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Bonds

Welcome

Learning

What is a Bond Definitions Types of Bonds- Call ability/Put ability and Convertibility Bond Valuation Bond Risk- Systematic and Unsystematic Applications

What is a Bond-?

A debt investment in which an investor loans money to an


entity (corporate or governmental) that borrows the funds for a defined period of time at a fixed interest rate. Bonds are used by companies, municipalities, states and U.S. and foreign governments to finance a variety of projects and activities. Bonds are commonly referred to as fixed-income securities Bonds pay fixed coupon (interest) payments at fixed intervals (usually every 6 months) and pay the par value at maturity.

Definitions

Par or Face Value

The amount of money that is paid to the bondholders at maturity. It also generally represents the amount of money borrowed by the bond issuer.

Coupon Rate

The coupon rate, which is generally fixed, determines the periodic coupon or interest payments. It is expressed as a percentage of the bond's face value. It also represents the interest cost of the bond to the issuer.

Definitions

Coupon Payments

The coupon payments represent the periodic interest payments from the bond issuer to the bondholder. The annual coupon payment is calculated by multiplying the coupon rate by the bond's face value. Since most bonds pay interest semiannually, generally one half of the annual coupon is paid to the bondholders every six months.

Maturity Date

The maturity date represents the date on which the bond matures, i.e., the date on which the face value is repaid. The last coupon payment is also paid on the maturity date.

Definitions

Original Maturity

The time from when the bond was issued until its maturity date.

Remaining Maturity

The time currently remaining until the maturity date.

Call Date

For bonds which are callable, i.e., bonds which can be redeemed by the issuer prior to maturity, the call date represents the earliest date at which the bond can be called.

Definitions

Call Price

The amount of money the issuer has to pay to call a callable bond (there is a premium for calling the bond early). When a bond first becomes callable, i.e., on the call date, the call price is often set to equal the face value plus one year's interest.

Required Return

The rate of return that investors currently require on a bond.

Definitions

Yield to Maturity The rate of return that an investor would earn if he bought the bond at its current market price and held it until maturity. reflects all the interest payments that are available through maturity and the principal that will be repaid, and assumes that all coupon payments will be reinvested at the current yield on the bond. This is the most valuable measure of yield because it reflects the total income that you can receive

Definitions

Market Value- A Bond may be traded ina stock exchange. The price at which it is currently sold or bought is referred to as the market value. Market value may be different from the Par value or the maturity Value.

Call ability of Bonds

A bond that can be redeemed by the issuer prior to its maturity. Usually a premium is paid to the bond owner when the bond is called. Also known as a "redeemable bond". The main cause of a call is a decline in interest rates. If interest rates have declined since a company first issued the bonds, it will likely want to refinance this debt at a lower rate of interest. The company will call its current bonds and reissue them at a lower rate of interest.

Call ability of bonds

The call premium is somewhat of a penalty paid by the issuer to the bondholders for the early redemption Call Provision-A provision on a bond or other fixedincome instrument that allows the original issuer to repurchase and retire the bonds. If there is a call provision in place, it will typically come with a time window under which the bond can be called, and a specific price to be paid to bondholders and any accrued interest are defined

Definitions

PUT Provisions-The opposite of a callable bond, a bond with a put provision allows the bondholder to redeem the bond at par value with the issuer at a specified point before maturity. Investors might choose to do this if interest rates increase after the bond was issued. The bond will restrict the dates when this can be done. These bonds are quite rare.

Types of Bonds

Zeros-Bonds that pay only PAR value at maturity and no coupon payments. Euro Bonds-Bonds denominated in one currency and sold in another currency. example - suppose Disney decides to sell $1,000 bonds in France. These are U.S. denominated bonds trading in a foreign country. Why do this? If borrowing rates are lower in France, To avoid SEC regulations.

Zero Coupon Bond-IDBI[1992]

Also called deep discount bonds, Zero Interest Bonds Do Not carry a rate of Interest. It provides for a payment of a lump sum amount at a future date in exchange for the current price of the bond The difference between the face value and the purchase price of the Bond is the YTM for the investor

Example-Zero Coupon Bonds

A company may issue a pure discount Bond of Rs 1000 face value at Rs 520 today for a period of 5 years

PV = CFt / (1+r)t

PV= 520 CF= Face Value = Rs 1000 T= Maturity= 5 years R= Rate of Interest/YTM= 14%

Types of Bonds

Security

Collateral secured by financial securities Mortgage secured by real property, normally land or buildings Debentures unsecured

Convertibility of Bonds

Many corporate bonds are convertible bonds These bonds can be exchanged for some specified amount of common or preferred stock in the issuing company. At the time of issue, the terms of conversion will be outlined, including the times, prices, and conditions under which it can occur

Convertibility of Bonds

Most convertible bonds are also callable. This means, in effect, that the company can force bondholders to convert their bonds into stock (called "forced conversion"). Convertibility affects the performance of the bond in certain ways

Convertibility of Bonds

First and foremost, convertible bonds tend to have lower interest rates than non-convertibles because they also accrue value as the price of the underlying stock rises Therefore, convertible bonds offer some of the benefits of both stocks and bonds Convertibles earn interest even when the stock is trading down or sideways, but when the stock prices rises, the value of the convertible increases.

Convertibility of Bonds

Convertibles, therefore, can offer protection against a decline in stock price.

