds
. Bond valuation
. Important relationships in bond pricing
. Bond rating
. Bond markets
. Who issues bonds
Bond: a long-term debt
Treasury bonds: issued by the federal government, no default risk
Municipal bonds (munis): issued by state and local governments with some default risk - tax benefit (returns are tax exempt)
Corporate bonds: issued by corporations with different levels of default risk
Mortgage bonds: backed by fixed assets (first vs. second)
Debenture: not secured by a mortgage on specific property
Subordinated debenture: have claims on assets after the senior debt has been paid off
Zero coupon bonds: no interest payments (coupon rate is zero)
Junk bonds: high risk, high yield bonds
Eurobonds: bonds issued outside the U.S. but pay interest and principal in U.S. dollars
International bonds
. Characteristics of bonds
Claim on assets and income
Par value (face value, M): the amount that is returned to the bondholder at maturity, usually it is $1,000
Maturity date: a specific date on which the bond issuer returns the par value to the bondholder
Coupon interest rate: the percentage of the par value of the bond paid out annually to the bondholder in the form of interest
Coupon payment (INT): annual interest payment
Fixed rate bonds vs. floating rate bonds
Zero coupon bond: a bond that pays no interest but sold at a discount below par
Indenture: a legal agreement between the issuing firm and the bondholder
Call provision: gives the issuer the right to redeem (retire) the bonds under specified terms prior to the normal maturity date
Convertible bonds: can be exchanged for common stock at the option of the bondholder
Putable bonds: allows bondholders to sell the bond back to the company prior to maturity at a prearranged price
Income bonds: pay interest only if it is earned
Sinking fund provision: requires the issuer to retire a portion of the bond issue each year
Indexed bonds: interest payments are based on an inflation index
Required rate of return: minimum return that attracts the investor to buy a bond;
It serves as the discount rate (I/YR) in bond valuation
. Bond valuation
Market value vs. intrinsic (fair) value
Market value: the actual market price, determined by the market conditions
Intrinsic value: the fair or fundamental value
(1) Intrinsic value: present value of expected future cash flows, fair value
Annual and semiannual coupon payments using a financial calculator
Discount bond: a bond that sells below its par value
Premium bond: a bond that sell above its par value
(2) Yield to maturity (YTM): the return from a bond if it is held to maturity
(3) Yield to call: the return from a bond if it is held until called
(4) Current yield (CY) = annual coupon payment / current market price
. Important relationships in bond pricing
(1) The value of a bond is inversely related to changes in the investor’s
present required rate of return (current interest rate); or
As interest rates increase, the value of a bond decreases
Interest rate risk: the variability in a bond value caused by changing
interest rates
Interest rate price risk: an increase in interest rates causes a decrease in
bond value
Interest reinvestment risk: a decrease in interest rates leads to a decline in
reinvestment income from a bond
(2) If the required rate of return (or discount rate) is higher than the coupon
rate, the value of the bond will be less than the par value; and
If the required rate of return (or discount rate) is less than the coupon rate,
the value of the bond will be higher than the par value
(3) As the maturity date approaches, the market value of a bond approaches
its par value
(4) Long-term bonds have greater interest rate risk than short-term bonds
(5) The sensitivity of a bond’s value to changing interest rates depends not
only on the length of time to maturity, but also on the pattern of cash
flows provided by the bond (or coupon rates)
. Bond rating
Importance: firm’s credit
Moody’s and S&P provide bond ratings
AAA
AA
A Investment-grade bonds
BBB
BB
B Junk bonds
.
Criteria to consider
Financial ratios: for example, debt ratio and interest coverage ratio
Qualitative factors: for example, contract terms, subordinated issues, etc.
Other factors: for example, profitability ratios and firm size
. Bond markets
OTC markets
Quotes: quoted as a % of par value of $100
Invoice price (dirty price) = quoted price (clear price) + accrued interest
.
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