Chapter 6

Bond (debt)

characteristi
cs and
valuation
 Debt
Characteristics
Debt is a loan to a firm, government , or
individual. Many types of debt instruments
exist: home mortgages, commercial paper,
term loans, bonds, secured and unsecured
notes, and marketable and nonmarketable
debt, among others.
Principal Amount = Face Value = Maturity
Value = Par Value: The amount of money
borrowed
 Debt
Characteristics
Interest Payments: The specified number of
dollars of interest paid each period, generally
each six months, on a bond.
Interest Rate: The stated annual rate of
interest paid on a bond.
Discounted Securities: Securities selling for
less than par value.
Maturity Date: A specified date on which the
par value of a bond must be repaid.
 Debt
Characteristics
Priority to Assets and Earnings: Corporate
debt holders have priority over stockholders
with regard to distribution of earnings and
liquidation of assets.
Control of the Firm (Voting Rights): Corporate
debt holders do not have Voting rights, so
they cannot attain control of the firm.
 Types of Debt

Short-Term Debt: Short-term debt generally

refers to debt instruments with maturities of
one year or less.
Long-Term Debt: Long-term debt refers to
debt instruments with maturities greater than
one year.
 Short-term Debt
Treasury bills (T-bills): Discounted short-
term debt instruments issued by government.
Repurchase Agreement (Repo): An
arrangement in which one firm sells some of its
financial assets to another firm with a promise
to repurchase the securities at a later date.
Bankers acceptance: An instrument issued
by a bank that obligates the bank to pay a
specified amount at some future date.
 Short-term Debt
Commercial paper (CP): A discounted
instrument that is a type of promissory note, or
legal IOU, issued by large, financially sound firms.
Certificate of deposit (CD): An interest-
earning time deposit at a bank or other financial
intermediary.
Negotiable CD: Certificate of deposit that can
be traded to other investors prior to maturity;
redemption is made by the investor who owns
the CD at maturity .
 Short-term Debt

Eurodollar deposit: A deposit in a foreign

bank that is denominated in U.S. dollars.
Money market mutual funds: Pools of
funds managed by investment companies
that are primarily invested in short-term
financial assets .
 Long-term Debt

Term loan: A loan, generally obtained from

a bank or insurance company, on which the
borrower agrees to make a series of
payments consisting of interest and principal.
Bond: A long-term debt instrument.
Coupon rate: Interest paid on a bond or
other debt instrument stated as a percentage
of its face, or maturity value.
 Long-term Debt
Government bond: Bonds issued by the
government.
Municipal bond: A bond issued by local
governments.
Revenue bond: A municipal bond that
generates revenue, which in turn can be used to
make interest payments and repay the principal.
General obligation bond: A municipal bond
backed by the local governments ability to
impose taxes.
 Long-term Debt
Corporate bonds: Long-term debt
instruments issued by corporations.
Mortgage bond: A bond backed by fixed
assets. First mortgage bonds are senior in
priority to claims of second mortgage bonds.
Debenture: A long-term bond that is not
secured by a mortgage on specific property.
Subordinated debenture: A bond that has
a claim on assets only after the senior debt
has been paid off in the event of liquidation.
 Long-term Debt

Income bond: A bond that pays interest to the

holder only if the interest is earned by the firm.
Indexed ( purchasing power) bond: A bond
that has interest payments based on an inflation
index to protect the holder from inflation.
Floating-rate bond: A bond whose interest
rate fluctuates with shifts in the general level of
interest rates.
 Long-term Debt

