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FIN401-ClassnotesCh10

FIN401-ClassnotesCh10 - FIN 401 Principles of Investments...

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FIN 401 – Principles of Investments and Security Markets Chapter 10: Bond Prices and Yields
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2 Bond Characteristics A bond is a security that is issued in connection with a borrowing arrangement. The borrower issues (sells) a bond to a lender for some specified amount of cash. The issuer has to pay coupon payments (semi-annually or annually) over the life of the bond and, when the bond matures, he/she has to pay back the bond’s par value .
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3 Different Types of Bonds There are different types of bonds: Treasury Bonds Zero-coupon Bonds Corporate Bonds Callable/Puttable Bonds Convertible Bonds Floating-rate Bonds International Bonds
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4 Treasury Bonds Treasury notes’ maturities range up to 10 years, while Treasury bonds are issued with maturities ranging from 10 years to 30 years. Apart from the different maturity structures, the only major difference between T-notes and T-bonds is that T-bonds contained a “call provision”. This gives the Treasury the right to repurchase the bond at par value.
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5 Zero-coupon Bonds Zero-coupon bonds are issued that make no coupon payments. In this case, investors receive par value at the maturity date but receive no interest payments until then. In this case, the bond has a coupon rate of zero. These bonds are issued at prices considerably below par value. The investors’ return comes solely from the difference between issue price and the payment of par value at maturity.
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6 Corporate Bonds Corporations, like governments, will borrow through the issue of bonds. Example: AT&T has issued a bond maturing in 2022 paying a coupon rate of 8.125%. The face value is $1000 and the current market price is $1058.75. This gives a current yield of 7.7% which is the product of dividing the annual coupon payment ($81.25) with the bond price.
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7 Call Provision Most corporate bonds contain call provisions, allowing the issuer to repurchase the bond at a specified call price before the maturity date. How can this be used? Can firms benefit from this? If interest rates are high, then a company will issue a bond with a high coupon rate…if interest rates fall, the company may want to retire the high coupon bond and issue new bonds at a lower coupon rate, reducing interest payments.
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8 Convertible Bonds A convertible bond is an instrument giving the bondholder the right to exchange the bond for a specified number of shares of equity. This feature allows the bondholder to take advantage of favorable movements in the issuer’s equity prices. The conversion ratio gives the number of shares for which each bond may be exchanged.
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9 Floating-rate Bonds Floating-rate bonds (floaters) make interest payments that are tied to some measure of current market rates. Ex) Libor + x%. Ex) Fed fund rate + x% Example: The rate might be adjusted annually to the current T-bill rate plus 3%.
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