c6: bonds

• A bond is a long-term contract between a borrower and its lenders/bondholders. The borrower/issuer promises to pay interest and principal to bondholders on specific dates. ex. gov of canada bonds
• the Par value of a bond is its Face value; paid at maturity. assume $1,000
• the Coupon interest rate of a bond is the Stated interest rate. it's generally fixed but can vary
• the Maturity of a bond is the Years until a bond must be repaid; declines over time
• the Issue date of a bond is the Date when a bond was issued
• the Default risk of a bond is the Risk that the issuer will not make interest or principal payments
• The call provision allows an issuer to refund a bond if the interest rates decline.
• the call provision helps the issuer but hurts the investor, so a call premium, must be paid. Issuers/borrowers are willing to pay more, and lenders require more, on callable bonds
• a call premium is an amount over the par value
• Retractable bonds allow investors to sell the bonds back to the issuer before maturity at a pre-set price. They protect investors from rising interest rates or event risk
• Sinking funds are a provision to pay off a loan over its life rather than all at maturity (similar to amortization on a term loan). They reduce risk to the investor and shorten average maturity, But if rates decline after issuance, they are not good
• Ways to handle sinking fund provision:

  • Call x% at par per year for sinking fund purposes
  • Buy bonds on the open market
• Bonds are traded primarily on the over-the-counter market and among the large financial institutions
• The required rate of return on debt (rd = the discount rate used to  

         calculate the present value of the bond’s cash flows; note that rd is

         not the coupon interest rate

  N = Number of years before the bond matures

  INT = Dollars of interest paid periodically (per year for an annual coupon

            bond) = Coupon rate × Par value

  M = Par, or maturity value of the bond, often = $1,000
• rd = The required rate of return on debt = the discount rate used to calculate the present value of the bond’s cash flows. not the coupon interest rate
• M (capital) = Par, or maturity value of the bond, often = $1,000
• N = Number of years before the bond matures
• INT = $ of interest paid periodically (per year for an annual coupon bond)

  calculate by Coupon rate * Par value
• generally, a bond sells at a price equal to its par value (selling at par, par value bond) whenever the going market rate of interest (rd) is equal to the coupon rate (i = I/M)
• When rd rises above the coupon rate, the bond’s value falls below par, so it sells at a discount. this is called a discount bond.
• If the coupon rate is greater than rd, the price rises above par, and the bond sells at a premium. this is called a premium bond
• bond yields is The rate of return on a bond
• yield to maturity (ytm) is the expected rate of total return earned on a bond held to maturity, assuming no default risk nor call. also called “promised yield” ≠ the coupon rate
• a bond's yield to maturity changes whenever market interest rates change
• Yield to call on bonds is the expected rate of return earned on a callable bond, assuming it's called at the first call date. The company must pay a price (the call price) higher than the par value to call the bond
• the current yield on a bond is A measure of the amount of cash income to be generated in a given year
• At maturity, the value of any bond must equal its par value
• at maturity The value of a premium bond would decrease to $1,000
• at maturity, The value of a discount bond would increase to $1,000
• A par bond stays at $1,000 if rd remains constant
• If coupon rate < rd, the bond sells at a discount
• If the coupon rate = rd, the bond sells at its par value.
• •If the coupon rate > rd, the bond sells at a premium
• If rd on a bonds rises, its price will fall
• The Real Risk-Free Rate of Interest (r*) = Rate of return on a riskless security if no inflation is expected
• The best estimate for r* is the short-term Government of Canada T-bills in an inflation-free world. it's not static, but changing over time
• The inflation premium (IP) is the extra points over r* to compensate bondholders for losing the purchasing power of money due to inflation. IP = Average expected inflation rate over the life of the security.
• the default risk premium (DRP) is the component of the nominal interest rate that compensates bondholders for taking the default risk
• Default risk is the chance that the interest or principal will not be paid on the due date and in the promised amount. The greater this risk, the higher the bond's DRP
• bond ratings Are bonds with letter grade assigned by rating agencies to reflect the probability that a bond will go into default. Investment-grade bonds are bonds with a grade of triple-B or better