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- Elliott Associates, on Behalf of Itself and All Other Holders of the 10% Convertible Subordinated Debentures of Centronics Data Computer Corp. Similarly Situated, Cross-Appellee v. J. Henry Schroder Bank & Trust Co. And Centronics Data Computer Corp., Cross-Appellants, 838 F.2d 66, 2d Cir. (1988)
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You are on page 1of 29

(chapter 7)

1

Vicentiu Covrig FIN303

Bond markets

Bond: A long-term debt instrument in which a borrower agrees to

make payments of principal and interest, on specific dates, to the

holders of the bond

Primarily traded in the over-the-counter (OTC) market.

Most bonds are owned by and traded among large financial

institutions.

Full information on bond trades in the OTC market is not published,

but a representative group of bonds is listed and traded on the bond

division of the NYSE.

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Vicentiu Covrig FIN303

Key Features of a Bond

Par value face amount of the bond, which

is paid at maturity (assume $1,000).

Coupon interest rate stated interest rate (generally fixed) paid

by the issuer. Multiply by par to get dollar payment of interest.

Maturity date years until the bond must be repaid.

Issue date when the bond was issued.

Yield to maturity - rate of return earned on

a bond held until maturity (also called the promised yield)

Call provision: Allows issuer to refund the bond issue if rates decline (helps the

issuer, but hurts the investor)

Allows issuer to refund the bond issue if rates decline (helps the issuer, but hurts the

investor).

Borrowers are willing to pay more, and lenders require more, for callable bonds.

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Vicentiu Covrig FIN303

Convertible bond: may be exchanged for common stock

of the firm, at the holders option.

Warrant: long-term option to buy a stated number of

shares of common stock at a specified price.

Putable bond: allows holder to sell the bond back to the

company prior to maturity.

Income bond: pays interest only when interest is earned

by the firm.

Indexed bond: interest rate paid is based upon the rate of

inflation.

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Vicentiu Covrig FIN303

0 1 2 N

r% ...

Value CF1 CF2 CFN

Value

1 r 1 r

1 2

1 r N

5

7-5

Vicentiu Covrig FIN303

What is the value of a 10-year, 10% annual coupon

bond, if rd (discount rate)= 10%?

0 1 2 n

kd ...

VB = ? 100 100 100 + 1,000

VB 1

... 10

10

(1.10) (1.10) (1.10)

VB $90.91 ... $38.55 $385.54

VB $1,000

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Vicentiu Covrig FIN303

Using a financial calculator to value

a bond

We have a bond with a coupon rate of 10%, paid annually, that

matures in 10 years, with a face/par value of $1,000, and rd is

13%. Calculate the bonds value. When rd is above the coupon

rate, the bonds value falls below par, and sells at a discount.

N I/YR PV PMT FV

OUTPUT -837.21

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Vicentiu Covrig FIN303

What is the value of a 10-year, 10%

semiannual coupon bond, if rd = 13%?

2. Divide nominal rate by 2 : I/YR = 13 / 2 = 6.5.

3. Divide annual coupon by 2 : PMT = 100 / 2 = 50.

N I/YR PV PMT FV

OUTPUT - 834.72

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Vicentiu Covrig FIN303

Exam type question

You intend to purchase a 10-year, $1,000 face value bond that pays interest of $60

every 6 months. If your nominal annual required rate of return is 10 percent with

semiannual compounding, how much should you be willing to pay for this bond?

a. $ 826.31

b. $1,086.15

c. $ 957.50

d. $1,124.62 *

Financial calculator solution:

Inputs: N = 20; I = 5; PMT = 60; FV = 1000.

Output: PV = -$1,124.62; VB = $1,124.62.

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Vicentiu Covrig FIN303

What is the YTM on a 10-year, 9% annual

coupon, $1,000 par value bond, selling for

$887?

Must find the rd that solves this model.

INT INT M

VB ...

(1 rd )1

(1 rd ) N

(1 rd ) N

90 90 1,000

$887 ...

