More Time-Value:

BONDS & INFLATION

Dr. Taqadus Bashir

 BONDS
Capital is a primary mean for a company to generate new business & revenue
through investment. There are essentially only two types of capital—debt
& equity.
Equity capital is developed from stock sales primarily & Debt capital is
developed by borrowing money directly.
A time-tested method of raising debt capital is through the issuance of BOND.
Bonds usually come from one of following 3 sources:
1) Federal Government
2) States & municipalities
3) Corporations
Bonds are usually issued when it would be difficult to borrow a large amount
from a single source or when repayment is to be made over a long period
of time.
The major feature that differentiates bonds from other forms of financing is
that bonds can be bought & sold in the open market by people other than
original issuer & lender.
 Bond Classification
A bond is a long-term note issued by a corporation or
governmental entity for the purpose of financing
major projects.

In essence, the borrower receives money now, in return

for a promise to pay later, with interest paid between
the time money was borrowed & the time it was
repaid.
The bond interest rate is often called “The Coupon
Rate”.
Bonds can be classified & sub-classified in literally
hundreds of ways. But 4 basic & general
considerations are:
A sample of Bond of an organization ABC Issued to Mr. Ali

ABC Corporation

To: Mr. Ali Samar____

Matures: 2020________

1000 1000
 Types of Bonds
Classification
Characteristic Types
of Bonds s
1) Treasury Backed by Bills
( less than 1 year)
securities Federal Notes ( 2—10 years)

Government Bonds (10—30 years)

2) Mortgages Backed by Firstmortgage

mortgages / 2nd Mortgage

specified assets Equipment trust

3)Debentures No lien to Convertible

creditors Non-convertible
Subordinated
Junk
ΩGeneral Obligation bonds (GOB)
4) Municipal Usually federal
ΩRevenue Bonds
income tax free
ΩZero coupon Bonds
ΩPut Bonds
 Treasury Securities
These are issued & backed by federal government &
thus are considered to be the lowest risk securities on
the market.
Their interest is commonly exempt from the state & local
income taxes.
There are three types of treasury securities.

The interest is payable at maturity in case of Treasury

Bills (T-Bills).

Treasury notes & bonds pay interest semi-annually.

It is the interest paid by the T-Bills that is referred to as
“safe investment”
 Mortgage Bonds
It is backed by a mortgage on specified assets of the company issuing
the bonds.
If the company is unable to repay the bond-holders at the time the bond
matures, the bond-holders have an option of fore-closing on the
mortgaged property.
Mortgage bonds can be subdivided into first-mortgage & second
mortgage bonds. As their names imply, in the event of fore-closure
by the bond-holders, the first-mortgage bonds take precedence
during liquidation.
These bonds thus provide the lowest rate of return (less risk).
2nd-mortgage bonds when backed by collateral of a subsidiary
corporation, are referred to as collateral bonds.
An equipment trust bonds is the one in which equipment purchased
through the bond serves as collateral.
These types of bonds are generally issued by railroads for purchasing
new locomotives & train cars.
 Debenture Bonds
These are not backed by any form of collateral.
The reputation of company is important for attracting investors to
this type of bonds.
As further incentive for investors, they sometimes carry a floating
interest rate or are often convertible to common stock at a
fixed rate as long as bonds are outstanding.

Example:
a $1000 convertible debenture bond issued by the company
may have a conversion option to 50 shares of company’s
common stock.
If the value of 50 shares of company’s common stock exceeds the
value of the bond at any time prior to bond maturity, the
bondholder has the option of converting the bond to common
stock, thus reaping the financial return.
 Debenture Bonds
Debenture bonds generally provide the highest
rate of interest because of the increased risk
associated with them.
Subordinate debentures represent debt that
ranks behind other debts (senior debts) in the
event of liquidation or reorganization of the
company.
Because they represent even riskier investments,
these bonds provide a higher rate of return to
investors than regular debentures
 Municipal Bonds
Their attractiveness to investors lies in their income-tax-free status. As such
the interest rate paid by the governmental entity is usually quite low.
Municipal bonds can be either General Obligation Bonds or Revenue Bond.

GOB are issued against the taxes received by governmental entity (i.e. city,
country, state) that issued the bonds and are backed by the full taxing
power of the issuer.
School bonds are an example of GOBs.
Revenue Bonds are issued against the revenue generated by the project
financed, as a water treatment plant or a bridge. Taxes cannot be levied for
repayment of revenue bonds.
Zero-coupon Bonds are securities for which no periodic interest payments
are made. They are sold at a discount from their face value, which is paid at
maturity.
Variable-rate Bonds have coupon rates that are adjusted at specified point in
time (weekly, monthly, annually etc)
Put Bonds give the holder the option to Cash-In the bonds on specified dates
(one or more) prior to maturity.
 Bonds Rating
In order to assist prospective investors, all bonds are rated by
various companies according to the amount of risk associated
with their purchase.

One such rating is “Standard & Poor’s”, which rate bonds from
AAA (finest quality) to DDD (bonds in default).

In general 1st Mortgage Bonds carry the highest rating, but it is

not common for Debenture Bonds of large corporations to carry
a AAA rating or even higher than 1st Mortgage bonds of
smaller, less reputable companies.

