REAL-WORLD BOND VOCABULARY

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1 SUPPLEMENTAL READING COB 241 Sections 13, 14, 15 To Accompany Homework Assignment 17 REAL-WORLD BOND VOCABULARY Remember: a Bond is a Loan. The bond document is a promissory note. The issuer of the bond is the borrower. The borrower sells the bond to the lender. Chapter 10 s title is Long Term Liabilities. The textbook Chapter 10, the Professor s Class Notes, List of Terms, and Classroom Lectures for Units 16 and all discuss concepts on the issuance and accounting for bonds from the borrower s perspective. In practice, most people who deal with bonds on a daily basis are individual investors, investment brokers, financial planners, and the general public. These parties compose the original buyers of the bond e.g., they purchase the promissory note from the issuer. They view bond concepts from the perspective of the lender. Once the lender has loaned money to the company, the lender is said to be the holder of the bond. As time goes by, the holder of a bond may decide he or she doesn t want to own the bond anymore (usually because the market rate of interest has changed). The lender now becomes a seller of the bond. This new transaction is not a loan, it is a true sale: the original lender sells the promissory note outright. The new buyer of the bond is simply making a purchase of the piece of paper (the promissory note). Once this sale is completed, the new buyer is now the holder of the bond, and has the right to collect all future periodic interest payments, as well as the right to collect the face value of the bond at its maturity. This new holder of the bond may later decide to sell the bond again, in which case the newest buyer holds the bond, and obtains the rights to the future periodic cash flow and face value at maturity. Because of this constant buying and selling of bonds, a parallel vocabulary a set of words and phrases has arisen to convey the concepts of bond pricing from the perspective of the buyers and sellers in the market. You can consider the textbook and classroom lectures as being from a seller s perspective, whereas this parallel set of terminology is from the buyer or market s perspective.

2 REVIEW OF HOW TO CALCULATE BOND PRICES The classroom lecture and Professor s Class Notes have covered the theory behind calculating bond prices. A quick review: 1. Bonds have a face value printed on them. This is the fixed dollar amount which the holder of the bond will receive on the maturity date. 2. The bond has a maturity date printed on it. On the maturity date, the original borrower (the company issuing the bond) will pay off the bond by paying the face value to whoever holds the bond on that date. This is called redeeming the bond. 3. A bond also has a stated rate of interest printed on it. In practice, the only thing this stated rate of interest is used for, is to determine the periodic payment the holder will receive each year. Multiplying the face value by the stated rate of interest (both of which are printed on the bond) gives the periodic payment amount. 4. Some bonds call for two payments to be made each year, rather than one. The two payments are made, six months apart. These are known as semi-annual payments. The amount of semi-annual payment is determined by multiplying the face value printed on the bond by half of the stated rate of interest printed on the bond. 5. Once the periodic payment amount has been determined, the Stated Rate of Interest printed on the bond can, for all practical purposes, be completely ignored. 6. The bond price at any given point in time is always calculated by adding two values together. The two values are: a. The Present Value of the bond s face value, and b. The Present Value of the future periodic payments. 7. The present value of the bond s face value is found by multiplying the face value by the factor found in a Present Value of $1 Table. The present value of the future periodic payment stream is found by multiplying the periodic payment by the factor found in a Present Value of An Annuity Table. 8. It is critically important to note that when using the Tables, the column is determined by the current Market Rate of Interest, not the rate of interest printed on the bond! 9. The row of the table is determined by the number of remaining periods until the bond s maturity date. Example: if a 20-year bond is sold by the lender after 4 years, the row of the Present Value Table used will be 16, not 20.

3 FINANCIAL MARKETS AND BOND PRICES Once the Present Value tables have been used to determine the present price of a bond, that price is divided by the face value printed on the bond. This gives a percentage. The financial press, along with bond brokers, bond trading companies, and others involved in the bond markets, refer to this number, but they don t bother using the word percentage they just give the unit-less number and refer to this as the price of the bond. In reality, it is not the current bond price in dollars, but rather, it is the current bond price in percentage points of the face value. Example: a bond broker might say he has a $25,000 bond available for purchase at a Price of 96. This means that the actual price of the bond in dollar is 96% of the $25,000 face value, or $24,000. Example: a bond broker might way he has a $75,000 bond available at a Price of 104. This means that the bond s price in dollars is 104% of $75,000, which is $78,000. Bond markets involve both buyers and sellers of bonds, and thus the financial markets do not refer to selling price or buying price. They refer to a trading price. Example: a bond with a face value of $100,000 is calculated to have a present price of $95,000. The financial markets would say that this bond is Trading at a price of 95. Example: a bond with a face value of $100,000 is calculated to have a present price of $110,000. The financial markets would say that this bond is Trading at a price of 110. Example: a bond with a face value of $25,000 is calculated to have a present price of $23,000. Dividing $23,000 by $25,000 is 0.92 or 92%. The financial markets would say that this bond is Trading at a price of 92. When referring to bond prices, fractions of a percent are always expressed as a fraction rather than a decimal value: Example: a bond with a face value of $100,000 is calculated to have a present price of $96,250. Dividing $96,250 by $100,000 is or percent. The financial markets would say that this bond is trading at a price of 92¼ rather than When referring to bond prices, the financial markets almost always round to the nearest 1/8 of a percent: Example: a bond with a face value of $25,000 is calculated to have a present price of $23,050, which is or 92.2 percent. The financial markets would say that this bond is trading at a price of 92¼. Example: a bond with a face value of $75,000 is calculated to have a present price of $79,000. Dividing $79,000 by $75,000 is or %. The financial markets would say this bond is trading at a price of 105-3/8.