Zero coupon bond: A bond that pays no

annual interest but is sold at a discount
below par, thus providing compensation to
investors in the form of capital appreciation.
Junk bond: A high-risk, high-yield bond
used to finance merger, leveraged buyouts,
and troubled companies.
 Bond Contract
Features
A firm's managers are concerned with both the
effective cost of debt and any restrictions in debt
contracts that might limit the firm's future actions
Indenture: A formal agreement (contract)
between the issuer of a bond and the bondholders.
Trustee: An official who ensures that the
bondholders interests are protected and that the
terms of the indenture are carried out.
Restrictive covenant: A provision in a debt
contract that constrains the actions of the borrower.
 Bond Contract
Features
Call provision: A provision in a bond
contract that gives the issuer the right to
redeem the bonds under specified terms prior
to the normal maturity date.
Sinking fund: A required annual payment
designed to amortize a bond issue.
Conversion feature: Permits bondholders
to exchange their investments for a fixed
number of shares of common stock.
 Foreign Debt
Instruments
Foreign debt: Debt issued by a foreign
borrower but denominated in the currency of the
country in which it is sold.
Euro debt: Debt issued in a country other than
the one in whose currency the debt is
denominated.
LIBOR: The London Inter-Bank Offer Rate; the
interest rate offered by the best London banks on
deposits of other large, very creditworthy banks.
Valuation of
Bonds
 Finding Bond
Yields
Yield to maturity (YTM): The average rate
of return earned on a bond if it is held to
maturity.
Yield to call (YTC): The average rate of
return earned on a bond if it is held until the
first call date.
Call price: The price a firm has to pay to
recall a bond; generally equal to the principal
amount plus some interest.
 Interest Rates & Bond
Values
Par Value Bond

Discount Bond

Premium Bond
 Par Value
Bonds
Par Value Bond:
When the going interest rate = the
bonds coupon interest rate
The market value of a bond will always
approach its par value as its maturity
date approaches, provided the firm
does not go bankrupt.
 Discount
Bonds
An increase in interest rates in the
economy causes the price to fall
Discount Bond
= when a bond sells below its par value
occurs whenever the going rate of interest
rises above the coupon rate
The bond value decreases so that the
rate of return investors earn equates to
the higher kd.
 Premium Bonds
A decrease in interest rates in the
economy causes the bond price to rise
Premium
= when a bond sells above its par value
occurs whenever the going rate of interest
falls below the coupon rate
The bond value increases so that the rate
of return investors earn equates to the
lower kd.
 Calculating a Bonds
Yield
Interest (current) yield: The interest payment
divided by the market price of the bond.
Current INT
yield

Vd
Capital gains yield: The percentage change in
the market price of a bond over some period of
time.

Bond yield = Current yield + Capital gains yield

 Year k d = 10% k d = 15% k d = 20%
0 $1,380.30 $1,000.00 $766.23
1 $1,368.33 $1,000.00 $769.47
2 $1,355.17 $1,000.00 $773.37
3 $1,340.68 $1,000.00 $778.04
4 $1,324.75 $1,000.00 $783.65
Time path of value of 5 $1,307.23 $1,000.00 $790.38
a 15% Coupon, 6 $1,287.95 $1,000.00 $798.45
$1000 par value bond 7 $1,266.75 $1,000.00 $808.14
8 $1,243.42 $1,000.00 $819.77
when interest rates 9 $1,217.76 $1,000.00 $833.72
are 10%, 15%, and 10 $1,189.54 $1,000.00 $850.47
20% 11 $1,158.49 $1,000.00 $870.56
12 $1,124.34 $1,000.00 $894.68
13 $1,086.78 $1,000.00 $923.61
14 $1,045.45 $1,000.00 $958.33
15 $1,000.00 $1,000.00 $1,000.00
 Changes in Bond
Values Over Time
Time path of value of a 15% Coupon, $1000 par
value bond when interest rates are 10%, 15%, and
20% Bond Value
$1,500
kd < Coupon Rate
$1,250
kd = Coupon Rate
$1,000
$750
kd > Coupon Rate
$500
$250
$0
1 3 5 7 9 11 13 15
Years
 Finding the Interest Rate on a
Bond: Yield to Maturity
YTM is the average rate of return earned on a bond
if it is held to maturity.
Financial calculator solution:

INPUTS 15 ? -950 150 1000

N I/YR PV PMT FV
OUTPUT 15.89
 Interest Rate Risk on
a Bond
Interest Rate Price Risk: the risk of changes in
bond prices to which investors are exposed
due to changing interest rates.

Interest Rate Reinvestment Rate Risk: the risk

that income from a bond portfolio will vary
because cash flows have to be reinvested at
current (presumably lower) market rates.
 Value of Long and Short-Term
15% Annual Coupon Rate
Bonds
Value of
Current Market
1-Year Bond 14-Year Bond
Interest Rate, kd
5% $ 1,095.24 $ 1,989.86
10% $ 1,045.45 $ 1,368.33
15% $ 1,000.00 $ 1,000.00
20% $ 958.33 $ 769.47
25% $ 920.00 $ 617.59