The term Junk Bonds refers to debenture Bonds rated lower

than BBB. Junk Bonds are frequently issued when a corporation
wants to raise enough money to purchase another company.
 Bond Value Calculations
The bond face value, which refers to the denomination of the
bond, is usually an even denomination starting at $100, with
most common being the $1000 bond. The face value is
important for 2 reasons:
1) It represents the lump-sum amount that will be paid to
bondholder on the bond maturity date.
2) The amount of interest “I” paid per period prior to the bond
maturity date.
This amount of interest is determined by multiplying the face
value of bond by the bond interest rate per period as follows:
I = (face value) X (bond interest rate)___
Number of payment periods per year
= (v X b) / c
Often a bond is purchased at a discount (less than FV) or a
premium (greater than FV), but only FV not purchase price
is used to compute the bond interest amount I.
 Example
A bicycle manufacturing company planning an expansion
issued $1000 bonds @ 4% for manufacturing the project.
The bond will mature in 20 years with interest paid semi-
annually.
Mr. Smith purchased one of the bonds through his stock
broker for $800. what payment is Mr. Smith entitled to be
receive.
Solution:
Face value of the bond is $1000. so Mr. Smith will receive it
on the date the bond matures i.e. 20 yrs from now. In
addition, he will receive the semiannual interest the
company promised to pay when the bond was issued. The
interest every 6 months will be computed as:
V = $ 1000 b = 0.04 C=2
I = (Vb) / C = (1000)(0.04) /2 = $40 / 2 = $20 every 6 months
 Exercise
Determine the amount of interest you will receive per
period if you purchase a 6% Rs. 5000 bond which
matures in 10 years with interest payable quarterly.

Since interest is payable quarterly, you would receive

the interest payment every 3 months.

I = 5000(0.06) = Rs.300 = Rs.75

4 4
So, you will receive Rs.75 interest every 3 months in
addition to the Rs.5000 lump sum after 10 years.
 INFLATION
An increase in the general price level of goods is called inflation. Or in
short: Too much money chasing too few goods.

Most people are very well aware of fact that Rs.50 now does not
purchase the same amount as it did in 1995 or 1990 & purchases
significantly lesser than in 1970. why?
This is inflation in action.

Inflation is an increase in the amount of money necessary to obtain the

same amount of product or service before the inflated price was
present.
It occurs because the value of the currency has changed, it has gone
down in value. The value of money has decreased & as a result it takes
more Rupee / dollar for fewer goods. This is a sign of inflation.
Inflation……….. Cont
In order to make comparisons b/w monetary amounts
which occurs in different time periods, the different-
valued $ / Re must first be converted into constant-
value $ / Re in order to represent the same buying
power over time.

This is especially important when future sum of money

are considered, as is the case with all alternative
evaluations.
DEFLATION is the opposite of inflation. The
computations for inflation are equally applicable to a
deflationary economy.
Money in one period of time, t1 can be brought to the same value
as money in another period of time, t2 by using a generalized
equation:

currency in period t1 = ___$ in period t2________

Inflation rate b/w t1 & t2

Let currency in period t1 be called today’s currency & currency in

period t2 be called future currency or then-current currency.
f = The inflation rate per period
n = # of time periods b / w t1 & ts

Today’s currency = then-current currency

(1 + f) n
Another term for today’s currency is constant-value currency. It is
always possible to state future inflated amount in terms of
current currency by applying this equation.
 Example
If an item costs Rs.45 in 1998 & inflation averaged 4%
during the previous year, in constant 1997 Rs, the cost
is equal to
Rs.45 / (1.04) = Rs. 43.27

If inflation averaged 4% per year over the previous 10 years,

the constant 1998 Rs equivalent is considerably less at
Rs.45 / (1.04) 10 = Rs. 30.4
Actually there are 3 different rates & out of those the first
two are interest rates:
1) Real interest rate (i)
2) Market interest rate (if)
3) Inflation rate (f)
1. Real or Inflation-Free Interest Rate (i):
it is the rate at which interest is earned when the effects of
changes in the value of a currency have been removed. Thus,
the real interest rate presents an actual gain in buying power.

2. Market Interest Rate (if):

as name implies this is the interest rate in market place—the
rate we hear about & commonly quoted every day. This rate
is the combination of real interest rate (i) & inflation rate (f),
& thus it changes as the inflation rate changes. It is also
known as the ‘inflated interest rate’.

3. Inflation Rate (f):

this is the measure of rate of change in value of currency.
(1) (2) (3) (4) = (3) / (1.04)n (5)=(
Yr Cost increase due to Cost in Future cost in PW @ 10%
n inflation future $ (current today’s $)

0 $5000 $5000 $5000

1 $5000 (0.04) $5200 $5200 / (1.04) 1 $4545

= $200 = $5000

2 $5200 (0.04) $5408 $5408 / (1.04) 2 $4132

= $208 = $5000

3 $5408 (0.04) $5624 $5624 / (1.04) 3 $3757

= $216 = $5000

4 $5624 ( 0.04) $5849 $5849 / (1.04) 4 $3415

= $225 = $5000
 inf lation
st at 4%
6000 a l c o
Actu
$5849 Increased
cost due to
$s
Future inflation

5000
Constant $s $5000
Decrease in
PW due to
4000 interest

10%
PW

3000 $3415

1 2 3 4

Fig: Comparison of constant-value $, future $ & PW $

 Calculation of Market Interest Rate
Formula:
if = i + f + (i)(f)
Let
i = real interest rate = 0.10
f = inflation rate = 0.04
if = inflated / market interest rate

if = 0.10 + 0.04 + (0.10) (0.04)

= 0.14 + 0.0040
= 0.144