Lecture 6, Spring 2008 1 Fundamentals of Finance Chapter 8 – Bonds
Lecture 6, Spring 2008 2 Bonds A bond is just a promissory note where the bond issuer agrees to pay the holder, or lender a specified amount of interest each year, as well as repaying the original principal. Note that the principal amount on the bond is assumed to be $1,000. It is also the price of the bond in the case below. Borrower’s perspective on a 10% annual coupon bond: +1000 -100 -100 -100 -1100 |----------|----------|----------|----~~~~------| t 0 t 1 t 2 t 3 t n
Lecture 6, Spring 2008 3 Bonds Characteristics Claim on assets/income: bondholders come before common & preferred shareholders for both income and assets (in case of default). They receive interest, unless the firm defaults whereby the bondholders lay claim to the firms assets. Interest is paid before dividends! Par value: Face value (amount) that is returned to bondholders at maturity. This is typically $1,000 for corporate debt. Convention says that prices are quoted in percent of par ( 90 3/8 ==> .90375 * 1,000 = $903.75).
Lecture 6, Spring 2008 4 Bonds Coupon interest rate : The percentage of par which is paid out annually in interest (9% coupon pays $90 in a year - the $90 is called the coupon payment). Note that in the U.S., corporate bonds make coupon payments semi-annually. Maturity : the length of time until the borrower pays back the principal (when the bond matures). Indenture : The agreement between the firm & investors. The details of the bond issue. This is usually related to what the borrowing firm cannot do as long as the bonds are outstanding.
Lecture 6, Spring 2008 5 Bonds Default Risk – How do we know how likely firms are to default? – We should do some credit analysis ourselves, but maybe we can use the services of someone who has inside information. • Credit Agencies: S&P, Moody’s • AAA -- AA -- A -- BBB |-- BB -- B -- CCC ..... D (Default)
Lecture 6, Spring 2008 6 Bonds • Investment Grade: at or above BBB (because some investment or mutual funds require BBB or above) • Junk: BB or below (also called high yield)