Chapter 6 : Bond Valuation

Mortgage Bonds

A bond that has specific collateral, such as a piece of real estate, behind it.

Duration

A measure of the interest rate sensitivity of a bond

Par Value

Also known as the face value of the bond, the par value is the sum of money that the corporation promises to pay at the bond's expiration.

Zeros

Alternatively known as zero coupon bonds, zeros pay no coupon payments—their coupon rate is 0%.

Current Yield

Annual Coupon/Market Price of the Bond, this is an estimate of the YTM that ignores the time value of money

What does PV represents in regards to a bond?

Current bond price, must be entered as a negative number on the calculator when calculating bonds

Debentures

Debentures are unsecured bonds.1 There is no specific collateral associated with these bonds. Because these types of bonds are not secured with collateral, they are risky.

Currently, XYZ's 10-year bonds are selling for $975. What is the bond's yield to maturity given that the bond has a $1,000 face value and that it pays 6 percent interest annually?

FV = $1,000 PV = -$975 PMT = $60 N = 10 YTM = 6.35%

Ord's 5-year bonds pay 6 percent annual interest semiannually on a $1,000 face value. If bonds sell at $985, what is the bond's expected rate of return?

FV = $1000 PMT = 30 (60/2) N = 10 (5x2) PV = -985 I/Y = 3.18x2 = 6.35%

LLY Corporation is planning to issue a $1,000 face value bond with a maturity of 30 years. The annual coupon rate is expected to be 7.25% and interest payments are expected to be paid semi-annually. If the market is requiring a return of 10% annually on similar bonds, then what should LLY expect to receive for each bond they issue?

PV ($739.72) FV 1000 PMT 36.25 [(1000x.0725)/2] N 60 (30x2) I 5% (10/2)

What does I/Y represent in regards to a bond?

The Yield to Maturity (YTM) A.K.A. the market rate of interest or discount rate

What is the Cash Flow of a bond?

The final coupon payment + the face-value

Prices vs. Yields

There is an inverse relationship between prices and yields: If market interest rates increase, the price of existing bonds will fall. If market interest rates fall, the price of existing bonds will increase.

Foreign Bonds

These are bonds that are issued in a domestic market by a foreign firm, but in the domestic currency. So, if a Chinese firm floats debt in the US and the debt is payable in dollars, then China has floated a foreign bond.

Negative covenants

Things the company pledges not to do—for example, not to sell off certain assets, not to pay out large dividends, or not to issue new debt with a superior claim.

Junk Bonds

Speculative bonds that are rated at BB or below. They are seen as too risky to be considered investment grade.

Semiannual Payments

The bondholder receives half of the annual payment every 6 months.

Coupon Rate

The coupon rate is the interest rate of the bond and is also known as the coupon yield. Multiplying the coupon rate by the par value gives the amount of the bond's yearly coupon, or interest payment.

Subordinated Debentures

Bonds that are not backed by any specific collateral. In addition, subordinated debentures have a lower claim than normal debentures to the assets of the firm in the event of firm liquidation. Often the order of debenture subordination is based upon the date of issue.

Affirmative covenants

Describe things the company pledges itself to do. Examples include paying taxes on time, maintaining a certain level of working capital, maintaining a minimum debt ratio, etc.

Convertible Bonds

More than being a "type" of bond, convertibility is a feature that may be added to any of the above bond types. Convertibility refers to the ability to convert a bond into equity securities, usually common stock.

Covenants

Rules set forth in the bond indenture that outline things the company is obligating itself to do or not do in order to protect bondholders. If a company does not comply with the covenants in its bond indentures, it stands in default.

Indenture

This is essentially the bond contract between the bond issuer (the corporation) and the bondholder (investor) and describes all of the bond's features: coupon rate, par value, maturity, etc. It also lists the covenants associated with the bond.