Finance Management

Bonds and Their Valuation-1

 Bonds
• A bond is 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.
• Bonds are issued by corporations and
government agencies that are looking for
long-term debt capital.
 Bonds
• For example, on January 3, 2017 Allied Food
Product Co. Borrowed $170 million by issuing
$170 million of bonds.
• For convenience, we assume that Allied sold
170,000 individual bonds for $1,000 each.
• Actually, it could have sold one $170 million
bond, 17 bonds each with a $10 million face
value, or any other combination that totaled
$170 million.
• In any event, Allied received $170 million on
specified maturity date.
 Bonds
• Until the 1970s, most bonds were beautifully
engraved pieces of paper and their key terms,
including their face values, were spelled out on
the bonds.
• Today, though, virtually all bonds are
represented by electronic data stored in the
secure computers, much like the money in a
bank a checking account.
 Bonds
• Bonds are grouped in several ways.
• One grouping is based on issuer: Treasury,
corporations, state and local governments,
and foreigners.
• Each bond differs with respect to risk and
consequently its expected return.
 Treasury bonds
• T-bonds, generally called ‘’Treasuries’’ and
sometimes referred to as government bonds.
• The Treasury actually call its debt ‘’bills’’,
‘’notes’’, or ‘’bonds’’.
 bills - notes - bonds
• T-bills generally have maturities of 1 year or less
at the time of issue, notes generally have original
maturities of 2-7 years, and bonds originally
mature in 8-30 years.
• There are technically differences between bills,
notes, and bonds; but they are not important for
our purposes,
• so we generally call all Treasury securities
‘’bonds’’.
 Treasury bonds
• It is reasonable to assume that the
government will make good on its promised
payments,
• so Treasuries have no default risk.
• However these bonds’ prices to decline when
interest rates rise; so they are not completely
riskless.
 Corporate bonds
• Corporate bonds are issued by business firms.
• Unlike Treasuries, corporates are exposed to
default risk.
• If the issuing company gets into trouble, it
may be unable to make the promised interest
and principal payments and bondholders may
suffer losses.
 Corporate bonds
• Corporate bonds have different levels of
default risk depending on
– (1) the issuing company’s characteristics and
– (2) the terms of the specific bond.
• Default risk often referred to as ‘’credit risk’’;
and as we know the larger the risk, the higher
the interest rate investors demand.
 Municipal bonds
• Municipal bonds or munis, is the term given to
bonds issued by states and local governments.
• Like corporates, munis are exposed to some
default risk; but they have one major advantage
over all bonds.
• Interest earned on most munis is exempt from
federal taxes and from state taxes-in the USA- if
the holder is a resident of the issuing state.
• Consequently, the market interest rate on a muni
is considerably lower than on a corporate bond of
equivalent risk.
 Foreign bonds
• Foreign bonds are issued by a foreign
government or a foreign corporation.
• All foreign corporate bonds are exposed to
default risks, as are some foreign government
bonds.
• Indeed in recent years, concerns have risen
about possible defaults in many countries
such as Greece, Ireland, Portugal, and Spain.
 Foreign bonds
• An additional risk exists when the bonds are
denominated in a currency other than that of the
investor’s home country.
• Consider Turkish investor who purchases a corporate
bond denominated in Japanese yen.
• At some point, the investor will want to close out his
investment and convert the yen back to TL.
• If the JPY unexpectedly falls relative to TL, the investor
will have fewer TL than the originally expected to
receive.
• So the investor still lose money even if the bond does
not default.
 The key characteristics of bonds
1-par value
2-coupon interest rate
3-maturity date
4-call provisions
5-sinking funds
6-other features
 The key characteristics of bonds
• Although all bonds have some common characteristics.
• Different types of bonds can have different contractual
features.
• For example, most corporate bonds have provisions that
allow the issuer to pay them off early (‘’call features’’),
but the specific call provisions vary widely among
different bonds.
• Similarly, some bonds are backed by specific assets that
must be turned over to the bondholders if the issuer
defaults, while other bonds have no such collateral
backup.
 The key characteristics of bonds
• Differences in contractual provisions, and in
the fundamental underlying financial strength
of the companies backing the bonds, lead to
differences in bonds’ risks, prices, and, so
expected returns.
