FINC 310 - Ch 7 - Bonds

what is a bond

a lont-term debt instrument in which a borrower agrees to make pmts or principal and interest on specific dates to holders of the bond

• issued by corps and govs to earn lont-term debt capital

4 main types of bonds

1. Treasury

2. Corporate

3. Municipal

4. Foreign

Treasury bonds (Treasuries)

LT bonds issued by tghe gov (notes and bonds)

• mature 2-30 yrs

• no default risk (risk free — except they still have the risk that a bonds price will decline when int rates rise)

• pay semi-annual int

Corporate bonds (corporates) and its 2 types

LT bonds issued by corps to raise funds

• maturity 2-40 yrsa

• has default risk (credit risk)

• pay semi-annual int

Types:

1. Mortgage bonds — bonds secured by specific fixed assets of the firm; secured with specific collateral

2. Debentures — bonds that are not secured by specific fixed assets of the firm (unsecured debt with no collateral) — more risky

Municipal bonds (munis)

LT bonds issued by state and local govs to raise funds

• maturity up to 30yrs

• riskier than US gov securities

• pay semi-annual int

• Int is excempt from fed taxes

• Int is excempt from state taxes if holder is resident of the state

• rate of retutn (yield) is lower relfecting the tax advantage

foreign bonds

LT bonds issued by foregin corps or govs and denominated in the currency of the country where they are sold

• foreign corp bonds have default risk

• foregin gov bonds may have default risk

par value

the stated face (principal) value

• amount paid at maturity

• generally $1000

maturity

the date at whcih the principal value will be paud

coupon rate

stated annual % int rate

• coupon payments calculated on par value

• ex) 1000 face, coup rate 5%, annual coup is 50

fixed vs floating coupon rate

fixed — int is fixed for entire life

floating — int is linked to some benchmark int rate and varies with changed in the benchmark rate

• ex) Int rate = 10-yr treasury bond yield + 1%

• set for 6 months and then adjusted every 6 months on some open market rate

origional issue discount bond (OID)

any bond origionally offered at a price below its par value

origional maturity

the matruity at the time the bond is issued

zeros

zero coupon bonds

• pay no int, only principal at maturity

• always sold at a discount to par value

• provide capital appreciation (diff between maturity value and purchase price)

• capital gains = par - price

callable bonds (call provision) and what is the call price and a deferred call

provide the option to the issuer to redeem prior to maturity

• call price = par value + call premium

• deferred call = callable several yers after issue date giving call protection for a period of time

why do firms issue callable bonds

to take advantage of possible lower int rates in the future

• when rates decline, issue new bonds at a lower rate and pay pff high-rate existing bonds (bond refudning, refunding operation))

how do callable bonds affect the investor?

while it helps the issuer to reduce int expenses, it hurts the investopr bevausde they have to invest at lower rates now and as a result investors require higher yields on callable bonds to compenstae for the “call risk”

covertible bonds

gives bondholdere the righ to convert bond into common shares

• gives the investor the opportunity to giab from future increases in share price

• yields are less than straight bonds due to valuable option given

indexed / purchasing power bond

int rate is based on an inflation index, cuh as the CPI

• treasury is the main issuer of these bonds

warrants

insetad of gi ing the investor an option to exchange the bonds for sotkc, warrants give the holder an option to buy stock for a stated price

• carry lower coupon rates

income bond

pays int only if the issuer has earned enough money to pay it

• cannot bankrupt a compnay

• riskier than regular bonds

putable bonds

gives bondholder the righ to sell bonds to the issuer prior to maturity at a specified price

• gives opportunity to gain from future increase in int rates

• investors can sell bonds back to the issuer and reinvest the proceeds in higher coupon bonds

• pays lower return than non-putable bonds

sinking fund provisions

• provision to pay pff the bond over its life rather than all at maturity (a mandatory payment)

• options are call X% of the issue at par or buy bonds in the open market

• ex) 100 mil, 20 yr bonds, 5% redmeption per year → 5mil

• similar to amortization on a term loan

• reduced risl to investor, shortens avg maturity

• but not good for investors if rastes decline after issuance

valuation of bonds (and equation)

value of an asset is the true present value of the future stream of CFs it is expected to produce

Value = CF1 / (1+r) + CF2 / (1+r)² and so on

r = disc rate

bond valuation eqaution with annual int pmts

value of a bond is the PV of its future Cfs discoounted at an appropriate required rate of return to bondholders

Vb = sum ( Int / (1 + r)^t + M / (1+r)^N

Vb - bond value at time 0

INT = int payment per yr

M - principal value

N - num of yrs to maturity

rd - investoprs annual required rate of return (market rate of int or disc rate on the bond)

Ex with financial calulcator: what is the vlaue of 1000 par vbalue, 6% bond that matures in 15 yrs ? RRR = 8%

15 N; 8 I; 60 PMT; 1000 FV; CPT PV = -828.81

bond valuation equation: semi annual int

Vb = sum from t=1 to 2N of ( Int/2 / (1 + r/2)^t + M / (1+r/2)^2N

Ex: what is value of 1000 par value 6% bond that matures in 15 yrs? RRR = 8%. Int paid semi-annually

30 N; 4 I; 30 PMT; 1000 FV; CPT PV = -827.08

Bond value and RRR

value of a bond (Vb) and RRR (rd) are inversely related

as the RRR inc, value (price) decreases and vice versa

Ex: what is value of 1000 par value 6% bond that matures in 15 yrs? If RRR = a) 8%. b) 4%, c) 6%. Int paid semi-annually

a) -827.08

b) -1223.96

c) -1000

discount bond

TBD