AE 18 – BONDS AND THEIR VALUATION

 Bond

 a long-term contract under which a borrower agrees to make payments of interest and
principal, on specific dates, to the holders of the bond
 issued by corporations and government agencies that are looking for long-term debt
capital

 Treasury bonds

- also called government bonds

- no default risk
- still exposed to risk of rising interest

 Corporate bonds

- issued by business firms

- exposed to default risk (credit risk)

 Municipal bonds

- also called munis

- issued by state and local governments
- also exposed to default risk

 Foreign bonds

- issued by a foreign government or a foreign corporation

- exposed to default risk

 Key Characteristics of Bonds

 Par Value

- face value
- the amount of money the firm borrows and promises to repay on maturity date

 Coupon Interest Rate

- stated annual interest rate on a bond

o fixed-rate bond – interest rate is fixed for the entire life of the bond
 o floating-rate bond – a bond whose interest rate fluctuates with shifts in the
general level of interest rate

o zero coupon bond

– (zeros) a bond that pays no annual interest but is sold at a discount

below par, OID (original issue discount) bond

 Maturity Date

- specified date on which the par value must be paid

- original maturity, number of years to maturity at the time of issuance

 Call Provision

- gives the issuer the right to redeem the bonds under specified terms prior to the
normal maturity date
- call premium, additional sum paid on top of par value for calling the bonds
- deferred call, bonds not callable on a specified number of years – call protection
- refunding operation, company sells a new issue of low-yielding securities if and when
interest rates drop, use the proceeds of the new issue to retire the high-rate issue,
thus, reduce its interest expense

Issuer – debtor, the one who needed the funds

Holder – creditor, the one who provides the funds

 Sinking Fund Provision

- a provision in a bond contract that requires the issuer to retire a portion of the bond
issue each year
- failure to meet sinking fund requirement constitutes a default
- issuer can handle sinking fund requirement in two ways:

a. call in for redemption

b. purchase in open market

 Other Features

 Convertible Bonds

- exchangeable for the issuing firm’s common stock at the option of the holder
 Warrant

- a long-term option to buy a stated number of shares of common stock at a specified

price

 Putable bond
- allows investors to sell bonds back to the company prior to maturity at a prearranged
price

 Income bond

- pays interest only if the issuer has earned enough money to pay the interest

 Indexed (Purchasing Power) Bond

has interest payments based on an inflation index so as to protect the holder from
inflation