T HE BOND MARKET

P URPOSE OF CAPITAL MARKET Firms and individuals use capital markets for long-term investments

C APITAL MARKET PARTICIPANTS Issuers of capital market securities are federal government, local government and corporations Corporations sell both stock and bonds while governments sell only bonds Largest buyer of capital market securities is households Alternatively, individuals deposit funds in financial institutions that use the funds to purchase capital market instruments such as stock and bonds

C APITAL MARKET TRADING Primary market Secondary market

P RIMARY MARKET New issues of stocks and bonds are introduced Issues of the security receives the proceeds of sale First issue of securities is Initial Public Offering Investment funds, individuals and corporations are buyers

S ECONDARY MARKETS Sale of previously issued securities takes place Two types of exchanges: Organized exchanges Over the counter exchanges

B ONDS A debt owed by the issuer to the investor Bonds obligate the issuer to pay a specified amount at a given date, generally with periodic interest payments Par, face, or maturity value of the bond is the amount that the issuer must pay at maturity

B ONDS Coupon rate is the rate of interest that the issuer must pay Periodic interest payment is often called the coupon payment. If the repayment terms of a bond are not met, the holder of a bond has a claim on the assets of the issuer

BONDS Long-term bonds traded in the capital market include long-term government notes and bonds, municipal bonds, and corporate bonds

C ORPORATE BONDS Most corporate bonds have a face value of $1,000 and pay interest semi-annually Bond indenture is a contract that states the lenders rights and privileges and the borrowers obligations

C HARACTERISTICS OF CORPORATE BONDS Bearer bonds: Payments are made to whoever has physical possession of coupons Registered bonds: Payments are made to registered owners

R ESTRICTIVE COVENANTS Rules and restrictions on managers designed to protect the bondholders interests

C ALL PROVISION Issuer has the right to force the holder to sell the bond back Call provision usually requires a waiting period between the time the bond is initially issued and the time when it can be called Price bondholders are paid for the bond is usually set at the bonds par price or slightly higher (usually by one years interest cost)

C ALL PROVISION If interest rates fall, the price of the bond will rise If rates fall enough, the price will rise above the call price, and the firm will call the bond Because call provisions put a limit on the amount that bondholders can earn from the appreciation of a bonds price, investors do not like call provisions.

C ALL PROVISION A second reason that issuers of bonds include call provisions is to make it possible for them to buy back their bonds according to the terms of the sinking fund Sinking fund is a requirement in the bond indenture that the firm pay off a portion of the bond issue each year

C ALL PROVISION This provision is attractive to bondholders because it reduces the probability of default when the issue matures Because a sinking fund provision makes the issue more attractive, the firm can reduce the bonds interest rate

C ALL PROVISION A third reason firms usually issue only callable bonds is that firms may have to retire a bond issue if the covenants of the issue restrict the firm from some activity that it feels is in the best interest of stockholders

C ALL PROVISION Finally, a firm may choose to call bonds if it wishes to alter its capital structure A maturing firm with excess cash flow may wish to reduce its debt load if few attractive investment opportunities are available.

C ALL PROVISION Because bondholders do not generally like call provisions, callable bonds must have a higher yield than comparable noncallable bonds. Despite the higher cost, firms still typically issue callable bonds because of the flexibility this feature provides the firm.

CONVERSION Some bonds can be converted into shares of common stock This feature permits bondholders to share in the firms good fortunes if the stock price rises Bond can be converted into a certain number of common shares at the discretion of the bondholder

T YPES OF CORPORATE BONDS

S ECURED BONDS Collateral attached

U NSECURED BONDS Backed by only the general credit worthiness of the issuer Carry a higher interest rate than comparable secured bonds Subordinated debentures: carry a lower priority claim Variable rate bonds: tied to another market interest rate

J UNK BONDS Speculative grade bonds

F INDING THE VALUE OF COUPON BONDS 1. Identify the cash flows that result from owning the security 2. Determine the discount rate required to compensate the investor for holding the security 3. Find the present value of cash flows estimated in step 1 using the discount rate determined in step 2

Y IELD TO MATURITY The Yield to maturity (YTM) of a bond is the discount rate that equates the todays bond price with the present value of the future cash flows of the bond

10-27 T HE B OND P RICING F ORMULA The price of a bond is found by adding together the present value of the bonds coupon payments and the present value of the bonds face value. The formula is: In the formula, C represents the annual coupon payments (in $), FV is the face value of the bond (in $), and M is the maturity of the bond, measured in years.

C URRENT YIELD Yield to maturity on coupon bonds Current yield = yearly coupon payment / price of the coupon bonds

10-29 P REMIUM AND D ISCOUNT B ONDS, I. Bonds are given names according to the relationship between the bonds selling price and its par value. Premium bonds :price > par value YTM < coupon rate Discount bonds :price < par value YTM > coupon rate Par bonds :price = par value YTM = coupon rate

10-30 R ELATIONSHIPS AMONG Y IELD M EASURES for premium bonds : coupon rate > current yield > YTM for discount bonds : coupon rate < current yield < YTM for par value bonds : coupon rate = current yield = YTM

I NVESTING IN BONDS Bear a lower risk than stocks Suffer from interest rate risk