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Department
Commerce
Course
COMMERCE 2FA3
Professor
Kevin Brewer
Semester
Winter

Description
Commerce 2FA3 Chapter 7: Interest Rates and Bond Valuation Bonds and Bond Valuation Bond Features and Prices - A bond is normally an interest-only loan, meaning the borrower pays the interest every period, but none of the principal is repaid until the end of the loan Coupons: The stated interest payments made on a bond Face value: The principal amount of a bond that is repaid at the end of term. Also par value  Government and provincial bonds frequently have much larger face or par values Coupon rate: the annual coupon divided by the face value of a bond Maturity date: Specified date at which the principal amount of a bond is paid - Once the bond has been issued, the number of years to maturity declines as time goes by Bond Values and Yields - To determine the value of a bond on a particular date, we need to know the number of periods remaining until maturity, the face value, the coupon, and the market interest rate of bonds with similar features Yield to maturity (YTM): The market interest rate that equates a bond’s present value of interest payments and principal repayment with its price - Sometimes called the bond’s yield - A bond that sells for less than face value is a discount bond - A bond that sells for more than face value is a premium bond Bond value= C X (1-1(1+r)^t)/r + F/(1+r)^t C- the coupon paid each period r- The rate per period t- the number of periods F- The bond’s face value Bond value= PV of the coupons + PV of the face amount Interest Rate Risks - The risk that arises for bond owners from fluctuating interest rates (market yields) - How much interest risk a bond has depends on how sensitive its price is to interest rate changes 1) All other things being equal, the longer the time to maturity, the greater the interest rate risk 2) All other things being equal, the lower the coupon rate, the greater the interest rate risk Finding the yield to maturity - Given a bond value, coupon, time to maturity, and face value, it is possible to filed the implicit discount rate or yield to maturity by trial and error only - Try different discount rates until the calculated bond value equals the given value - Increasing the rate decreases the bond value Bond Features - Securities issued by corporations may be classified roughly as equity securities and debt securities - When corporations borrow, they generally promise to make regularly scheduled interest payments and to repay the original amount borrowed (the principal) - The person or firm making the loan is called the creditor or lender - The corporation borrowing the money is called the debtor or borrower The main differences between debt and equity are the following: 1) Debt is not an ownership interest in the firm. Creditors generally do not have voting power 2) The corporation’s payment of interest on debt is considered a cost of doing business and is fully tax deductible. Dividends paid to shareholders are not tax deductible 3) Unpaid debt is a liability of the firm. If it is not paid, the creditors can legally claim the assets of the firm. This action can result in liquidation or reorganization, 2 of the possible consequences of bankruptcy. Thus, one of the costs of issuing debt is the possibility of financial failure. This possibility does not arise when equity is issued Is it Debt or Equity? - Equity represents an ownership interest, and it is a residual claim - Equity holders are paid after debt holders Long-term debt: The basics - All long-term debt securities are promises by the issuing firm to pay the principal when due and to make timely interest payments on the unpaid balances - The maturity of a long-term debt instrument refers to the length of time the debt remains outstanding with some unpaid balance - Debt securities can be short-term or long-term - Debt securities are typically called notes, debentures, or bonds - The 2 major forms of long-term debt are public-issue and privately placed - The main difference between the 2 is that the latter is directly placed with a lender and not offered to the public The Indenture Indenture: Written agreement between the corporation and the lender detailing the terms of the debt issue - Referred to as the deed of trust - A trustee (a trust company) is appointed by the corporation to represent the bondholders - The trust company must: 1) Make sure the terms of the indenture are obeyed 2) Manage the sinking fund 3) Represent the bondholders in default, that is, if the company defaults on its payments to them The bond indenture is a legal document Terms of the bond Registered of form: Registrar of company records ownership of each bond; payment is made directly to the owner of record Bearer form: Bond issued without record of the owner’s name; payment is made to whoever holds the bond - 2 drawbacks: 1) They are difficult to recover if they are lost or stolen 2) The company does not know who owns its bonds, it cannot notify bondholders of important events - The bearer form of ownership does have the advantage of easing transactions for investors who trade their bonds frequently Security - Debt securities are classified according to the collateral and mortgages used to protect the bondholder - Collateral is a general term that means securities pledged as security for payment of debt - Mortgage securities are secured by a mortgage on the real property of the borrower - The property involved may be real estate, transportation equipment, or other property Debenture: Unsecured debt, usually with a maturity of 10 years or more Note: Unsecured debt, usually with a maturity under 10 years - At the current time, most public bonds issued by industrial and finance companies are debentures. Seniority - Indicates preference in position over other lenders and debts are sometimes labeled as senior or junior to indicate seniority - Some debt is subordinated - In the event of default, holders of subordinated debt must give preference to other specified creditors - Debt cannot be subordinated for equity Repayment - Bonds can be repaid at maturity, at which time the bondholder receives the stated or face value of the bonds, or they may be repaid in part or in entirety before maturity - Early repayment in some form is more typical and is often handled through a sinking fund Sinking fund: Account managed by the bond trustee for early bond redemption - The company makes annual payments to the trustee, who then uses the funds to retire a portion of the debt - The trustee does this by either buying up some of the bonds in the market or calling in a fraction of the outstanding bonds - Improves the marketability of the bond The Call Provision Call provision: Agreement giving the corporation the option to repurchase the bond at a specified price before maturity - Corporate bonds are usually callable - Generally, the call price is more than the bond’s stated value (par value) Call premium: Amount by which the call price exceeds the par value of the bond  May also be expressed as a percentage of the bond’s face value - The amount becomes smaller over time - Call provisions are not usually operative during the first part of a bond’s life Deferred call: Call provision prohibiting the company from redeeming the bond before a certain date Call protected: Bond during period in which it cannot be redeemed by the issuer Canada plus call: Call provision, which compensates bond investors for interest differential, making call unattractive for issuer Protective Covenants - Part of the indenture limiting certain transactions that can be taken during the term of the loan, usually to protect the lender’s interest - They are designed to reduce the agency costs faced by bondholders - By controlling company activities, they reduce the risk of the bonds - Can be classified into 2 types: 1) A negative covenant limits or prohibits actions that t
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