(1 rd )1

(1 rd )10

(1 rd )10

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Vicentiu Covrig FIN303

Using a financial calculator to find

YTM

Solving for I/YR, the YTM of this bond is

10.91%. This bond sells at a discount, because

YTM > coupon rate.

N I/YR PV PMT FV

OUTPUT 10.91

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Vicentiu Covrig FIN303

Definitions

Annual coupon payment

Current yield (CY)

Current price

Change in price

Capital gains yield (CGY)

Beginning price

Expected Expected

Expected total return YTM

CY CGY

YTM yield - to maturity rate of return earned on a

bond if it is held to maturity

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Vicentiu Covrig FIN303

A 10-year, 10% semiannual coupon bond selling

for $1,135.90 can be called in 4 years for $1,050,

what is its yield to call (YTC)?

8%. Solving for the YTC is identical to solving for

YTM, except the time to call is used for N and the

call premium is FV.

8 - 1135.90 50 1050

INPUTS

N I/YR PV PMT FV

OUTPUT 3.568

13

Vicentiu Covrig FIN303

Exam type question

Consider a $1,000 par value bond with a 7 percent annual coupon. The bond pays

interest annually. There are 9 years remaining until maturity. What is the current

yield on the bond assuming that the required return on the bond is 10 percent?

a. 10.00%

b. 8.46% *

c. 7.00%

d. 8.52%

Current yield = Annual coupon payment/Current price.

Step 1: Find the price of the bond:

N = 9; I/YR = 10; PMT = 70; FV = 1000; and then solve

for PV = -$827.23. VB = $827.23.

Step 2: Calculate the current yield: CY = $70/$827.23 = 8.46%.

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Vicentiu Covrig FIN303

then (1) coupon > rd, so (2) a call is more

likely.

So, expect to earn:

- YTC on premium bonds.

- YTM on par & discount bonds.

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Vicentiu Covrig FIN303

At maturity, the value of any bond must equal its

par value.

If kd remains constant:

- The value of a premium bond would decrease

over time, until it reached $1,000.

- The value of a discount bond would increase

over time, until it reached $1,000.

- A value of a par bond stays at $1,000.

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Vicentiu Covrig FIN303

Interest rate risk is the concern that rising kd will

cause the value of a bond to fall.

+4.8% $1,048 5% $1,386 +38.6%

$1,000 10% $1,000

-4.4% $956 15% $749 -25.1%

changes, and hence has more interest rate risk.

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Vicentiu Covrig FIN303

What is reinvestment rate risk?

Reinvestment rate risk is the concern that kd will fall, and future CFs will have

to be reinvested at lower rates, hence reducing income.

EXAMPLE: Suppose you just won $1,000,000 playing the lottery. You

intend to invest the money and live off the interest.

If you choose to invest in series of 1-year bonds, that pay a 8% coupon you

receive $80,000 in income and have $1,000,000 to reinvest.

But, if 1-year rates fall to 3%, your annual income would fall to $30,000.

If you choose a 30-year bond that pay a 10 % coupon you receive $100,000 in

income; you can lock in a 10% interest rate, and $100,000 annual income for

30 years

18

Vicentiu Covrig FIN303

Conclusions about interest rate and

reinvestment rate risk

Short-term AND/OR Long-term AND/OR

High coupon bonds Low coupon bonds

Interest

Low High

rate risk

Reinvestment

High Low

rate risk

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Vicentiu Covrig FIN303

Default Risk

If an issuer defaults, investors receive less

than the promised return. Therefore, the

expected return on corporate and municipal

bonds is less than the promised return.

Influenced by the issuers financial

strength and the terms of the bond contract.