• To understand bonds, it is essential that you
understand the following terms.
 Par value
• Par value is the stated face value of the bond.
• It generally assumed a par value of $1,000,
although any multiple of $1,000 (e.g., $10,000
or 10 million) can be used.
• The par value generally represents the
amount of money the firm promises to repay
on the maturity date.
 Coupon interest rate
• Allied Food Products’ bonds require the company to
pay a fixed number of dollars of interest each year.
• This payment, generally referred to as the ‘coupon
payment’, is set at the time the bond is issued and
remains in force during the bond’s life.
• Today no physical coupon are involved, interest checks
are mailed or deposited automatically to the bond’s
registered owners on the payment date.
• Even so people continue to use the terms coupon and
coupon interest rate when discussing bonds.
• You can think of the coupon interest rate as the
promised rate.
 Coupon interest rate
• Typically, at the time a bond is issued, its
coupon payments is set at a level that will
induce investors to buy the bond at or near its
par value.
• Most of the examples and problems
throughout in our lectures will focus on bonds
with fixed coupon rates.
 Coupon interest rate
• When this annual coupon payment is divided by
the par value, the result is the coupon interest
rate.
• For example, Allied’s bonds have a $1,000 par
value, and they pay $100 in interest each year.
• The bonds coupon payment is $100, so its
coupon interest rate is $100ൗ$1,000 = 10%.
• In this regard, the $100 is the annual income that
an investor receives when he or she invests in the
bond.
 Coupon interest rate
• Allied’s bonds are fixed-rate bonds because the
coupon rate is fixed for the life of the bond.
• In some cases, however, a bond’s coupon
payments are allowed to vary over time.
• These floating-rate bonds work as follows:
• The coupon rate is set for an initial period, often
six months, after which it is adjusted every six
months based on some open market rate.
 Coupon interest rate
• For example, the bond’s rate may be adjusted so
as to equal to 10-year Treasury bond rate plus a
‘’spread’’ of 1.5 percentage points.
• Other provisions can be included in corporate
bonds.
• For example, some can be converted at the
holders’ option into fixed rate debts, and some
floaters have upper limits (caps) and lower limits
(floors) on how high or low the rate can go.
 Coupon interest rate
• Some bonds pay no coupons at all but are offered at a
discount below their par values and hence provide
capital appreciation rather than interest income.
• These securities are called ‘zero coupon bonds’
(zeros).
• Other bonds pay some coupon interest, but not
enough to induce investors to buy them at par value.
• Any bond originally offered at a price significantly
below its par value is called an original issue discount
(OID) bond.
 Maturity date
• Bonds generally have a specified maturity
date on which the par value must be repaid.
• Allied’s bonds, which were issued on January
3, 2014, will mature on January 2, 2029.
• Thus, they had a 15-year maturity at the time
they were issued.
 Maturity date
• But in 2015, a year later, Allied’s bonds will
have 14-year maturity.
• A year after that, they will have 13-year
maturity, and so on.

• Most bonds have original maturities (the

maturity at the time the bond were issued)
ranging from 10 to 40 years, but any maturity
is legally permissible.
 Call provisions
• Many corporate bonds and munis contain a
call provision. That gives the issuer the right
to call the bonds for redemption.
• The call provision generally states that the
issuer must pay the bondholders an amount
greater than the par value if they are called.
• The additional sum, which is termed a call
premium, is often equal to one year’s interest.
 Call provisions
• For example, the call premium on a 10-year
bond with a 10% annual coupon and a par
value of $1,000 might be $100, which means
that the issuer would have to pay investors
$1,100 (the par value plus the call premium) if
it wanted to call the bonds.
 Call provisions
• In most cases, the provisions in the bond contract
are set so that the call premium declines over
time as the bonds approach maturity.
• Also, while some bonds are immediately callable,
in most cases, bonds are often not callable until
several years after issue, generally 5 to 10 years.
• This is known as a deferred call, and such bonds
are said to have call protection.
 Call provisions
• Companies are not likely to call bonds unless
interest rates have declined significantly since the
bonds were issued.
• Suppose a company sold bonds when interest
rates were relatively high.
• Provided the issue callable, the company could
sell a new issue of low-yielding securities if and
when interest rates drop, use the proceeds of
new issue to retire the high-rate issue, and thus
reduce its interest expense.
