eFM2e, ch 09, Bonds

# eFM2e, ch 09, Bonds - Chapter 9 Bonds and Their Valuation...

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Bonds and Their Valuation Chapter 9 Key Features of Bonds Bond Valuation Measuring Yield Assessing Risk 9-1

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What is a bond? A long-term debt instrument in which a borrower agrees to make payments of principal and interest, on specific dates, to the holders of the bond. Most corporate bonds are issued with a par, or face, value of \$1,000, all bonds are quoted as a percentage of par. A \$1,000-par-value bond quoted at 94.007 is priced at \$940.07 (94.007% \$1,000). Thus, Company C’s price of 103.143 for the day was \$1,031.43—that is, 103.143% \$1,000. 9-2
What is a bond? Miller Company, a large contractor, on January 1, 2007, issued a 10% coupon interest rate, 10-year bond with a \$1,000 par value that pays interest semiannually. Investors who buy this bond receive the contractual right to two cash flows: (1) \$100 annual interest (10% coupon interest rate \$1,000 par value) distributed as \$50 (1/2 \$100) at the end of each 6 months, and (2) the \$1,000 par value at the end of the tenth year. Assuming that interest on the Miller Company bond issue is paid annually and that the required return is equal to the bond s coupon interest rate, I = \$100, r d = 10%, M = \$1,000, and n = 10 years 9-3

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Bond Markets Primarily traded in the over-the-counter (OTC) market. Most bonds are owned by and traded among large financial institutions. The Wall Street Journal reports key developments in the Treasury, corporate, and municipal markets. Online edition lists trading for each day the most actively-traded investment- grade, high-yield, and convertible bonds. 9-4
Key Features of a Bond Par value – face amount of the bond, which is paid at maturity (assume \$1,000). Coupon interest rate – stated interest rate (generally fixed) paid by the issuer. Multiply by par value to get dollar payment of interest. Maturity date – years until the bond must be repaid. Issue date – when the bond was issued. Yield to maturity – rate of return earned on a bond held until maturity (also called the “promised yield”). 9-5

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Effect of a Call Provision Allows issuer to refund the bond issue if rates decline (helps the issuer, but hurts the investor). Borrowers are willing to pay more, and lenders require more, for callable bonds. Most bonds have a deferred call and a declining call premium. 9-6
What is a sinking fund? Provision to pay off a loan over its life rather than all at maturity. Similar to amortization on a term loan. Reduces risk to investor, shortens average maturity. But not good for investors if rates decline after issuance. 9-7

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How are sinking funds executed? Call x% of the issue at par, for sinking fund purposes. Likely to be used if r d is below the coupon rate and the bond sells at a premium. Buy bonds in the open market. Likely to be used if r d is above the coupon rate and the bond sells at a discount.
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