1 FIN 2004 Finance Tutorial 5 : Bonds Conducted by : Mr Chong Lock Kuah, CFA
2 Revisit some important concepts • A bond is a long-term contract under which a borrower (issuer) agrees to make payments of interest and principal, on specific dates, to the holders of the bond. • Bonds are classified into four main types : Treasury, corporate, municipal, and foreign. • Treasury Bonds – Bonds issued by federal government, sometimes referred to as government bonds. It is reasonable to assume that the federal government will make good on its promised payments, so these bonds have no default risk. However, Treasury bond prices decline when interest rates rise, so they are not free of all risks. • Corporate Bonds – Bonds issued by corporations. They are exposed to default risk. The larger the default or credit risk, the higher the interest rate the issuer must pay. • Municipal bonds, or “ munis, ” are issued by state and local governments. Like corporate bonds, munis have default risk. The interest earned on most municipal bonds is exempt from federal taxes, and also from state taxes if the holder is a resident of the issuing state. • Foreign Bonds are issued by foreign governments or foreign corporations. In additional to default risk, foreign bonds denominated in foreign currency are also subject to foreign currency risk.
3 Cont ’ d • The par value is the stated face value of the bond. The par value generally represent the amount of money the firm borrows and promises to repay on the maturity date. • The coupon interest rate is the stated annual rate of interest on a bond. The coupon interest may be fixed or floating. • The coupon payment is the specified number of dollars of interest paid each period. Annual coupon payment is equal to coupon interest rate x par value. • Maturity date is a specified date on which the par value of a bond must be repaid. • Coupon Bond is a bond that pays specified interest rate on a specified period. • Zero Coupon Bonds ( “ Zeros ” ) are bonds that pay no annual interest but are sold at a discount below par, thus providing compensation to investors in the form of capital appreciation. • Callable Bonds contain a call provision, which gives the issuer the right to call (or redeem) the bonds under specified terms prior to the normal maturity date. When the bonds are called, the issuer usually pays the bondholders an amount greater than the par value. This excess amount is termed as a call premium (typically set equal to one year ’ s interest if the bonds are called during the first year). The premium declines at a constant rate INT/N each year thereafter.
4 Cont ’ d • Bonds are often not callable until several years (generally 5 to 10) after they were issued. This is known as deferred call, and the bonds are said to have call protection.
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- Fall '18