Chapter 7

Coupon Payment

(Pmt)= Stated interest payment made on the bond

Face Value

(par value) = typically $1,000

Security

(what is backing up the terms of the bond) collateral mortgage debentures notes

If YTM < Coupon rate then par value ____ Bond price

<

Maturity

= Specified date on which the principal amount of the bond will be repaid

If YTM = coupon rate, then par value __ bond price

= bond price

Bond

= debt security. Usually an interest-only loan

If YTM < coupon rate, then par value < bond price -Why?

Higher coupon rate causes value above par -Price above par value, called a premium bond

discount bond

If a bond sells for LESS than its face value Its yield to maturity is HIGHER than the coupon rate.

premium bond

If a bond sells for MORE than its face value Its yield to maturity is LOWER than the coupon rate.

Consider a bond with a 10% annual coupon rate, 15 years to maturity and a par value of $1,000. The current price is $928.09. Will the yield be more or less than 10%?

Nper = 15; PV = -928.09; FV = 1,000; PMT = 100 CPT Rate = 11%

If YTM = coupon rate, then par value = bond price •If YTM > coupon rate, then par value > bond price -Why?

The discount provides yield above coupon rate -Price below par value, called a discount bond

companies pay rating agencies such as Moody's and S&P to rate their bonds, and the costs can be substantial. however, companies are not required to have their bonds rated; doing so is voluntary. why do you think they do it?

an issuer will gladly pay a rating agency to rate its bonds, so that investors will have a better idea of what a bond is worth, and purchase it if it meets their investment needs. Unrated bonds essentially pose a mystery to investors who then must do their own research into the issuer's credit worthiness. the chances of a rated bond being sold to investors is much greater than unrated bonds, all else equal.

Which bonds will have the higher coupon, all else equal? A callable bond versus a non-callable bond:

callable bond is unattractive and cheaper

A bond can be a premium bond at a _____________ time and become a ____________ bond at a later time (or vice versa).

certain discount

________ never changes ________ does change

coupon rate YTM

As bond prices rise, the yield to maturity

decreases

The present value of a bond is calculated by

discounting the interest payments (coupons) and face value at the current market rate.

As bond prices fall, the yield to maturity

increases

Yield to Maturity (YTM)

is the rate of total return that a purchaser of a bond will receive if he/she holds the bond until maturity.

If a bond sells at face value, its YTM is equal to

its coupon rate

Higher yield-> __________ price

lower

the coupon rate _________ ________ after a bond is issued

never changes

is it true that a US treasury security is risk-free?

nothing is totally risk free. it is possible that someday the US government might default on its bonds, but it has never done so, nor are there any signs it is likely to even coming close to doing do in the foreseeable future. US treasury securities are closer to being completely risk-free than any other4 security in the investment market, therefore they are a good proxy for a "risk-free" asset.

Bond prices/values and interest rates always move in ____________ directions. They have an ___________ relationship

opposite Inverse

If YTM > Coupon rate then par value ____ Bond price

par value > bond price

Seniority

position in the capital structure

Liquidity premium

represents compensation for lack of liquidity. Bonds that have more frequent trading will generally have lower required returns

Default risk premium

represents compensation for the possibility of default

The coupon rate depends on

risk characteristics of the bond when issued

Collateral

secured by firm assets

Mortgage

secured by real property, normally land or buildings

bearer form

the form of bond issue in which the bond is issued without record of the owner's name; payment is made to whomever holds the bond similar to money

registered form

the form of bond issue in which the registrar of the company records ownership of each bond; payment is made directly to the owner of record registered electronically that you own the bond

Call provisions

the issuer can forcibly by that bond back from you during a specified time period. Negative for investor, good for the issuer

Anything else that affects the risk of the cash flows to the bondholders will affect

the required returns

Debentures

unsecured bonds unsecured debt, usually with a maturity of 10 years or more

Notes

unsecured debt with original maturity less than 10 years

Which bonds will have the higher coupon, all else equal? Subordinated debenture versus senior debt:

willing to pay less for subordinated because there's more risk

Which bonds will have the higher coupon, all else equal? Secured debt versus a debenture:

willing to pay more for secured debt, more attractive

Which bonds will have the higher coupon, all else equal? A bond rated AA versus a bond rated A:

AA is less risky, so higher price, more attractive

bond indenture

Contract between the company and the bondholders

Zero Coupon Bonds

Make no periodic interest payments (coupon rate = 0%) •The entire yield-to-maturity comes from the difference between the purchase price and the par value •Sometimes called zeroes, deep discount bonds, or original issue discount bonds (OIDs) •Treasury Bills and principal-only Treasury strips are good examples of zeroes

Coupon Rate

Stated in the indenture (contract) Coupon rate: coupon rate/1000 on exam (always assume the denominator is 1000)

How does a bond issuer decide on the appropriate coupon rate to set on its bonds? Explain the difference between the coupon rate and the required return on a bond.

issuers of bonds must ensure that investors will receive the rate of return that they require for purchasing the bonds, otherwise the bonds will not sell. If the bonds are to be issued at par value (which is usually, but not always the case), then the coupon rate must equal the required rate of return. Determining investor's required rate of return is not an exact science (the market will make this judgment!), but doing a thorough job of research should give the issuer a pretty good idea of what investors are expecting. If the issuer estimates that investors will require a return of, for example, 6% in order to purchase the bonds, it will have to set the semi-annual coupon payments at $30 (6% of $1000 par value = $60/2 for semi annual payments). the coupon rate is what investors who buy the bond at par value will receive as a rate of return if they hold the bond to maturity. The yield o maturity essentially adjusts the coupon rate to account for a capital gain or loss (difference between buying price and price received at maturity) that occurs when the market price of the bond either rises above or falls below par value.

when doing zero coupon bonds you always have to assume what kind of payments?

semiannual