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MGFB10H3 (19)
Chapter 6

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Department
Finance
Course
MGFB10H3
Professor
Sultan Ahmed
Semester
Winter

Description
Chapter 6: Bond Valuation and Interest Rates  Bonds: long-term debt instruments that promise fixed payments and have maturities of longer than 7 years o Major source of financing for companies  Notes: bonds with maturities b/w one and seven years  Bills or paper: short-term bonds w/ a maturity of less than one year 6.1 The Basic Structure of Bonds  Key feature of 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 maturity date  Although many payment structures are possible, the traditional “coupon-paying” bond provides for identical payments at regular intervals (usually semi-annually or annually) with the full principal to be repaid at the stated maturity rate  Bullet payment/ balloon payment: a principal payment made in one lump sum at maturity  Bonds are not referred to as fixed income securities b/c the interest payments and the principal repayment are specified or fixed at the time the bond is issued  Difference b/w loan/mortgage payments and bond payments: loans and mortgage payments include principal repayment and interest payments whereas bond payments are regular interest payments throughout its life and a balloon payment of principal 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 (e.g. collateral for the bond), held and administered by a trust company  Bond indentures include basic features attached to cash payments: o Par value=face value= maturity value: represents the amount that is paid at maturity for traditional bonds  Bond prices are typically quoted based on a par value of 100. In other words, if the price of a bond is quoted at 99.583, a $1000 par value bond would be selling for $995.83 o Terms to maturity of a bond: time remaining until the maturity date o Interest payments=coupons: determined by multiplying the coupon rate (which is stated on an annual basis) by the par value of the bond Security and Protective Provisions  Mortgage bonds: debt instruments that are secured by real assets  Debentures: debt instruments that are similar to bonds but are generally unsecured or are secured by a general floating charge over the company’s unencumbered assets (i.e. assets that have not been pledged as security for other debt obligations)—e.g. govt bonds  Collateral trust bonds: secured by a pledge of other financial assets (e.g. common shares, bonds or treasury bills)  Equipment trust certificates: secured by equipment  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: bonds that give the issuer the option to “call” or repurchase outstanding bonds at predetermined prices at specified times (risk for bondholder) Good for  Retractable bonds: allow the bondholder to sell the bonds back to the issuer at predetermined prices at specified times earlier than the maturity date (maturity of bond is shortened) bondholder  Extendible bonds: allow the bondholder to extend the maturity date of the bond  Sinking fund provisions: the requirement that an issuer set aside funds each year to be used to pay off the debt at maturity (two ways to do this): 1. Firm repurchases a certain amount of debt each yr so that the amount of debt goes down 2. The firm pays money into the sinking fund to buy other bonds, usually govt bonds, so that money is available at maturity to pay off the debt, although the amount due at maturity is unchanged  Purchase fund provisions: similar to sinking fund provisions but they require the repurchase of a certain amount of debt only if it can be repurchased at or below a 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= bond price, I=interest/coupon payments, kb= the bond discount rate or market rate, n= the term to maturity, F= the face (par) value of the bond  Interest payments are multiplied by the standard present value annuity factor while the par value is multiplied by the present value interest factor  Discount/premium: the difference b/w the bond’s par value and the price it trades at, when it trades below (above) the par value o Couple rate< market rate  When investing in bonds, if interest rates increase, the market prices of bonds decline and vice versa  The longer the time to maturity, the more sensitive the bond price is to changes in market rates o Therefore, it is a disadvantage for the investor  Interest rate risk: sensitivity of bond prices to changes in interest rates  Duration: an important measure of interest rate risk that incorporates several factors 1. The prices of bonds w/ higher durations are more sensitive to interest rate changes than are those w/ lower durations 2. All else being equal, durations will be higher when (1) market yields are lower, (2) bonds have longer maturities and (3) bonds have lower coupons  Yield: describes the amount in cash that returns to the owners of a security Cash Prices versus Quoted Prices:  Prices reported in the media are referred to as “quoted” prices  These differ from the actual prices investors pay for bonds whenever bonds are sold at a date other than the date of a coupon payment  Therefore, bond purchaser must pay the bond seller the quoted price plus the accrued interest on the bond (AKA “cash price” of the bond) 6.3 Bond Yields  Yield to maturity (YTM): the discount rate used to evaluate bonds o The yield that an investor would realize if he or she bought the bond at the current price, held it to maturity, received all the promised payments on their scheduled dates and reinvested all he cash flows received at the YTM o Use the same formula as above except calculate for kbinstead of B: o A special form of internal rate of return (IRR) Yield to Call (YTC):  The yield that is associated w/ a bond’s first call date is known as yield to call  Similar to above formula except replace time to maturity (n) w/ the time to first call (c), replace face value (F) with the call price (CP)  If call price is above its current market price, it is unlikely that the bond would be called back by the issuer (selling based on its YTM rather than its YTC) Current Yield (CY):  Current Yield= Flat Yield= Cash Yield: the ratio of the annual coupon interest divided by the current market price Price-Yield Relationships Bond Price Relationship Par Coupon Rate=CY=YTM Discount Coupon Rate < CY < YTM Premium Coupon Rate > CY > YTM 6.4 Interest Rate Determinants Base Interest Rates:  Changes in interest rates are referred in terms of “basis points,” each of which
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