CHAPTER 8 Bonds and Their Valuation.ppt

CHAPTER 7Bonds and Their Valuation Updated: 23 June 2018
Key features of bonds
Bond valuation
Measuring yield
Assessing risk
What is a bond?
A long-term debt instrument in which a borrower agrees to make payments of principal and interest, on specific dates, to the holders of the bond.
Bond markets
Primarily traded in the over-the-counter (OTC) market.
Most bonds are owned by and traded among large financial institutions.
Full information on bond trades in the OTC market is not published, but a representative group of bonds is listed and traded on the bond division of the NYSE.
Key Features of a Bond
Par value – face amount of the bond, which is paid at maturity (assume $1,000).
Coupon interest rate – stated interest rate (generally fixed) paid by the issuer. Multiply by par value to get dollar payment of interest.
Maturity date – years until the bond must be repaid.
Issue date – when the bond was issued.
Yield to maturity - rate of return earned on a bond held until maturity (also called the “promised yield”).
Effect of a call provision
Allows issuer to refund the bond issue if rates decline (helps the issuer, but hurts the investor).
Borrowers are willing to pay a higher interest rate, and lenders/investors require a higher rate, for callable bonds.
Most bonds have a deferred call and a declining call premium.
What is a sinking fund?
Provision to pay off a loan over its life rather than all at maturity.
Similar to amortization on a term loan.
Reduces risk to investor, shortens average maturity.
But not good for investors if rates decline after issuance.
How are sinking funds executed?
Call x% of the issue at par, for sinking fund purposes.
Likely to be used if rd is below the coupon rate and the bond sells at a premium.
Buy bonds in the open market.
Likely to be used if rd is above the coupon rate and the bond sells at a discount.
The value of financial assets
0
1
2
N
r%
CF1
CFN
CF2
Value
...
Other types (features) of bonds
Convertibl