Copyright 2004 Pearson Education, Inc. All rights reserved. Bonds
What is a Bond? Debt securities that may pay a rate of interest based upon the face amount or par value of the bond Bond investors receive full face amount when bonds mature Interest payments for coupon bonds are commonly semiannual; Zero coupon bonds no periodic payment Primarily traded in the over-the-counter (OTC) market; Most bonds owned by and traded among large financial institutions Prices change daily
Bonds versus Stocks Bonds A loan No ownership interest No voting rights Finite life Legal recourse if payments missed Stocks An Investment Ownership interest Common stockholders vote Perpetual life No legal recourse if dividends not paid
Why do Corporations issue Bonds? Capital Investment Deficit Management Debt Management
Why do Investors Buy Bonds? Passive strategy: The lower risk portion of diversified portfolio of stocks and bonds, held for a period of time Interest rate strategy: selecting bonds for investment based on interest rate expectations (Purchase long-term bonds if interest rates expected to fall) Maturity matching strategy: investing in bonds that will generate payments to match future expenses (e.g. you might invest in a bond that will mature at the right time to help pay for child s college education)
Types and Characteristics of Bonds There are many different types of bonds. Each type can have different features and characteristics Issuer Government Municipality Corporation Banks Tenor Short (bills) Medium (notes) Long Term (bonds) Perpetual Income Zero Floating Fixed Inflation Adjusted Redemption Callable Putable Convertible Foreign Euro Bonds, International Bonds (Yankee Samurai, Bull Dog), Global, EM US EE, Treasury, TIPS, Agency, Municipal, Corporate, Asset Backed, CDO, CP
Common Features of Bonds Par value face amount of the bond, paid at maturity (usually $1,000). Issue date when the bond is issued Issue price the price on date of issue Coupon interest rate stated interest rate paid by the issuer Coupon payment - multiply rate by par value to get dollar payment of interest Maturity date the date on which bond must be repaid. Yield to maturity - rate of return earned on a bond IF held to maturity
Pricing a Coupon Bond P (1 C 1 r ) 1 (1 C 2 r ) 2... PAR (1 C r ) N N Where r = is the market interest rate (Yield to Maturity) for a bond of similar maturity and with the same level of risk
Other Properties on Coupon Bonds Price vs. Yields to Maturity Price of Bond ($) Yield to Maturity (%) 1200 7.13 1100 8.48 1000 10.00 900 11.75 800 13.81 Consider this bond with the following characteristics: 10% Coupon-Rate, Face Value = $1000 Three Interesting Facts Emerge from the table above: 1. When bond is at par, yield equals coupon rate 2. Price and yield are negatively related 3. Yield greater than coupon rate when bond price is below face value; yield is lower than the coupon rate when bond price is above face value
Premiums and Discounts The relationship between the coupon rate and the bond s yield-to-maturity (YTM) determines if the bond will sell at a premium, at a discount, or at par If Then Bond Sells at a: Coupon < YTM Market < Face Discount Coupon = YTM Market = Face Par Coupon > YTM Market > Face Premium
Risk Factors and Bond Prices Interest Rate Risk Inflation Risk Liquidity Risk Default Risk Political Risk
Inflation Risk Bond Price = C 1 (1+r) If C 1 = Face = $1,000 r = nominal interest rate of 10% Current inflation rate = 5% Then, Bond price = $909.09 And the real interest rate is 5% Let s assume that inflation increases to 10%. The value of r increases as well r = 5% + 10% = 15% The price of the bond, therefore, falls to $869.57 12
Measuring Default Risk Bond Ratings Mergen/ Standard & Fitch/ Moody's Poor's ICBA Best quality/premium/highest quality Aaa AAA AAA High quality/higher grade/unlikely to be affected Aa AA AA Upper-medium/Upper-medium/strong ability to pay A A A Medium grade/medium grade/adequate ability Baa BBB BBB Speculative/Lower-medium-speculative/low grade Ba BB BB Unwise to invest/low grade/highly speculative B B B Poor standing/vulnerable to default/could lead to default Caa CCC CCC Highly speculative/subordinated to CCC/minimal protect Ca CC,C CC
Measuring Default Risk.. Hmm.. Moody s Downgrades the bonds to Junk!! AA Rating on Lehman Bonds