Bond evaluation Lecture 7 Shahid Iqbal
Have you ever borrowed money???
Of course you have! Whether we hit our parents up for a few bucks to buy candy as children or asked the bank for a mortgage, most of us have borrowed money at some point in our lives.
Just as people need money, so do Companies and the Governments.
A company needs funds to expand into new markets, while governments need money for everything from infrastructure to social programs.
The problem large organizations run into is that they typically need far more money than the average bank can provide. Now what solution you think?
The solution is to raise money by issuing bonds (or other debt instruments) to a public market. Thousands of investors then each lend a portion of the capital needed. Really, a bond is nothing more than a loan for which you are the lender. The organization that sells a bond is known as the issuer. You can think of a bond given by a borrower (the issuer) to a lender (the investor).
Of course, nobody would loan his or her hard-earned money for nothing. The issuer of a bond must pay the investor something extra for the privilege of using his or her money. This "extra" comes in the form of interest payments, which are made at a predetermined rate and schedule. The interest rate is often referred to as the coupon. The date on which the issuer has to repay the amount borrowed (known as face value) is called the maturity date.
What is a BOND? A bond is essentially a loan made to a company or a government body. The lender and the borrower enter into an agreement under which the lender will receive periodic interest payments and ultimately will get back the amount lent (the principal). The duration of the agreement, known as the maturity, can vary from days to decades.
The first thing that comes to most people's minds when they think of investing is the stock market.
After all, stocks are exciting. The swings in the market are scrutinize in the newspapers and even covered by local evening newscasts. Stories of investors gaining great wealth in the stock market are very common.
Bonds are known as fixed-income securities because you know the exact amount of cash you'll get back if you hold the security until maturity. For example, say you buy a bond with a face value of $1,000, a coupon of 8%, and a maturity of 10 years. This means you'll receive a total of $80 ($1,000*8%) of interest per year for the next 10 years. Actually, because most bonds pay interest semi-annually, you'll receive two payments of $40 a year for 10 years. When the bond matures after a decade, you'll get your $1,000 back.
Why Bother With Bonds?
It's an investing axiom that stocks return more than bonds. In the past, this has generally been true for time periods of at least 10 years or more. However, this doesn't mean you shouldn't invest in bonds. Bonds are appropriate any time you cannot tolerate the short-term volatility of the stock market. Take two situations where this may be true:
Retirement The easiest example to think of is an individual living off a fixed income. A retiree simply cannot afford to lose his/her principal as income for it is required to pay the bills.
Shorter time horizons Say a young executive is planning to go back for an MBA in three years. It's true that the stock market provides the opportunity for higher growth, but the executive cannot afford to take the chance of losing the money going towards his/her education. Because money is needed for a specific purpose in the relatively near future, fixed-income securities are likely the best investment.
These two examples are clear cut, and they don't represent all investors. Most personal financial advisors advocate maintaining a diversified portfolio and changing the weightings of asset classes throughout your life. For example, in your 20s and 30s a majority of wealth should be in equities. In your 40s and 50s the percentages shift out of stocks into bonds until retirement, when a majority of your investments should be in the form of fixed income.
Bond Features The bond indenture is the contract between the issuer (the borrower) and the bondholder (the lender), which sets forth all the obligations of the issuer. It usually specifies the interest rate, maturity date, convertibility, and other terms. Important features of bonds are:
Face Value/Par Value The face value (also known as the par value or principal) is the amount of money a holder will get back once a bond matures.
Redemption date The date on which the loan will be repaid is called the redemption date or the maturity date.
Coupon (The Interest Rate) The coupon is the amount the bondholder will receive as interest payments. It's called a "coupon" because sometimes there are physical coupons on the bond that you tear off and redeem for interest. However, this was more common in the past. Nowadays, records are more likely to be kept electronically.
Most bonds pay interest every six months, but it's possible for them to pay monthly, quarterly or annually. The coupon is expressed as a percentage of the par value. If a bond pays a coupon of 10% and its par value is $1,000, then it'll pay $100 of interest a year. A rate that stays as a fixed percentage of the par value like this is a fixed-rate bond.
Another possibility is an adjustable interest payment, known as a floating-rate bond. In this case the interest rate is tied to market rates through an index, such as the rate on Treasury bills. You might think investors will pay more for a high coupon than for a low coupon. All things being equal, a lower coupon means that the price of the bond will fluctuate more.
Redemption value A bond's redemption value or maturity value is the amount that the issuer promises to pay on the redemption date. In most cases the redemption value is the same as the face value if so, the bond is redeemed at par.
Set Maturity Dates: Bonds have set maturity dates that can range from one to 30 years: Short-term bonds (mature in three years or less) Intermediate bonds (mature in three to ten years) Long-term bonds (mature in ten years or more)
Interest Payments: Bonds typically offer some form of interest payment; however, this depends on their structure: Fixed Rate Bonds provide fixed interest payments on a regular schedule for the life of the bond. Floating Rate Bonds have variable interest rates that are periodically adjusted. Zero Coupon Bonds do not pay periodic interest at all, but offer an advantage in that they are can be bought at a discounted price of the face value.
Principal Investment Repayment: Bond issuers are obligated to repay the full principal amount of a bond in a lump sum when the bond reaches maturity
Bond s Benefits Bonds can be a reliable source of current income depending on the structure of the bond you buy. Bonds provide a certain element of liquidity, as the bond market is large and active. If you sell a bond before it matures, you may receive more or less than your principal investment because bond values fluctuate Generally, interest income from federal government bonds is exempt from taxation at the state and local level, and the interest income from municipal bonds is usually not subject to federal tax. In the spectrum of the investment options, investment grade bonds are a relatively low risk investment
Other types (features) of bonds
Callable Bonds: If the bond has a "call feature", the issuer is allowed to redeem the bond before its maturity date, repay the loan and thus, stop paying interest on it
Putable bond: Allows holder to sell the bond back to the company prior to maturity.
Income bond: Pays interest only when interest is earned by the firm.
Indexed bond: Interest rate paid is based upon the rate of inflation.
Interest Rates of Bonds Fixed Stays same until maturity; ie: buy a $1000 bond with 8% fixed interest rate and you will receive $80 every year until maturity and at maturity you will receive the $1000 back.
Floating Adjustable to prevailing market rates.
Payable at Maturity Receive no payments until maturity and at that time you receive principal plus the total interest earned compounded semi-annually at the initial interest rate.
PRICE The amount you pay for the bond Newly issued bonds will pay close to their face-value. Bonds traded higher than their face-value are said to be sold at a premium Bonds traded lower than their face-value are said to be be sold at discount
Yield Yield is the return you actually earn on the bond price you paid and the interest payment you receive. Two Types of Yields are: Current Yield: is derived by dividing the bond's interest payment by its purchase price Yield To Maturity: total return you will receive by holding the bond until it matures or is called.
Bond Benefits High degree of safety with regular, scheduled, predictable payments