• This process is called a refunding operation.
 Call provisions
• Thus, the call privilege is valuable to the firm
but detrimental to long-term investors, who
reinvest the funds they receive at the new and
low rates.
• Accordingly, interest rate on a new issue of
callable bonds will exceed that the one the
company’s new non-callable bonds.
 Call provisions
• For example, on February 28, 2014, PT Co. sold a bond
issue yielding 6% that was callable immediately.
• On the same day, NM Co. sold an issue with similar risk
and maturity that yielded only 5.5% but its bonds were
non-callable for 10 years.
• Investors were willing to accept a 0.5% lower coupon
interest rate on NM’s bonds for the assurance that the
5.5% interest rate would be earned for at least 10
years.
• PT Co., on the other hand, had to incur a 0.5% higher
annual interest rate for the option of calling the bonds
in the event of a decline in rates.
 Call provisions
• The refunding operation is similar to a
homeowner’s refinancing his/her home mortgage
after a decline in interest rates.
• For example, a homeowner with an outstanding
mortgage at 7%.
• If mortgage rates fall to 4%, the homeowner will
probably find beneficial to refinance the
mortgage.
• There may be some fees involved in the
refinancing, but the lower rate may be more than
enough to offset those fees.
 Sinking funds
• Some bonds include a sinking fund provision
that facilitates the orderly retirement of the
bond issue.
• Sinking fund provisions require the issuer to
buy back a specified percentage of the issue
each year.
• A failure to meet the sinking fund requirement
constitutes a default, which may throw the
company into bankruptcy.
 Sinking funds
• Suppose a company issued $100 million of 20-year
bonds and it is required to call 5% of the issue, or $ 5
million of bonds, each year.
• In most cases, the issuer can handle the sinking fund
requirement in either of two ways:
1-It can call in for redemption, at par value, the required
$5 million of bonds. The bonds are numbered serially,
and those called for redemption would be determined by
a lottery administrated by the trustee.
2-The company can buy the required number of bonds on
the open market.
 Sinking funds
• The firm will choose the least-cost method.
• If interest rates have fallen since the bond was issued, the
bond will sell for more than its par value.
• In this case, the firm will use the call option.
• However, if interest rates have risen, the bonds will sell at a
price below par.
• So the firm can and will buy $5 million par value of bonds in
the open market for less than $5 million.
• Note that a call for sinking fund purposes is generally
different from a refunding call because most sinking fund
calls require no call premium. However, only a small
percentage of the issue is normally callable in a given year.
 Other features of the bonds
• Convertible bonds
• Warrants
• Putable bonds
• Income bonds
• Indexed, or purchasing power bonds
 Convertible bonds
• Several other types of bonds are used sufficiently
often to warrant mention.
• First, convertible bonds are bonds that are
exchangeable into shares of common stock at a
fixed price at the option of the bondholder.
• Convertibles offer investors the chance for capital
gains if the stock price increases.
• But that feature enables the issuing company to
set a lower coupon rate than on nonconvertible
debt with similar credit risk.
 Warrants
• Bonds issued with warrants are similar to
convertibles.
• But instead of giving the investor an option to
exchange the bonds for stocks, warrants give the
holders an option to buy stock for a stated price.
• Thereby providing a capital gain if the stock’s
price rises.
• Because of this factor, bonds issued with
warrants, like convertibles, carry lower coupon
rates than otherwise similar nonconvertible
bonds.
 Putable bonds
• Whereas callable bonds give the issuer the
right to retire the debt prior to maturity,
putable bonds allow investors to require the
company to pay in advance.
• If interest rates rise, investors will put the
bonds back to the issuing company and
reinvest in higher coupon bonds.
 Income bonds
• Another type of bond is the income bond,
which pays interest only if the issuer has
earned enough money.
• Thus, income bonds can not bankrupt a
company.
• But from an investor’s standpoint, they are
riskier than ‘regular’ bonds.
 Indexed, or purchasing power bonds
• The interest rate is based on an inflation index
such as the consumer price index (CPI).
• So the interest paid rises automatically when
the inflation rate rises, thus protecting
bondholders against inflation.
• Remember Treasury Inflation Protected
Securities (TIPS).