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Bonds and Bond Valuation Chapter 7

Bonds and Bond Valuation Chapter 7. TYPES OF BONDS. A. Mortgage bonds: bonds secured by real property B. Equipment trust certificates: bonds secured by equipment (rolling stock) C. Debentures: unsecured bonds (no collateral).

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Bonds and Bond Valuation Chapter 7

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  1. Bonds and Bond ValuationChapter 7

  2. TYPES OF BONDS A. Mortgage bonds: bonds secured by real property B. Equipment trust certificates: bonds secured by equipment (rolling stock) C. Debentures: unsecured bonds (no collateral). D. Revenue bonds: interest paid only if a specified level of earnings is achieved

  3. TYPES OF BONDS E. Convertible bonds: bonds that may be converted into the firm's common stock F. Variable interest rate bonds: coupons that change with changes in interest rates G. Zero coupon bonds (also called pure discount bonds): don’t pay coupons. H. Callable Bonds: can be “called” prior to stated maturity (early redemption).

  4. CHARACTERISTICS OF ALL DEBT INSTRUMENTS • Pay Interest (coupons) and have a fixed maturity value ($1000 for corporate bonds). • Indenture Agreement 1. Loan agreement between lender and borrower. 2. Appoints the trustee; a fiduciary responsible for guarding the lenders' interests. • Indenture agreement provides for legal remedies if terms & conditions of indenture are not met. • May specify call provisions • May require a sinking fund or serial redemption

  5. CHARACTERISTICS OF ALL DEBT INSTRUMENTS C. Sources of risk 1. Default; probability of not getting all of the promised interest and principal. 2. Price; changes in prices as interest rates change over time. The longer the time to maturity, the greater the sensitivity. (See Fig 7-3) 3. Purchasing power; effects on inflation on buying power of coupon income. 4. Liquidity: inability to buy or sell at intrinsic value due to inactive market or small float.

  6. BOND VALUES AND BOND YIELDS • Bond valuation model; • VB = Coupon * PVIFA + Face Value * PVIF • The value of a bond (VB) is a combination of a present value of an annuity (PV of coupons to be received) and PV of face value of the bond. VB is also the PV of all expected cash flows

  7. BOND VALUES AND BOND YIELDS • Current yield = coupon divided by the [current] price (PV) • Yield to maturity (YTM) = rate earned if held to maturity • Interest rates and bond values • YTM go up --- bond prices go down [and vice-versa] • If company gets riskier, then YTM goes up and prices down [and vice-versa].

  8. USING FINANCIAL CALCULATORS TO COMPUTE BOND VALUES A bond pays a coupon of $120 per year, paid semi-annually. The bond matures in 20 years and has a face value of $1,000. If the current YTM rates are 9 percent, how much should this bond sell for? • ENTER 20 [2nd] [N], [N]: Display: N = 40.00 • ENTER 9 [I/Y]: Display: I/Y = 9.00 • ENTER 60 [PMT]: Display: PMT = 60.00 • ENTER 1000 [FV]: Display: FV = 1,000.00 • PRESS [CPT] [PV]: Display: PV = -1,276.02

  9. USING FINANCIAL CALCULATORS TO COMPUTE BOND VALUES • What If Examples • Suppose the YTM is 11 percent; "I/Y" = 11. Enter 11, press [I/Y], then [CPT] , then [PV]; -1,080.23. • If the YTM is 12%; enter 12, press [I/Y], then [CPT], [PV]; PV = 1,000.00 or $1,000.00. • If the YTM is 15%, the price [PV] is $811.08. • Note as YTM increases, VB decreases

  10. HOMEWORK CHAPTER 7 • Self-Test: ST-1, par value, e, h • Questions: 7-3, 7-6, 7-8, 7-9 • Problems: 7-1, 7-8, 7-11 (part a)

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