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Chapter 7

FIN 300 - Chapter 7 Notes

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FIN 300
Mike Inglis

FIN 300 – Chapter 7: Interest Rates and Bond Valuation 7.1 Bonds and Bond Valuation  When a corporation or a government wishes to borrow money from the public on a long-term basis, it usually does so by issuing or selling debt securities that are generically called bonds. Bond Features and Prices  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. o If coupon is constant and paid every year, those types of bonds are called level coupon bond.  Face Value – The principal amount of a bond hat is repaid at the end of the term. Also called par value.  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. o Once a bond is issued, the number of years to maturity declines as time goes by. Bond Values and Yields  Interest rates change in the marketplace as time goes by, but the cash flows from a bond, however, stay the same because the coupon rate and maturity date are specified when it is issued. o Due to this, the value of the bond fluctuates. o When interest rates rise, the PV of the bond‟s remaining cash flows declines, and the bond is worth less. When interest rates fall, the bond is worth more.  To determine the value of a bond on a particular date; the number of periods remaining until maturity, the face value, the coupon, and the market interest rate for bonds with similar features is needed. o Yield to Maturity (YTM) – The market interest rate that equates a bond‟s present value of interest payments and principal repayment with its price.  A bond that sells for less than face value, or at a discount, is called a discount bond.  A bond that sells for more than face value, or at a premium, is called a premium bond.  A general expression can be created for the value of a bond. If a bond has (1) a face value of F paid at maturity, (2) a coupon of C paid per period, (3) t periods to maturity, and (4) a yield of r per period, its value is: o Bond Value = C × (1 – 1/(1 + r) )/r + F/(1+r)t o Bond Value = PV of the coupons + PV of the face amount  Bond prices and interest rates (or market yields) are inversely related and move in opposite directions.  Most bonds are issued at par, with the coupon rate set equal to the prevailing market yield or interest rate. Interest Rate Risk  The risk that relates for bond owners from fluctuating interest rates (market yields) is called interest rate risk.  Interest risk a bond has depends on how sensitive its price is to interest rate changes. o Sensitivity directly depends on two things: the time to maturity and the coupon rate.  Keep these two things in mind when looking at a bond: 1. All other things equal, the longer the time to maturity, the greater the interest rate risk. 2. All other things equal, the lower the coupon rate, the greater the interest rate risk. Finding the Yield to Maturity  The only way to find the yield to maturity is through trial and error because you cannot solve the equation because of the equation and the one unknown, r. o You can speed up the trial and error method by knowing bond prices. If the bond is selling at discount, then the coupon rate is suppose to be higher, but if it is selling at a premium, then the coupon rate should be lower. 7.2 More on Bond Features  Securities issued by corporations may be classified as equity securities and debt securities.  The person or firm making the loan is called the creditor or lender.  The corporation borrowing the money is called the debtor, or borrower.  There are three major differences between debt and equity: o Debt is not an ownership interest in the firm. Generally no voting power. o 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. o Unpaid debt is a liability of the firm. If not paid, creditors can legally claim the assets of the firm; can result in liquidation and reorganization. Is It Debt or Equity?  General rule, equity represents an ownership interest, and it is a residual claim. o Equity holders are paid after debt holders.  The risks and benefits associated with owning debt and equity are different. o The maximum reward for owning a debt security is ultimately fixed by the amount of the loan, whereas there is no upper limit to the potential reward from owning an equity interest. Long-Term Debt: The Basics  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 balance.  The maturity of a long-term debt instrument refers to the length of time the debt remains outstanding with some unpaid balance.  Debt securities are typically called notes, debentures, or bonds.  The two major forms of long-term debt are public-issue and privately placed. o Main difference between public and private 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, it is also known as the deed of trust.  Usually a trust company is hired to represent the bondholders. The trust company must (1) make sure the terms of the indenture are obeyed, (2) manage the sinking fund, and (3) represent the bondholders in default, that is, if the company defaults on its payments to them.  The indenture is a large document that is very important and generally includes the following provisions: (1) basic terms of the bonds, (2) amount of bonds issued, (3) description of property used as security if he bonds are secured, (4) repayment agreements, (5) call provisions, and (6) details of protective covenants. Terms of Bond  Registered Form – Registrar of company records ownership of each bond; payment is made directly to the owner of record. o Cheque or a coupon attached to the bond certificate is sent for interest payments.  Bearer Form – Bond issued without record of the owner‟s name; payment is made to whoever holds the bond. o Certificate is basic evidence of ownership, and corporation pays the bearer. o Two drawbacks: (1) difficult to recover if lost or stolen, and (2) company doesn‟t know who owns bonds, so can‟t notify bondholders of important events. o The advantage: 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. o Usually of stock or bonds.  Mortgage Securities are secured by a mortgage on real property of the borrower. o Real estate, transportation, or other property is valid. o Can also be called mortgage trust indenture or trust deed. o Specific property = chattel mortgage, all real property = blanket mortgage  Debenture – Unsecured debt, usually with a maturity of 10 years or more.  Note – Unsecured debt, usually with a maturity under 10 years. Seniority  Seniority indicates preference in position over other lenders, and debts are sometimes labelled as “senior” or “junior” to indicate seniority.  Some debt is subordinated, which means that in the event of a default, holders of subordinated debt must give preference to other specified creditors. 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.  Sinking Fund – Account managed by the bond trustee for early bond redemption.  Reduces the risk that the company will be unable to repay the principal at maturity, it also improves the marketability of the bonds. The Call Provision  Call Provision – Agreement giving the corporation the option to repurchase the bond at a specified price before maturity.  Call Premium – Amount by which the call price exceeds the par value of the bond.  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  Protective Covenants – Part of the indenture limiting certain transactions that can be taken during the term of the loan, usually protect the lender‟s interest. o Reduce agency costs faced by bondholders and by controlling company
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