FINANCE FIN2004 Lesson 6 Bonds RWJLT Chapter 7
Scope • Bonds and Terminology • Bond Valuation • Yield-to-Maturity (YTM) and Market Interest Rate • Relationship Between Interest Rates and Bond Prices 6-1 • Bond Ratings and Default Risk • Zero Coupon Bonds and Other Bond Types • Bond Markets • Term Structure of Interest Rates
What is a Bond? square4 A bond is a long-term debt instrument sold by an issuer (borrower) to raise (borrow) money. square4 Government, municipalities and large or listed companies can turn to the public to borrow money by issuing bonds. square4 One who buys a corporate bond is a creditor (or lender ) of the company; not an owner. 6-2
Some Basic Terminology square4 Par Value :The face value of a bond (i.e. its principal amount) assigned by the issuer; this amount will be repaid at the end of the term. It is generally $1,000, unless otherwise stated. square4 Coupon :A bond's periodic interest payment to the bondholder. square4 Coupon rate : The nominal annual coupon interest rate of the bond. square4 Maturity (or Maturity Date ):Specified date on which the bond is due, and the bond’s principal (par) amount is paid. Year Per Payments Coupon of Number Value Par x Rate Coupon Annual Nominal Coupon (Periodic) = 6-3 It is equal to the annual dollar coupon divided by the par value of the bond. The coupon and the coupon rate are related as follows:
Bond Certificate 6-4
Bond Maturity square4 Unlike stocks, bonds have finite lifetimes. An issuer of bonds has to decide the life the bonds before issuing them, i.e. the issuer has to fix the bonds’ maturity date . • Some people use the word “maturity“ to refer to the original lifetime of the bond. For example, they may say “the bond has ten-year maturity” to mean that the bond has 10 yearslifetime at the time of issue . • The time remaining until the maturity date is known as the “term” of the bond. 6-5
Cash Flows from Bonds square4 If you buy a bond, the issuer (i.e. the borrower) promises to pay you: (i) periodic coupons (based on the number of coupon payments per year). (ii)the par value (on the maturity date). square4 The company has legal obligation to make these payments, regardless of its financial performance in any year. 6-6
Example You buy a GE bond with a $1,000 par value, a 5% coupon paid annually and a 10-year maturity. • GE guarantees to pay you annual coupon of $50 and also pay you back the par value of $1,000 on maturity date. • If you hold this bond to maturity, you know the exact cash amounts you will receive and when you will receive them (unless GE defaults on payment) barb4right Bond is considered a "fixed-income" investment, because you are assured a steady payout or periodic income. • This regular income is what makes bond returns inherently less volatile (hence less risky ) than stock returns.
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