BUSFIN 4211: 1.2 Time Value...: Bonds

PP and BOOK

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Bonds:

• A long-term debt instrument between borrower and holder

• Book: a long-term contract under which a borrower agrees to make payments of interest and principal on specific dates to the holders of the bond.

• are issued by corporations and government agencies that are looking for long-term debt capital.

Borrower:

• Gets money today, pays interest and principal later

Bond Holder

• Pays for bond today, gets interest and principal later

Can value a bond by

discounting its future cash flow!

Who issues bonds? Types of bonds.

• Treasury bonds.

• Corporate bonds.

• Municipality bonds.

• Foreign bonds.

Treasury bonds:

Issued by U.S. government

• Examples: T-bills, T-bonds

Corporate bonds:

Issued by business firms

Municipality bonds:

Issued by state and local governments

Foreign bonds:

Issued by foreign governments or foreign corporation

• Examples: Eurobonds, Panda bonds

Key Features of a (Coupon) Bond

• Par value.

• Coupon interest rate.

• Maturity date.

• Issue date.

• Yield to maturity.

Par value:

• Face amount of the bond, which is paid at maturity (aka, face value, principal)

• BOOK: we generally assume a a value of $1,000, although any multiple of $1,000 (e.g., $10,000 or $10 million) can be used.

• generally represents the amount of money the firm borrows and promises to repay on the maturity date.

Coupon Interest Rate

• The stated interest rate (typically fixed, semiannual) paid by the

  issuer. Multiply coupon interest rate by par value to get dollar payment of interest.

Multiply coupon interest rate by par value to get

dollar payment of interest.

Maturity date:

When the bond must be repaid

Issue date:

When the bond was issued

Yield to maturity:

• Rate of return earned on a bond held until maturity (“promised yield”)

• BOOK: Answers the question of “What rate of interest would you earn on your investment if you bought the bond, held it to maturity, and received the promised interest payments and maturity value?”

• the interest rate generally discussed by investors when they talk about rates of return

Coupon/Coupon Payment

• BOOK: The specified number of dollars of interest paid each year.

• is set at the time the bond is issued and remains in force during the bond’s life.

• Typically, at the time a bond is issued, its _ is set at a level that will induce investors to buy the bond at or near its par value.

Other Types (Features) of Bonds

• Zero coupon bond

• Convertible bond

• Callable bond

• Putable bond

• Income bond

• Indexed bond

Zero Coupon Bond

Does not pay coupon/interest; trades at a discount

Convertible bond:

• May be exchanged for common stock, at the holder’s option

• BOOK: Convertibles offer investors the chance for capital gains if the stock price increases, but that feature enables the issuing company to set a lower coupon rate than on nonconvertible debt with similar credit risk.

Callable bond:

• Allows issuer to buy the bond back

• BOOK: Companies are not likely to call bonds unless interest rates have declined significantly since the bonds were issued. Suppose a company sold bonds when interest rates were relatively high. Provided the issue is callable, the company could sell a new issue of low-yielding securities if and when interest rates drop, use the proceeds of the new issue to retire the high-rate issue, and thus reduce its interest expense. This process is called a refunding operation.

Putable bond:

• Allows holder to sell the bond back to the company prior to maturity

• BOOK: If interest rates rise, investors will put the bonds back to the company and reinvest in higher coupon bonds.

Income bond:

• Pays interest only when interest is earned by the firm

Indexed bond:

Interest rate paid is based upon the rate of inflation

What is the opportunity cost of debt capital?

The rate r that could be earned on alternative investments of equal risks!

Always compounded!

2 Yield to maturity:

Rate of return rate earned by an investor who buys the bond at a given market price, 𝑉𝐵,

holds the bond to maturity, and receives all interest payments 𝐶𝐹𝑁 along the way

Mathematically, it is the discount rate r that equates

the present value of the bond’s cash flows with its price

When the bond price is greater than the face value

We say the bond trades “above par” or “at a premium”

“above par” or “at a premium” occurs when

Coupon Rate > Yield to Maturity

When the bond price is equal to the face value

We say the bond trades “at par”

“at par” occurs when

Coupon Rate = Yield to Maturity

When the bond price is less than the face value

We say the bond trades “below par” or “at a discount”

“below par” or “at a discount” occurs when

Coupon Rate < Yield to Maturity

The payment is split between

coupons and face value

For the same YTM, if coupons are too generous, it must be that the

face value is low

If face value is large, it must be that

coupon rate is low

If coupons exactly amount to YTM,

face value and bond price must cancel out

bond YTMs and coupons can be expressed as

• annual without compounding

• AI: Because of tradition and ease.

Zero-coupon bonds always trade at a

discount

Coupon bonds may trade at a

discount or at a premium

Most issuers of coupon bonds choose a coupon rate so that

the bonds initially trade at,

or very close to, par. After the issue date, the market price of a bond changes over time

Market interest rate changes and bond prices:

• If a bond sells at par the only return investors will earn is from the coupons that the bond

pays. Therefore, the bond’s coupon rate will exactly equal its yield to maturity

• As interest rates in the economy fluctuate, the yields that investors demand will also change

Interest rate risk exposure and bond prices:

• Effect of time on bond prices is predictable, but unpredictable changes in rates also affect

prices. Bonds with different characteristics respond differently to changes in interest rates

• Investors view long-term bonds to be riskier than short-term bonds

• Long-term bonds are more sensitive to interest rate changes

Yield Curve

Shows bond yields at different maturities

In normal state of the world, long-term bonds yield

more

• Upward-sloping yield curve

Sometimes long-term bonds yield

less than short-term bonds

• Downward-sloping yield curve

Downward-sloping yield curve indicates

• potential recession

• Why?

Corporate bonds are often classified by their

• credit ratings

• Ratings range from AAA (best), AA+, AA, AA-, A+, A,…, to CCC, CCC-, CC, C, D (in default)

Investment grade bonds have ratings of

BBB- or higher

Speculative grade (“junk”) bonds have ratings of

BB+ or lower

Credit ratings play an important role in determining

which types of investors can buy a

bond and therefore how the bonds are priced in the market

• Some investors are restricted to purchasing only investment grade bonds

Bond investors rely on the

ratings agencies for information production

Almost all corporate bonds have a credit rating from

at least one major rating agency. In contrast, around half of loans to public firms are to firms without a credit rating

Issuers pay the major ratings agencies (S&P, Moody’s, Fitch) to

rate their bonds

• This arrangement was scrutinized after the 2008 financial crisis, when many highly rated

mortgage-backed securities defaulted. However, ratings for corporates proved accurate

We can plot a yield curve for

corporate bonds just as we can for Treasuries

The credit (or default) spread is the

difference between the yields of corporate bonds and Treasuries