Chapter 6 Bonds and Bond Pricing  Real Assets versus Financial Assets\  Application of TVM – Bond Pricing  Semi-Annual Bonds  Types of Bonds  Finding Yield to Maturity of a Bond  Bond Features  Bond Ratings  Quoting Conventions and Bond Markets

Real vs. Financial Assets  Real Assets have physical characteristics that determine the value of the asset  Size, Shape, Material, Color, etc.  Price based on the benefits of the physical characteristics  Financial Assets physical characteristics are inconsequential  Value based on claim to promised or anticipated cash flows  TVM concepts used to price financial assets

Application of TVM – Bond Pricing  Bond is a long-term debt instrument (long- term liability) of a company  Bond promises a specific set of cash payments in the future  Coupon (interest) payments  Principal repayment  Timing and amount of future cash payments stated on the bond

Application of TVM – Bond Pricing  Timeline for promised cash flows  Example, Patel Corporation Bond  $1,000 par value (principal)  8% annual coupon payments (interest)  Twenty year bond  Figure 6.2, Page 129  Principal $1,000 due 12/31/23 is lump sum  Coupons of $80 annually are annuity

Application of TVM – Bond Pricing  Steps to price a bond  Determine annuity stream  Coupon Rate times Par Value  8% x $1,000 = $80  Find PV of annuity stream  Find PV of principal repayment  Add PVs together for bond price  Patel Corporation Bond  PV of coupons is $  PV of principal is $  Price of Patel Corporation bond is $1,229.39

Application of TVM – Bond Pricing

Semi-Annual Bonds  Corporations and governments elect how often they will make coupon payments  Most common choice is every six months  Consistent with interest rates from chapter 4  Coupon rate is stated annually  Coupon payment = (Coupon Rate x Par Value) / 2  Discount rate for TVM is the yield to maturity / 2  Number of periods (n) is years x 2  Timeline of promised cash flows, Figure 6.5 page 133

Semi-Annual Bond

Types of Bonds  By Issuer  Corporate Bonds – Companies  Treasury Bonds – U.S. Government  Municipal Bonds – State and Local Governments  By Features – Table 6.1, page 137  Standard, Semi-Annual, Floating Rate (coupon rate changes), Zero, Consol,  Callable, Putable, Convertible

Types of Bonds  Special Pricing Feature of Zero-Coupon Bond  No coupon payments  Priced as Semi-Annual Bond for Principal repayment  Also know as deep discount bond  Price of bond is the initial principal  Difference between price and final payment is interest on bond  Interest is implied each year as bond price changes using the original yield to maturity  Amortization schedule (Table 6.2) shows implied interest payments each six months

Finding Yield to Maturity  Yield to maturity – return on the bond if held to maturity  Discount rate for pricing the bond  If price and cash flows are known you can find YTM  Iterative Process – can not isolate r in TVM formula  Calculator or Spreadsheet fast and accurate  Relationship of Coupon Rate and YTM

Bond Features  Variables  Price, Principal, YTM, Coupon Rate, Maturity Date, Frequency of Coupon Payments  Need all but one variable to determine missing variable  Indenture or Deed of Trust (Bond Contract)  Collateral or Security of Bond  Real Property is Collateral – Mortgage Bond  No Collateral - Debenture

Bond Features  Senior Debt versus Junior Debt  Older Issue is Senior  Junior Debt paid off after Senior Debt  Protective Covenants  Prohibits actions of bond issuer  Designed to protect bondholder  Added Features to Bond (Options)  Call, Put, Conversion  Provides issuer or holder future choices

Bond Ratings  Agencies Rate Bonds  Ratings based on potential default  Best rating AAA  Categories based on ratings  Investment Grade (AAA to BBB- or Baa3)  Speculative Grade (BB+ or Ba1 to B- or B3)  Also known as Junk Bonds  Extremely Speculative (C rating group)  Default (D rating by Standard and Poor’s)

Quoting Conventions and Markets  Bonds usually trade in a dealer market  Dealers state buying and selling prices  Dealers usually in money center banks  Some bonds listed on NYSE  Bonds listed by issuing company  Bond’s coupon rate and maturity date part of the bond name  Current yield  Volume, Closing Price, and Net Change

Problems  Problem 1 – Pricing with Annual Coupons  Problem 2 – Pricing with Semi-Annual Coupons  Problem 6 – Yield on Semi-Annual Bonds  Problem 10 – Coupon Rates  Problem 11– Pricing Semi-Annual Bond  Problem 13 – Zero Coupon Bond  Problem 19 – Conversion Option