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Bond

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Bond

  1. 1. BONDs & DEBENTUREs <ul><li>Both long term borrowings by way of a contract under which a borrower promises to pay interest on specific dates and principal upon maturity. </li></ul><ul><li>Debentures are secured by mortgage and a Trust creation </li></ul>
  2. 2. Debentures <ul><li>Oldest forms of borroweing </li></ul><ul><li>Instruments for debt over ten or even a longer period </li></ul><ul><li>Interest factor </li></ul><ul><li>Convertibility </li></ul><ul><li>Where advisable? </li></ul>
  3. 3. What is a BOND <ul><li>A long term contract under which a borrower promises to pay interest on specific dates and principal upon maturity. </li></ul><ul><li>Overcomes limitations of debentures </li></ul>
  4. 4. Owners Vs Loaners <ul><li>Bond holders are loaners </li></ul><ul><li>Ideal source of investment for those seeking regular flow of income </li></ul><ul><li>Bonds don’t give an ownership stake in the Company </li></ul><ul><li>Amount or Rate of Interest that different bonds pay depend on variety of factors </li></ul><ul><li>N </li></ul><ul><li>Value of Asset = ∑ Expected(Cash Flow) t </li></ul><ul><li>t=1 (1 + r ) t </li></ul>
  5. 5. <ul><li>N </li></ul><ul><li>Value of Asset = ∑ Expected(Cash Flow) t </li></ul><ul><li>t=1 (1 + r ) t </li></ul><ul><li>T </li></ul><ul><li>Bond Value = ∑ coupon + par value </li></ul><ul><li>t=1 (1 + r) t (1 + r) T </li></ul><ul><li>CURRENT YIELD = ANNUAL INTEREST / CURRENT PRICE </li></ul><ul><li>YIELD TO MATURITY: </li></ul><ul><li>r </li></ul><ul><li>Market Price = ∑ coupon + par value </li></ul><ul><li>t=1 (1 + YTM) t (1 + YTM) T </li></ul>
  6. 6. TYPES OF BONDS <ul><li>Treasury Bonds – Issued by U.S. Government. No default risk but have interest rate risk. </li></ul><ul><li>Corporate Bonds – Issued by corporations and have default risk and interest rate risk. </li></ul><ul><li>Municipal Bonds – Issued by state and local governments and have default risk and interest rate risk. </li></ul><ul><li>Foreign Bonds – Issued by foreign governments and corporations and have default risk and interest rate risk. </li></ul>
  7. 7. BOND CHARACTERISTICS <ul><li>Par Value – Issue price or face value. </li></ul><ul><li>Coupon Rate – Rate of interest paid as a percentage of the par value. </li></ul><ul><li>Maturity Date – Date the principal is repaid. </li></ul><ul><li>Call Provision – The borrower may redeem the bond early. Usually includes a call premium. </li></ul><ul><li>Sinking Fund Provision – Requires borrower to regularly retire a portion of the bond by either calling it or buying it on the open market. </li></ul>
  8. 8. BOND CHARACTERISTICS <ul><li>Convertible Bonds - Bonds may be converted into common stock at a fixed price. </li></ul><ul><li>Warrants – Options issued with the bonds allowing holders to convert warrants to common stock at a fixed price. </li></ul><ul><li>Income Bonds – Only pays interest if the company makes a profit. </li></ul><ul><li>Indexed bond – Interest based on an inflation index. </li></ul>
  9. 9. Call Provision on Corporate Bonds <ul><li>The call provision allows the issuer to repurchase the bonds at a specified call price before the maturity date. </li></ul><ul><li>It benefits the issuing Company in the situation of fall in interest rate at subsequent date. </li></ul><ul><li>It presupposes prior approvals and specific mention on the bonds and in the issue literatures. </li></ul>
  10. 10. COUPON PAYMENTS <ul><li>Fixed Rate – Interest rate stays the same through life of bond. </li></ul><ul><li>Floating Rate – Rate is fixed for a short time and then indexed to some other rate. </li></ul><ul><li>Zero Coupon Bonds – Issued at a deep discount and do not pay interest. </li></ul><ul><li>Original Issue Discount Bond – Any bond issued at less than par value. </li></ul>
  11. 11. BOND VALUATI0N <ul><li>A company issues a 30 year bond with a par value of $1,000 and a coupon rate of 10%. The required rate of return on the bond is also 10%. What is the value of the bond? </li></ul><ul><li>Par Value = 1,000 </li></ul><ul><li>Interest Payment = Par Value x Coupon Rate </li></ul>
  12. 12. Bond Valuation <ul><li>Bonds which sell for less than par value are known as discount bonds. </li></ul><ul><li>Bonds which sell for more than par value are known as premium bonds. </li></ul><ul><li>Bonds which are issued at a discount are known as original discount bonds. </li></ul>
  13. 13. YIELD TO MATURITY <ul><li>Let’s use the same example: we issue a bond with a 10% coupon. The price is $1,000 (the par value). What is the yield to maturity? </li></ul><ul><li>n = 30, Pmt = 100, FV = 1,000, PV = -1,000 </li></ul><ul><li>The FV and Pmt are amounts we will receive; the PV is an amount we pay so it is a minus. </li></ul>
  14. 14. YIELD TO CALL <ul><li>Company’s can call bonds early. </li></ul><ul><li>Company’s will generally call bonds when interest rates have fallen and new bonds can be issued with a lower coupon rate. </li></ul>
  15. 15. SEMIANNUAL COUPONS <ul><li>Most bonds have semiannual coupons. </li></ul><ul><li>When valuing a bond with semiannual coupons divide the Pmt by 2; multiply n by 2. </li></ul><ul><li>When finding the yield of a bond with semiannual coupons make the same adjustments and also multiply the answer by 2 to get the annual yield. </li></ul>
  16. 16. TYPES OF CORPORATE BONDS <ul><li>Mortgage Bonds – Bonds secured with real property. </li></ul><ul><li>Debentures – Unsecured bonds. </li></ul><ul><li>Subordinate Debenture – A debenture which has a claim subordinate to another debenture. </li></ul>
  17. 17. BOND RATINGS <ul><li>Bonds are rated as to their riskiness by several firms. (Moody’s Investment Service and Standard & Poor’s) </li></ul><ul><li>Bonds with the highest rating are rated AAA. </li></ul><ul><li>As bonds become riskier their ratings drop. Riskiness is the chance of default. </li></ul><ul><li>Investment grade bonds must be rated at least BBB. </li></ul><ul><li>Junk bonds are bonds rated lower than BBB. </li></ul>

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