4 BOND YIELD Bond yield is the amount of cash a bond holder receives expressed as a percentage of the price of the bond. There are several types of yield. Nominal yield is the interest rate printed on the bond. As said before, this value is used to determine the periodic payment amount, and nothing else. (By coincidence, it happens to be the current yield if the market rate of interest is the same as the rate printed on the bond.) Current yield is the annual payment divided by the bond s current market price. So if the bond is purchased at a discount (price lower than the face value), the current yield will be higher than the nominal yield. Remember, as the market rate of interest declines, bond prices go up. As the price of a bond goes up, its current yield falld. Stop and ponder this, and think about why this is so. If a bond holder decides to sell the bond before its maturity date, any profit or loss on the sale (trading price at the time of sale minus the trading price at time of purchase) are included along with the received periodic payments, in the Actual Yield. EXACTLY WHAT IS THE MARKET RATE OF INTEREST? The market rate of interest is not determined by any one authority. Nor is the market rate of interest a measurable number which can looked up somewhere. The Market Rate of Interest is the yield required to entice a buyer to purchase the bond. This means that the market rate for one bond is not necessarily the market rate for another bond. One company s bond might be viewed as riskier than another company s bond, and thus will require a higher yield to entice someone to buy the riskier bond. Example: Alpha Company s primary product is lithium batteries, a technology forecasted to grow tremendously with the popularity of electric automobiles, solar power, and wind power. Beta Company s primary product is opioid-based pain relievers, a product whose future is uncertain because of the dangers of addiction coupled with potential non-addictive replacement products. Because of the uncertainty surrounding Beta Company s future, Beta Company s bonds have a higher risk level than Alpha Company s bonds. The market rate required to sell a Beta Company 20-year bond will likely be higher than the market rate required to sell an Alpha Company 20-year bond, even though both may carry the same face value, the same printed interest rate, have the same periodic payment, and be offered for sale on the same day.

5 BOND RATINGS Because some companies bonds are riskier than others, three financial services firms have gone into the business of performing detailed analyses of the risk of default for corporate bond issues. These firms are: (1) Fitch, (2) Moody s, and (3) Standard & Poor s. All three companies use similar but slightly different rating designations, and they sometimes differ significantly in their judgment about how risky a company s bonds might be. The highest rating goes to companies which have the lowest risk companies with proven track records of profits, solvency, and competent management and governance, with bright prospects for the future, in a line of business which has potential for growth and profits. The lowest ratings go to companies who are, in the judgment of the rating company, a speculative investment, likely to result in the company s default on the bond before its maturity. The higher ratings are called investment-grade bonds. These ratings are given to bonds which the rating firm believes are relatively safe investments. Non-investment-grade bonds are considered speculative, and carry very high risk. They also therefore also carry higher market rates of interest. In addition to non-investmentgrade, these bonds are also called high yield bonds by their promoters, or junk bonds by their detractors. The highest rating issued by Moody s is Aaa, the next highest is Aa1, followed by Aa2, Aa3, A1, A2, A3, Baa1, Baa2, and Baa3. Ratings below Baa3 are non-investment grade (speculative), and start at Ba1, followed by Ba2, Ba3, B1, and so forth, down to C, which is the lowest rating. Moody s rating of C is reserved for companies which are in, or very near, default and will likely not be able to pay off a long-term bond. The highest rating for Fitch and Standard & Poor s are AAA, the next highest is AA+, followed by AA, AA-, A+, A, A-, BBB+, BBB, and BBB- Non-investment-grade ratings begin with BB+, followed by BB, and so forth, down to D. The rating of D means the company is already in, or near, default and likely will not pay off a long-term bond. Bond ratings are the primary factor in deciding what the market rate of interest is for a given bond. If you have two otherwise identical bonds, one with a rating of AAA and the other with a rating of B, the market rate of interest for the AAA bond will be lower than the bond rated B.

6 PAR VALUE Remember, a bond has a face value printed on it. This is sometimes known as the bond s Par Value. It happens to also be the amount the original issuer (original borrower) must pay the holder of the bond upon its redemption on the maturity date. SINKING FUND Remember, a bond carries a face value printed on it. While a single bond may have an amount between $1 and $1 million, in practice most bonds are issued in batches, which produces thousands or millions of dollars in loan proceeds for the bond issuer (the borrower) at the time of issue. Remember: On the bonds maturity date, the borrower (e.g., the original issuer) must pay back the face value of all of these bonds! That can mean a cash disbursement of thousands or even millions of dollars on a single day! To prepare for this massive cash payout, many companies will establish a sinking fund, as a kind of savings account to hold the money, while they accumulate enough to meet the payout obligation. In the past, this money was sometimes deposited in a special checking or savings account or CD known as the sinking fund. Sometimes, rather than being deposited into a savings or checking account, the money will be used to buy back the bonds on the open market, especially if the company currently has cash available and the market interest rate is higher than the stated interest rate printed on the bond. When the company buys back the bonds, they can retire them early by purchasing them at a discounted price, and avoid having to make those future periodic payments. This saves interest.