Bonds and Bond Pricing (Ch. 6) 05/01/06

Real vs. financial assets Real Assets have physical characteristics that determine the value of the asset 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 For Financial Assets physical characteristics are inconsequential For Financial Assets physical characteristics are inconsequential –The value is based on claim to promised or anticipated cash flows –TVM concepts are used to price financial assets

Bond basics Bond is a long-term debt instrument (long-term liability) of the issuing entity. Bond is a long-term debt instrument (long-term liability) of the issuing entity. By Issuer By Issuer –Corporate Bonds – Companies –Treasury Bonds – U.S. Government –Municipal Bonds – State and Local Governments

Bond basics The principal (or face value) is the amount borrowed by the company and the amount owed to the bond holder on the maturity date. The principal (or face value) is the amount borrowed by the company and the amount owed to the bond holder on the maturity date. The coupon rate is the specified interest rate (or $ amount) that must be periodically paid. The coupon rate is the specified interest rate (or $ amount) that must be periodically paid. –The rate is stated as an annual rate but is typically paid every six months The yield to maturity (YTM) represents The yield to maturity (YTM) represents –the return required by investors (or bondholders) in the bond. –the actual return achieved if the bond is held to maturity. –The YTM is determined by factors such as the risk-free rate, default, maturity, and liquidity premiums associated with a particular bond.

Valuing bonds For a typical corporate or treasury bond, there are two sets of cash flows: For a typical corporate or treasury bond, there are two sets of cash flows: –Coupon payments which occur every six months –Principal (or face value) payment, which occurs at maturity. The value of a bond is the present value of the coupon payments plus the present value of the principal payment. The value of a bond is the present value of the coupon payments plus the present value of the principal payment.

Valuing bonds Coupon payments represent semi-annual cash flows that can be valued as an annuity. Coupon payments represent semi-annual cash flows that can be valued as an annuity. The principal represents a single cash flow at maturity. The principal represents a single cash flow at maturity. Therefore, Therefore, where C represents the annual coupon payment, YTM represents the bond’s yield to maturity (or required rate of return), and t represents the number of semi-annual periods to maturity

Finding the YTM If the bond price and cash flows are known you can find YTM. If the bond price and cash flows are known you can find YTM. Without a financial calculator or a spreadsheet, the YTM can only be solved using trial and error. Without a financial calculator or a spreadsheet, the YTM can only be solved using trial and error.

Relationship between bond prices, coupon rates and YTMs If the bond price > face value (or principal), the bond is said to be selling at a premium. This will be the case if the YTM face value (or principal), the bond is said to be selling at a premium. This will be the case if the YTM < C. If the bond price C. If the bond price C. If the bond price = face value, then bond is selling at par and YTM = C. If the bond price = face value, then bond is selling at par and YTM = C.

Bond terminology A debenture, or unsecured bond, represents a corporate bond issue for which there are no specific assets that back the issue. A debenture, or unsecured bond, represents a corporate bond issue for which there are no specific assets that back the issue. A secured, or collateralized bond issue has specific assets, such as equipment or real estate, that the lender will take if the borrower does not meet their payment obligations. A secured, or collateralized bond issue has specific assets, such as equipment or real estate, that the lender will take if the borrower does not meet their payment obligations. Senior debt versus junior debt Senior debt versus junior debt –Older Issue is Senior –Junior debt paid off after senior debt

Bond contract The bond indenture is a legal document that specifies both the rights of the bondholders and the duties of the issuing corporation. The bond indenture is a legal document that specifies both the rights of the bondholders and the duties of the issuing corporation. Standard debt provisions (or covenants) in the indenture specify certain recordkeeping and general business procedures that the issuer must follow. Standard debt provisions (or covenants) in the indenture specify certain recordkeeping and general business procedures that the issuer must follow. Restrictive debt provisions (or covenants) are contractual clauses in a bond indenture that place operating and financial constraints on the borrower. Restrictive debt provisions (or covenants) are contractual clauses in a bond indenture that place operating and financial constraints on the borrower. –Minimum equity levels –Fixed asset restrictions –Constraints on subsequent borrowing –Limitations on cash dividends.

Bond contract Sinking fund requirements are restrictive provisions often included in bond indentures that provide for the systematic retirement of bonds prior to their maturity. Sinking fund requirements are restrictive provisions often included in bond indentures that provide for the systematic retirement of bonds prior to their maturity. A subordination clause stipulates that subsequent lenders must wait until all claims of the senior debt issues have been paid off before receiving payment. A subordination clause stipulates that subsequent lenders must wait until all claims of the senior debt issues have been paid off before receiving payment.

Types of bonds A Zero-Coupon (or deep discount) bond has no coupon payments and is priced as a semi-annual bond for principal repayment A Zero-Coupon (or deep discount) bond has no coupon payments and is priced as a semi-annual bond for principal repayment A Consol has standard coupon payments but no maturity A Consol has standard coupon payments but no maturity A Putable bond allows the buyer to sell back the bond to the issuing entity prior to maturity. A Putable bond allows the buyer to sell back the bond to the issuing entity prior to maturity. –This allows the buyer to be protected against actions that the issuing entity may take that may reduce the price of the bonds.

Types of bonds A callable bond allows the issuing entity to buy back the bond prior to maturity. A callable bond allows the issuing entity to buy back the bond prior to maturity. –This allows the entity to refinance their borrowing at a lower interest rate if interest rates fall. A convertible bond allows the buyer to convert the bond to (typically) a specified number of shares of the company. A convertible bond allows the buyer to convert the bond to (typically) a specified number of shares of the company.

Bond ratings allow investors to determine the default risk associated with a particular company. Bond ratings allow investors to determine the default risk associated with a particular company. Ratings also allow companies to market new bond issues. Ratings also allow companies to market new bond issues. Bond ratings

Quoting conventions and markets Bonds usually trade in a dealer market Bonds usually trade in a dealer market –Dealers state buying and selling prices –Dealers usually in money center banks JP Morgan Chase, Bank of America JP Morgan Chase, Bank of America Some bonds are listed on NYSE Some bonds are listed on NYSE

Bond quotations