20

7-20

Vicentiu Covrig FIN303

Types of Bonds

Mortgage bonds

Debentures

Subordinated debentures

Investment-grade bonds

Junk bonds

21

7-21

Vicentiu Covrig FIN303

Evaluating default risk:

Bond ratings

Investment Grade Junk Bonds

S&P AAA AA A BBB BB B CCC D

Bond ratings are designed to reflect the probability of a bond issue going

into default

Mortgage bonds: a bond backed by fixed assets

Debentures: unsecured bond

Investment-grade bonds

Junk bonds

22

Vicentiu Covrig FIN303

Factors affecting default risk and bond

ratings

Financial performance

- Debt ratio

- TIE ratio

- Current ratio

Bond contract provisions

- Secured vs. Unsecured debt

- Senior vs. subordinated debt

- Debt maturity

23

Vicentiu Covrig FIN303

Exam type question

Which of the following Treasury bonds will have the largest amount of interest

rate risk (price risk)?

a. A 7 percent coupon bond that matures in 12 years. *

b. A 9 percent coupon bond that matures in 10 years.

c. A 12 percent coupon bond that matures in 7 years.

d. A 7 percent coupon bond that matures in 9 years.

Statement a is correct. The longer the maturity and the lower the coupon of a bond

the more sensitive it is to interest rate (price) risk. The bond in answer a has a

maturity greater than or equal to and a coupon less than or equal to all the other bon

24

Vicentiu Covrig FIN303

Exam type question

Which of the following statements is most correct?

a. Junk bonds typically have a lower yield to maturity relative to investment

grade bonds.

b. A debenture is a secured bond that is backed by some or all of the firms

fixed assets.

c. Subordinated debt has less default risk than senior debt.

d. None of the statements above is correct. *

Statement d is correct; the others are false. Junk bonds have a higher yield to

maturity relative to investment grade bonds. A debenture is an unsecured bond,

while subordinated debt has greater default risk than senior debt.

25

Vicentiu Covrig FIN303

Bankruptcy

Two main chapters of the Federal

Bankruptcy Act:

- Chapter 11, Reorganization

- Chapter 7, Liquidation

For large organizations, reorganization

occurs more frequently than liquidation,

particularly in those instances where the

business is worth more alive than dead.

26

Vicentiu Covrig FIN303

Chapter 11 Bankruptcy

If company cant meet its obligations

- It files under Chapter 11 to stop creditors from

foreclosing, taking assets, and closing the business and

it has 120 days to file a reorganization plan.

- Court appoints a trustee to supervise reorganization.

- Management usually stays in control.

Company must demonstrate in its reorganization plan that it

is worth more alive than dead.

- If not, judge will order liquidation under Chapter 7.

27

Vicentiu Covrig FIN303

Reorganization

In a liquidation, unsecured creditors generally get

zero. This makes them more willing to

participate in reorganization even though their

claims are greatly scaled back.

Various groups of creditors vote on the

reorganization plan. If both the majority of the

creditors and the judge approve, company

emerges from bankruptcy with lower debts,

reduced interest charges, and a chance for

success.

28

Vicentiu Covrig FIN303

Learning objectives

What is a bond? Discuss the key features of a bond

Why are US treasury bonds not riskless?

What is the call provision? Why is a call provision advantageous to a bond issuer?

Know how to calculate YTM, YTC, value of a bond

Discuss the interest rate and reinvestment risks

Define mortgage bonds, debentures, investment grade bonds, junk bonds

Know bond rating criteria (slide 23 and see the previous two slides and pages 241

in the text)

NOT on the exam: sinking fund;

Make sure you know the answers to end-of-chapter ST-1, ST-2 (a-e)

Recommended end-of-chapter problems: 7.1 to 7.5;7-8 to 7-10; 7-16,7-18

29

- Elliott Associates, on Behalf of Itself and All Other Holders of the 10% Convertible Subordinated Debentures of Centronics Data Computer Corp. Similarly Situated, Cross-Appellee v. J. Henry Schroder Bank & Trust Co. And Centronics Data Computer Corp., Cross-Appellants, 838 F.2d 66, 2d Cir. (1988)Uploaded byScribd Government Docs
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