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Corporate Bond

Copyright 2006 by South-Western, a division of Thomson Learning. All rights reserved.

Status:
~ Bondholders are creditors (lenders)
~ They cannot vote suitable members in
boardrooms
~ Investment made is refunded once it is
called
back.

Return:
~ They receive fixed coupon payment

Your investment is
circulated in Capital

How should I
make decision?

Money has a price!!!

If you do not spend it, you can save it or


lend it to someone else for interest earned.

If you use money now, you may lose the


interest could be earned for future
consumption

A corporate bond represents a stream of future


payments

Future value = fixed coupon payment


+ principal
(Yr1 + 2)

(Yr2)

= Coupon (%) X
Principal + Principal

But present value is what we need to compute

Yr0

Yr1

Coupon (%) X Principal


Coupon (%) X Principal
+ Principal
?
?
Present value =

Future Value
(1 + Market Interest Rate) year

Yr2

C
C
C
F
n
1
2
P(1i)(1i).(1i)(1i)n
Coupon rate x Principal (Par Value)

Coupon

Principal (Par Value)

Bond holders required rate of


return or
Market interest rate

For public listed companies ~


It is Cost of debt the rate of return
necessary to compensate bondholders

For bondholders ~
It is minimum Required rate of return
Rate of return necessary to justify
undertaking an investment

,P(1.)1(.06)1$1,0
$
6
0
$
1

Suppose that Jane is about to buy


bond that will mature in 1 year

~ Principle is $1,000
~ Coupon rate is 6% per year
~ If bank depository or market interest
rate is 6%, Jane will be willing to pay

,P(1.8)1(.08)1$981.4
$
6
0
$
1

Suppose Citibank deposit rate rises to 8%


from 6%. The price of IBM bond now
becomes:

Jane would be willing to buy IBM bond for a

price below its par value. If not, She better


invests in banks deposit.
IBM should sell at discount! (lower than
par value)

Implication

As bank interest rate rises, price of


existing bonds falls
Because investors will choose deposit in
commercial bank who offers higher return
if compared to bond issue.
Bank rate = 8%
Coupon rate = 6%

Which one
you want?

,P(1.4)1(.04)1$1,09.23
$
6
0
$
1

Suppose Citibanks depository rate falls to 4%


from 6%
The price of IBM corporate bond now becomes:

Jane would be buying the bond for a price above its

face value as the return is better.

Corporation could sell at premium above par value

Implication

As bank interest rate falls, price of


existing bonds rise
Because investors will not choose deposit
in commercial bank who offers lower
return if compared to bond issue.
Bank rate = 4%
Coupon rate = 6%

Which one
you want?

General Motors bonds have 5 years to


maturity. Interest is paid annually, the
bonds have $1,000 par value, and
coupon interest rate and bank depository
rate is 8% per annum now.
1) What is the market price of these
bond?
2) If Citibank offers10%, what is the fair
price of this bond?

1) Central Bank & Commercial


Bank
In US

In UK

2) Inflation
Will you invest in bank if you have
surplus of pocket
money instead of spending it?
Because bank gives u interest rate that
higher than inflation rate to compensate
your loss in purchasing power.
Thus, bank deposit or coupon rate are
inclusive of inflation concern.

What you need to know is

Nominal Interest Rate


= Real Interest Rate +
Inflation Rate

Nominal Interest Rate


= Real Interest Rate + Inflation Rate
Implication

Nominal Interest Rate


= Real Interest Rate + Inflation Rate

Suppose bond coupon rate is 5% and the


current expected inflation rate is 3%

Expected real interest rate is 2%

It describes investors reacts to nominal


changes even though no changes in real
interest rate.

Interest Rates
(percent
per year)
Nominal interest rate

15%

10
5

0
Real interest rate

1965

1970

1975 1980 1985 1990 1995 2000 2005

Thank

You