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Chapter 6

Chapter 6 Notes


Department
Finance
Course Code
MGFB10H3
Professor
Derek Chau
Chapter
6

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Chapter 6 Bond Valuation and Interest Rates Notes
bills or paper short-term bonds with a maturity of less than one year
notes bonds with maturities between one and seven years
bonds long-term debt instruments that promise fixed payments and have maturities of longer than seven years
6.1 The Basic Structure of Bonds
the key feature of a bond is that the issuer agrees to pay the bondholder (investor) a regular series of cash payments and to repay
the full principal amount by the maturity date, which are stipulated in the bond contract and are a fixed contractual commitment
bullet payment or balloon payment a principal payment made in one lump sum at maturity
Basic Bond Terminology
bond indenture a legal document that specifies the payment requirements and all other salient matters relating to a particular
bond issue, held and administered by a trust company
collateral assets that can serve as security for the bond in case of default
par value, face value, maturity value the amount paid at maturity for traditional bonds
terms to maturity time remaining to maturity date
interest payments (or coupons) amounts paid on a bond at regular intervals
Security and Protective Provisions
mortgage bonds debt instruments that are secured by real assets
debentures debt instruments that are similar to bonds but re generally unsecured or are secured by a general floating charge
over the company’s unencumbered assets (i.e., those assets that have not bee pledged as security for other debt obligations)
government bonds are debentures because no specific security is pledged as collateral
collateral trust bonds bonds secured by a pledge of other financial assets, such as common shares, bonds, or treasury bills
equipment trust certificates a type of debt instrument secured by equipment, such as railway rolling stock
protective covenants clauses in a trust indenture that restrict the actions of the issuer; covenants can be positive or negative
Additional Bond Features
callable bonds give the issuer the option to “call” or repurchase outstanding bonds at predetermined prices at specified times
call prices prices, generally at a premium over par; at which issuers can repurchase bonds
retractable bonds bondholder can sell back to issuer at predetermined prices at specified times earlier than the maturity date
extendible bonds bonds that allow the bondholder to extend their maturity dates
sinking fund provisions the requirement that an issuer set aside funds each year to be used to pay off the debt at maturity
purchase fund provisions requirement certain amount of debt be repurchased if it can be repurchased at/below given price
convertible bonds bonds that can be converted into common shares at predetermined conversion prices
6.2 Bond Valuation
the price of a bond equals the present value of the future payments on the bond, which is the present value of the interest
payments and the par value repaid at maturity
B = (I / kb) (1 1/(1 + kb)n) + F / (1 + kb)n, where B = bond price, I = interest (or coupon) payments, kb = the bond discount rate
(or market rate), n = the term to maturity, and F = the face (par) value of the bond
discount/premium difference between bond’s par value and the price it trades at, when it trades below (above) the par value
Factors Affecting Bond Prices
interest rate risk the sensitivity of bond prices to changes in interest rates
duration an important measure of interest rate risk that incorporates several factors
the prices of bonds with higher durations are more sensitive to interest rate changes than are those with lower durations
durations will be higher when (1) market yields are lower, (2) bonds have longer maturities, and (3) bonds have lower coupons
6.3 Bond Yields
Yield to Maturity
yield to maturity (YTM) the discount rate used to evaluate bonds
kb represents discount rate that equates known market price (B) with PV of future interest payments and face value repayment
this rate is simply a special form of internal rate of return (IRR)
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