There is always some chance that corporations may

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There is always some chance that corporations may default. The risk that a bond issuer may default on its obligations is called default risk(or credit risk). Companies compensate for it by promising a higher coupon interest than the Canadian government when borrowing money. The difference between the promised yield on a corporate bond and the yield on a Canada bond with the same coupon and maturity is called the default premium, or credit spread. The greater the risk, the higher the spread. Bonds rated BBB or above are called investment-grade, while those with a rating of BB or below are referred to as speculative-grade, high-yield, or junk bonds. The yield spreads are bigger for riskier bonds but not constant over time. Zero-coupon bonds have no coupons, so they are issued at considerably below face value. To meet the demand for single-payment bonds, investment dealers split some conventional bonds into a series of mini-bonds, each of which makes a single maturity payment. These single-payment bonds are called strip bonds. For example, a five-year Canada bond with a 5% coupon rate becomes 11 separate zero-coupon strip bonds (there are strip coupon bonds and the strip
21 FINE2000 Notes Ilan Kogan 2015 bond residual). They all sell at a discount. One advantage of strip bonds is that if you hold them to maturity, the YTM equals the rate of return on your investment. Floating-rate bonds make coupon payments tied to some measure of current market rates. Convertible bonds allow the buyer to exchange it for a specified number of shares of common stock (since this gives investors to enjoy the price appreciation of the company’s stock, investors will accept lower interest rates). Callable bonds allow the company the option to buy them back early at the call price (which makes interest rates higher). Therefore, bond investors calculate yield to call rather than yield to maturity for bonds at high risk of being called. The yield to call is calculated like YTM with time until call replacing time until maturity and the call price replacing the face value. Most callable Canadian corporate bonds have a special call feature known as the Canada call or Doomsday call. With a Canada call, the call price is determined at the time of the call to generate a specific yield, with pay value the minimum price. A typical Canada call provision states that the call price, referred to as the Canada yield price, must offer an equivalent yield to a GOC bond of the same maturity plus an additional pre-stated amount, for default risk. With the Canada call, the call price increases as interest rates fall, making it less attractive to call the bond. Chapter 7: Valuing Stocks Common stock(or common equityor common shares) are ownership shares in a corporation. Common stock is entitled to the firm’s residual cash flow, the remaining cash flow after employees and all other suppliers, lenders, and the government taxes have been paid.

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