2504 Essentials of Business Finance

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Chapter 7

• 2504 Essentials of Business Finance

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1. Bond Valuation Terminologies

• Coupon regular interest payments that the issuer
  of the bond promises to make.
• Face Value amount repaid at the end of the loan.
  
• Coupon rate annual coupon payment divided by the
  face value.
• Maturity date specified date at which the
  principal amount of a bond is paid.
• Time to Maturity number of years until the face
  value is paid is called the bonds time to
  maturity.
• Yield to Maturity the interest rate used for the
  estimation of the price of bond. It is a rate
  that the market requires on the bond, expressed
  as APR.
• Par Bond A bond that sells for its face value
  (YTM coupon rate).
• Discount Bond A bond that sells for less than
  its face value (YTM gt coupon rate).
• Premium Bond A bond that sells for more than its
  face value (YTM lt coupon rate).
• Stripped (zero-coupon) bonds make no coupon
  payments, thus initially priced at a deep
  discount.

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1. Bond Valuation

• If a bond has (1) a face value of F paid at
  maturity (2) a coupon of C paid per period (3)
  t periods to maturity and (4) a yield of r per
  period, its value is

We cant always find r when it is unknown, using
an usual calculator.

• YTM is quoted as APR
• Time to maturity is expressed as of years.
• Therefore

CAUTION!!!
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1. Interest Rate Risk

• YTM coupon rate ? bond price face value,
  i.e., sells at a par
• YTM gt coupon rate ? bond price lt face value,
  i.e., sells at a discount
• YTM lt coupon rate ? bond price gt face value,
  i.e., sells at a premium. See Questions and
  Problems 22 page 199.
• Interest Rate Risk
• YTM ? bond price?. Since YTM ? as interest rate
  ?, interest rate ? bond prices ?. See Questions
  and Problems 14, page 198.
• Time to maturity ? price sensitivity to Interest
  rate ?. WHY?
• Coupon rate? price sensitivity to Interest rate?.
  WHY?
• See Questions and Problems 16 and 17, page 198.
  
• If you predict a significant drop in interest
  rate in near future, you should buy bonds with
  long times to maturity and low coupons!

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1. Interest Rate Risk
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6. Real vs. Nominal Rates

• Nominal rates Interest rate or rates of return
  that have not been adjusted to inflation.
• Real rates Interest rate or rates of return that
  have been adjusted to inflation.
• The Fisher Effect
• 1 R (1 r)(1 h)
• Where R nominal rate, r real rate, h
  inflation rate
• Approximation R r h

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7. Factors Determining YTM

• Real interest rate
• Inflation premium compensation for expected
  future inflation.
• Interest rate risk premium compensation for
  bearing interest rate risk (arising from the
  fluctuations in interest rates).
• Default risk premium compensation for the
  possibility of default.
• Standard Poors, Moodys, Dominion Bond Rating
  Service (see Table 7.2 in section 7.3).
• Liquidity premium compensation for lack of
  liquidity.
• Taxability.

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7. Term Structure of Interest Rates

• Term structure of interest rate the relationship
  between short- and long-term interest rates.
  More specifically, the relationship between
  nominal interest rates on default free, pure
  discount securities and tune to maturity (i.e.,
  the pure time value of money).
• Risk associated with bonds shrinks as maturity
  approaches, bond prices get close to the face
  value as maturity approaches. Usually, the
  sensitivity of price to time to maturity is the
  greatest at the shortest maturity length.

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7. Yield Curve graphical representation of the
term structure
This is what we usually observe upward-sloping,
long-term yields are higher than short-term yields
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7. Yield Curve graphical representation of the
term structure
Inverted long-term yields are lower than
short-term yields
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7. Government of Canada Yield CurveNovember 29,
2002
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2. How Bond differ from Equity

• Debt represents something that must be repaid.
  It is the result of borrowing money. It differs
  from equity mainly in terms of
• Debt holders do not have ownership of the firm.
  They do not have voting power. Shareholders
  have.
• Interests on debt is fully tax deductive.
  Dividends paid to shareholders are not tax
  deductible.
• Equity is always subordinated to debt. If debt
  is not paid, the creditors can legally claim the
  assets of the firm. Unlike issuing equity,
  issuing debt generates the possibility of
  bankruptcy (and liquidation, reorganization).
  Equity holders are paid after debt holders.
• Max. reward for owning a debt security is fixed,
  whereas the potential reward for owning equity is
  unlimited.

