FIN 320F Exam 3 Unit 9

Market value of a bond

its economic value: the present value of the promised payments taken at the bond's opportunity cost.

calculator

N= # of periods

I/YR= YTM

PV= price

PMT= coupon payments

FV= face value

Coupon payment (C)

The amount of regular, per-period interest payments promised by the company issuing the bond.

Principal/Face value/par value

The amount borrowed and the amount bondholders should receive when the bond matures.

- The face value of bonds is generally set at $1,000 per bond.

Opportunity cost

The rate the bondholders expect to earn given the risk of the bond.

- the rate of return the investor should earn on other similar bonds.

Maturity (M)

The length of time the bond will exist and when the bond should repay the principal to the bondholder.

Coupon rate (i)

The annual stated rate of interest paid on the bond.

- set when the bond is issued and does not change.

- will set up the cash flows of the bond's timeline.

formula: annual coupon rate= annual coupon payment/face value

Yield to maturity (YTM)

The current opportunity cost on all bonds of equivalent risk and maturity.

- earn only if they hold all the way until maturity

-the rate required by market participants to invest in the bond.

- changes depending on market and risk

- discount rate used to discount the bond's cash flows to determine its economic value.

- calculated as the bonds current internal rate of return

current yield + capital gains yield

current yield

return we earn from just coupon payments (positive)

CY0= PMT1/P0

capital gains yield

return from price changes

pos or neg

CGY0=P1-P0/P0

who issues debt?

1. federal gov

- treasury bills (t-bills): 0 coupon

- treasury notes/bonds: interest only loans

- Treasuries are free of default risk

2. municipal govs (city gov)

- issued to raise money

3. corporations

- bank loans: secured (asset would change ownership if cant be paid--mortgage) or unsecured

- corporate bonds: unsecured (debenture bonds) or secured (mortgage bonds)

Interest only bond

A bond that makes regular periodic interest payments and pays the entire principal upon maturity.

Zero-coupon bond/pure discount

A bond that pays no interest and has a 0% coupon rate!

- At maturity it pays the face value plus accumulated interest.

Amortized loan

A loan with a scheduled number of equal payments, with each payment including both interest payments and a partial payment on the amount on the loan's principal.

- annuities

- ex: mortgages (car/house)

Calc:

1. N= # of pmts

2. I/YR= interest rate

3. PV = principal

4. PMT = SOLVE

5. FV = 0

Convertible bonds

A type of bond that can be exchanged for common stock offered by the bond-issuing company.

- provides the stable income and fixed payment of the debt, but also allows the bondholder to share in a company's growth and profitability.

Indenture

Written agreement between the corporate debt issuer and the lender.

- aka deed of trust

- info included: FV, coupon rate, maturity time and date, seniority of bonds (order paid in case of liquidation), repayment options, protective covenants

Call provision

Part of a bond indenture that allows the issuer to buy back the bond under certain conditions.

Protective covenant

Part of the indenture that protects bondholders by limiting certain actions a company might otherwise take.

Collateral

Assets that are pledged as security for payment of debt.

Discount

A bond sells at a discount when its market price is less than its face value.

-occurs when the coupon rate is less than the current YTM.

- YTM goes up, price of bond goes down

Premium

A bond sells at a premium when its market price is greater than its face value.

- occurs when the coupon rate is greater than the current YTM.

- YTM goes down, price of bond goes up

Par Value (F)

the principal amount of the bond

coupon rate equals YTM

market price equals face value

Debenture

A bond that is not secured by an underlying asset.

Interest rate risk

The market price of a bond varies inversely with the current required rate of return.

- bonds with longer maturity have more risk

- bonds with lower coupon rates have more risk

Default risk

The risk that a bond issuer may not honor the provisions of the bond indenture, causing a loss in value of the bond.

- risk investors wont get paid back

bond rating grades

used to understand how good or bad companys bonds are

- 3 agencies: S&P, Moodys, Fitch

- recognized by SEC as nationally recognized statistical rating orgs

Investment Grade Bonds

Bonds are rated to have a relatively low probability of default and are acceptable to prudent (smart) investors such as pension funds.

Speculative Bonds/junk bonds

Bonds are rated to have a higher probability of default.

- would be attractive to investors who have a high tolerance for risk, but would not be held by companies with fiduciary obligations, such as pension funds.

components of bond yields

R = Risk-free rate of return + Risk premium

- Risk free → Default-free government securities

- Risk premium → Premium for risks associated with risky investments.