CF Winter 2014

Bonds & Beyond ch 7

What’s a Bond, Again? “bond” = “note” = “debenture” a loan  a promise to pay certain amount on a certain day regular payments before that  usually

What’s a Bond, Again?  no ownership interest voting rights  interest a cost of doing business tax deductible  bondholders have legal recourse can lead to financial distress

Bonds Definitions definitions  Maturity date  Face value aka: par value  Coupon payment  Coupon rate  Yield aka: yield to maturity rate implied by market price & payments amount paid per installment coupon payment face value

Purposes of Bond Pricing not just to figure out bond prices bond as benchmark  explicit can develop formulas Which projects should we choose? Where should we get the money?

Purposes of Bond Pricing because everything “has a price”  all investments can be weighed together  can compare & separate out risk return attractiveness

Bond Pricing “Theorems” bonds of similar risk & maturity  will yield about the same return regardless of the coupon rate if  open market flexible prices multiple participants  all information available

Real-World Bonds The Bond Indenture contract between company & bondholders  basic terms  total amount of bonds issued  description of security (property)  sinking fund provisions  call provisions  details of protective covenants

Real-World Bonds main types  Government Bond  Municipal Bond  Corporate Bond

Real-World Bonds Required Returns  perceived risk=  required return  flexibility=  required return

Real-World Bonds variations  secured vsdebenture  senior debtvssubordinated  sinking fundvswithout  convertiblevsnon-convertible  registeredvsbearer ( aka coupon)  time to maturity  callable vsnon-callable

Real-World Bonds more variations  disaster bonds  income bonds  put bond aka retractable bond  LYON bond

Real-World Bonds still more variations  call provisions call premium deferred call call protected Canada plus call

Real-World Bonds one more variation  Stripped bonds »“Zero-coupon bonds” »“Zeroes” »“Deep discount bonds” coupon rate = 0  no interest payments  YTM = par value - purchase price

Real-World Bonds ratings  High Grade AAA, AA  strong ability to pay  Medium Grade A, BBB  ability may be affected by circumstances

Real-World Bonds ratings  Low Grade BB, B, CCC, CC  speculative  Very Low Grade C  immediate danger of default D  in default

Real-World Bond Markets mainly OTC  many issues  little trading so prices may not be up to date both  primary market  secondary market exception: Treasury securities

Real-World Bond Markets Secondary market  once bond issued, price can vary If  market value < face value “discount bond”  selling at a discount YTM > coupon rate

Real-World Bond Markets Secondary market  once bond issued, price can vary If  market value > face value “premium bond”  selling at a premium YTM < coupon rate

Idealized Bonds calculations assume idealized bond  no default risk contract constraints “external” events  markets  exchange rates  interest rates  yield curve rational buyers & sellers

Bond Calculation Symbols t number of periods f bond’s face value par value c coupon (amount) paid each period r rate per period  converted into annual rate: “Yield” “YTM”  “Yield To Maturity”

Bond Pricing

Bond-Pricing Equation

Example 1 par value  $1,000 coupon  rate of 10%  paid annually years to maturity 55 Yield to Maturity (YTM)  11% price? f = $1, c = $ t = 5 r = 0.11 PV b = ?

Example 1

Example 2 par value  $1,000 coupon  rate of 10%  paid annually years to maturity  20 Yield to Maturity (YTM)  8% price? f = $1, c = $ t = 20 r = 0.08 PV b = ?

Example 2

Example 3 par value  $1,000 coupon  rate of 8%  paid semi-annually years to maturity 77 Yield to Maturity (YTM)  5% price? f = $1, c = $40.00 t = 14 r = 0.05 PV b = ? Semi-Annual Coupon

Example 3 Semi-Annual Coupon

The Fisher Effect connects together  real rates  nominal rates  inflation r R h

The Fisher Effect connects together  real rates  nominal rates  inflation r rnrn riri r R h

The Fisher Effect connects together  real rates  nominal rates  inflation r R h

Applied we’re considering a project that will  cost us $5,000 to start up  generate $500/year in “profit” equipment can be sold after 10 years  for $1,000 What’s our return?

Applied Project PV = -$5, c = $ t= 10 f = $1, r = ? = 3.03%

Applied we can borrow money  7% we’re considering a project that will  have $2,000 in start-up costs  generate $600/year in “profit” equipment sold for scrap  after 15 years  for $500 Should we do this?

Applied Project PV = -$2, c = $ t= 15 f = $ r > 7%? = 8.90%

Applied we have a line of credit  9% we’re considering a project that will  generate $300/year in “profit” can re-sell equipment  after 5 years  for $2, What’s the most we should spend at start-up?

Applied Project c = $ t= 5 f = $ r = 9.00? PV =? spend no more than $2, on start-up

Need to know bonds  different kinds  how to use formulas  keeping semi-annual & annual straight projects  how to apply bond formulas  what the answers mean