The Bond Indenture

Contract between the company and the bondholders and includes


The basic terms of the bonds The total amount of bonds issued A description of property used as security, if applicable Sinking fund provisions Call provisions Details of protective covenants

Bond Valuation
Welcome

Bond Valuation

Bonds are valued using time value of money concepts. Their coupon, or interest, payments are treated like an equal cash flow stream (annuity). Their face value is treated like a lump sum.

Present Value of Future Cash Flows

Link Risk & Return

Expected Return on Assets

Valuation

Example

Assume Hunter buys a 10-year bond from the KLM corporation on January 1, 2003. The bond has a face value of $1000 and pays an annual 10% coupon. The current market rate of return is 12%. Calculate the price of this bond today.

CF 1 CF 2 CF n + + . . .+ P0 = 1 2 n (1+ r ) (1+ r ) (1+ r )

P0 = Price of asset at time 0 (today) CFt = cash flow expected at time t r = discount rate (reflecting assets risk) n = number of discounting periods (usually years)

Example
2.

First, find the value of the coupon stream Remember to follow the same approach you use in time value of money calculations. You can find the PV of a cash flow stream

PV = $100/(1+.12)1 + $100/(1+.12)2 + $100/(1+.12)3 + $100/(1+.12)4 + $100/(1+.12)5 + $100/(1+.12)6 + $100/(1+.12)7 + $100/(1+.12)8 + $100/(1+.12)9+ $100/(1+.12)10

PV = $565.02

Example
3.

Find the PV of the face value

PV = CFt / (1+r)t PV = $1000/ (1+.12)10 PV = $321.97

4.

Add the two values together to get the total PV

$565.02 + $321.97 = $886.99

Present Value of Cash Flows as Rates Change

Bond Value = PV of coupons + PV of par Remember, as market interest rates increase present values decrease So, as interest rates increase, bond prices decrease and vice versa- Logical explanation

Why value Bonds -?

Can the intrinsic value of an asset differ from the market value?

The value of a bond is compared with the current market price of the bond so as to determine whether the bond is undervalued or overvalued. If Value > Market Price- Buy- Price will go up If Value < Market Price- Dont buy- Price will go down

What happens to bond values if required return is not equal to the coupon rate?

The bond's value will differ from its par value

R > Coupon Interest Rate

P0 < par value

= =

DISCOUNT

R < Coupon Interest Rate

P0 > par value

PREMIUM

Yield to maturity

Suppose that the bond price is known. Yield to maturity = implicit discount rate Solution of following equation:

C C CF P0 ... 2 1 y (1 y ) (1 y )T

Bond Analysis
Systematic Risk Unsystematic Risk

Systematic Risk- Bond Analysis

Un-diversifiable Purchasing- Power risk Interest Rate Risk

Purchasing- Power Risk

Necessity to adjust the rate of interest for price changes. Example Inflation indexed bonds

Example

Suppose you lend $ 100 today for a promise to be repaid $ 105 at the end of a year. The Rate of interest is 5 %, However assume that prices over the next year are assumed to rise 6 %, your money has appreciated in Value by 5 %, but the inflation rate is 6 % means that you have actually suffered a loss of 1 %, ur interest rate should have matched the inflation rate therefore to cover this risk of loss of purchasing power.

Interest Rate Risk

Price Risk
Change in price due to changes in interest rates Long-term bonds have more price risk than short-term bonds

Reinvestment Rate Risk

Uncertainty concerning rates at which cash flows can be reinvested

Price Risk

Bond prices are inversely related to interest rates, so if interest rates increase, the price of the bond will decrease The interest rate on a bond is set at the time it is issued. Generally, the coupon will reflect interest rates at the time of issuance.

Price Risk

However, if interest rates increase, people will be unwilling to purchase the bonds in the secondary market at the earlier rate For example, if the coupon is set at 6% and interest rates in the market are at 7%, the interest rate on the bond is well below what you could get from a different investment. Therefore, the price of the bond will decrease For this reason, it can be risky to buy long-term bonds during periods of low interest rates.

Reinvestment Risk

A drop in the interest rates causes a decline in the expected income from investing interim coupon payments Example: Suppose you purchase a bond @ 8 %- Par Value- $ 1000 today, the semi annual coupon that you obtain shall be $ 40, you can reinvest the same @ 8 % if the interest rates have not declined, but if the interest rates during such period decline to @ 6%, the reinvestement income will decline from $1.60[ $40*.04] to $1.20[$ 40 *0.03]

Bond Analysis-Unsystematic Risk

Credit Risk Call Risk

Credit Risk

Just as individuals occasionally default on their loans or mortgages, some organizations that issue bonds occasionally default on their obligations. If this is the case, the remaining value of your investment can be lost. Government Bonds carry a lower credit risk than corporate bonds

Credit Risk

Definitely the return is much more in a corporate bond as compared to a government bond There are Bond investment agencies that evaluate the quality of the bonds and rank them in categories according to the relative probability of default, this helps the investor in assessing the credit risk-AAA is the best,, D Bonds that have been defaulted.

Call Risk

When a bond is issued, it will be either callable or non-callable A callable bond is one in which the company can require the bondholder to sell the bond back to the company. Buying back outstanding bonds is called "redeeming" or "calling". When issued, the bond will explain when it can be redeemed and what the price will be.

When a bond first becomes callable, i.e., on the call date, the call price is often set to equal the face value plus one year's interest.

Call Risk

A company will often call a bond if it is paying a higher coupon than the current market interest rates Basically, the company can reissue the same bonds at a lower interest rate, saving them some amount on all the coupon payments; this process is called "refunding callable bonds will carry something called call protection. This means that there is some period of time during which the bond cannot be called.

Application
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