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350-06a_note[1]

# 350-06a_note[1] - 350-06a_note 11S TOPIC 6 BONDS AND THEIR...

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350-06a_note, 11S Page 1 of 18 TOPIC 6: BONDS AND THEIR VALUATION (CHAPTER 7) I. Outline A. Key Features of Bonds 1. Basic features 2. Call provision, sinking fund, and others B. Bond Valuation 1. Required return rate vs. Intrinsic Value C. Measuring Yield 1. Market price vs. Estimated return rate D. Interest Rate Summary E. Assessing Risk 1. Interest rate risk vs. reinvestment risk F. Special Topics II. Homework Assignment Chapter 7 Question 3-8, 11, 13, 14 Problem 1, 3-5, 7-9, 11, 13, 15, 17 ================================================================ Class Notes I. Key Features of A Bond A. Basic Features: (Case A) 1. 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. 2. Bond Markets a) Primarily traded in the over-the-counter (OTC) market. b) Most bonds are owned by and traded among large financial institutions. c) Full information on bond trades in the OTC market is not published, but a representative group of bonds is listed and traded on the bond division of the NYSE. Example: IBM Description Issue Date: 06/24/2004 When the bond was issued Issuer: IBM Borrower Par Value: \$1000 Face amount of the bond, which is paid at maturity Shares 100,000 Coupon: 5%, paid annually Stated interest rate (generally fixed) paid by the issuer. Multiply by par value to get dollar payment of interest. Determine CF Maturity: 06/24/2024 Years until the bond must be repaid. T = 20 years. Yield to Maturity: Need to be calculated Rate of return earned on a bond held until maturity (also called the “promised yield”). Call Provision: IBM can buy back the bond at \$1150 in year 5 See Part B Sinking Fund: Call 5% back at par Buy bond in the market See Part B

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350-06a_note, 11S Page 2 of 18 B. Other Features (Case B) 1. Call Provision: IBM can buy back the bond at \$1150 in year 5. a) Who can “Call” back bonds? b) What will happen when the bond is called back?? c) When will the firm call back bonds? Assumption Call Price Action Explanation The market price is \$1200 \$1150 The market price is \$800 \$1150 d) Summary (1) Allows issuer to refund the bond issue if interest rates decline (helps the issuer, but hurts the investor). (2) Borrowers (Issuers) are willing to pay more, and lenders require more, for callable bonds. (3) Most bonds have a deferred call and a declining call premium 2. Sinking Fund: Provision to pay off a loan over its life rather than all at maturity. a) How are sinking funds executed? (1) Call 5% of the issue at par, for sinking fund purposes. (2) Buy bonds in the open market at market price. b) Example: Assumption Action Explanation The market price is \$1170 The market price is \$970 c) Summary (1) Similar to amortization on a term loan. (2) Reduces risk to investor, shortens average maturity. (3) But not good for investors if rates decline after issuance.
350-06a_note, 11S Page 3 of 18 3. Others a) Reminder: CFs for issuers (borrowers) and bondholders (investors, lenders). The IBM bond (from previous example) is currently traded at \$980.

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350-06a_note[1] - 350-06a_note 11S TOPIC 6 BONDS AND THEIR...

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