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2. Types of Bonds/Debt

• Debt can be either secured, or unsecured.
• A bond is, strictly speaking, a secured debt. It
  can be secured by
• (a) collateral (other bonds and/or stocks).
  e.g., collateral trust bonds usually involve a
  pledge of common stock held by the corporation.
• (b) mortgage (real estate, equipment, etc.).
• A debenture is an unsecured bond, usually a
  maturity of 10 years or more. Most public bonds
  issued by industrial and finance companies are
  debentures. Most utility and railroad bonds are
  secured.
• A note is an unsecured bond, usually a maturity
  of less than10 years.
• Seniority indicates preference in position over
  other lenders. Debts are sometimes labeled as
  senior or junior or subordinated

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2. Bond Features

• Indenture the written agreement b/w the
  corporation and its creditors.
• Protective covenant part of indenture that
  limits certain actions a company might otherwise
  wish to take during the life of the debt. There
  are negative covenants and positive covenants.
• Usually, a trustee (a trust company) is appointed
  by the corporation to represent bondholders. The
  trustee must (1) make sure the terms of the
  indenture are obeyed (2) manage the sinking
  fund (3) represent the bondholders in default.
  
• Bonds can be repaid at maturity, or before
  maturity. Early repayment is often handled
  through a sinking funds.
• Sinking fund an account managed by the bond
  trustee for the purpose of repaying the bonds.
  The company makes annual payments to the trustee.
  The trustee uses the funds to buy up some of the
  outstanding bonds in the market or calling in a
  fraction of the outstanding bonds. A sinking
  fund reduces the risk that the company will be
  unable to repay the principle at maturity, thus
  improves the marketability of the bonds.

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2. Bond Features Call Provision

• A call provision allows the company to repurchase
  (or call) a part or all of the bond issued at a
  specified price (call price) over a specified
  period.
• Call price gt face value. Call price face value
  call premium.
• Deferred call call provision prohibiting the
  company from redeeming the bond before a certain
  date. For example, a company might be prohibited
  from calling its bonds for the first 10 years.
  During this period, the bond is call protected.
• Corporate bonds are usually callable. Why so
  popular?

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2. Bond Refunding and Call Provision

• Suppose a firm issued long-term debt with 12
  coupon one year ago. After that, the interest
  rate has declined and the firm find that it could
  pay an 8 coupon to raise the same amount of
  capital. In this case, the firm wants to redeem
  the outstanding bonds (with 12 coupon) and issue
  new bonds with 8 coupon. This process is bond
  refunding.
• Call provision makes it easier for the firm to
  redeem the outstanding bonds even if interest
  rate ? and bond prices extremely ?, the firm can
  buy back them not at very high price in the
  market but at the call price.
• Call provision limits bondholders gain.
• (a) interest rate ? and bond prices extremely ?,
  the firm may buy back the bonds, making it
  impossible for bondholders to sell them and
  receive a huge capital gain.
• (b) it makes bond refunding easier for the firm ?
  decreases bondholders income from the coupon
  payments.
• Canada plus call in the event of call, the
  issuer must provide a call premium which will
  compensate investors for the difference in
  interest between the original bond and new debt
  issued to replace it.

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4. Exotic Bonds

• Junk bonds bonds with very high YTM, implying
  low creditworthiness (high-yield, high risk
  bonds) .
• Floating rate bonds coupon payments depend on
  the T-bill or other short-term interest rate
  (e.g., 0.4 more than the bankers acceptance
  rate).
• Disaster bonds pay interest and principal unless
  a particular event occurs (hurricane, earthquake,
  etc.).
• Income bonds coupon payments depends on company
  income.
• Real return bonds coupons and principals are
  indexed to inflation to provide a stated real
  return.
• Retractable (put) bonds bonds with put
  provisions allows the holder to force the issuer
  to buy back the bonds at a stated price.
• Convertible Bonds can be swapped for a fixed
  number of common stock at any time prior to the
  bonds maturity.

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Some Bond Types and Terminology

•  
• I.                    Bond Types
•  
• Senior -- backed by a specific claim
• Junior/Debenture -- unsecured LT debt
• Subordinated Debenture -- 2nd in line
• Convertible Bond -- converts to common shares at
  a pre-specified rate
• Zero-Coupon Bond -- interest accumulates and is
  paid at maturity
• Floating Rate Bond -- coupon rate tied to some
  rate (Prime/LIBOR)
• Indexed Bond -- real-return bonds indexed to
  inflation
• Extendible Bond -- option to holder
• Retractable Bond -- option to holder
• Callable Bond -- option to issuer
• Junk Bond -- low rated (Ba/BB or lower)
• Mortgage Bond -- backed by specific real assets
  (real estate)

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Some Bond Types and Terminology

•  
• II.                   Bond Terminology
•  
• Indenture -- trust deed
• Trustee -- overseer of indenture
• Default -- inability to make interest payments
• Protective/Restrictive Covenant -- outlines
  specific uses of
• Call Provision -- embedded option to issuer
• Deferred Call -- prohibits call until a specified
  date
• Sinking Fund -- systematic payments to reduce
  payment at maturity
• Bond Rating -- Moodys (Aaa, Aa, A, Baa,), SP
  (AAA, AA...)
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• III.               Bond Risks
•  
• Interest Rate -- behavior of interest rates and
  their effect on prices
• Liquidity -- difficult to cash out
• Maturity -- longer to receive face
• Default/Business -- non-payment
• Call -- issuer retires bond

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Any questions? End see you next week