Topic 6: Bond Valuation: Fixed Income Analysis

subordinated debenture

A lower-ranked bond that is not secured by collateral or guarantees. n addition, subordinated debentures have a lower claim than normal debentures to the assets of the firm in the event of firm liquidation or example, if IBM issues bonds in both 20X2 and 20X3, the older bonds (20X2) will have the first claim to company assets. In other words, the 20X3 bonds will be subordinate to the 20X2 issue.

convertible bonds

Bonds that can be converted into common stock at the bondholder's option but to have this option ends up paying for this option in the form of lower yields

junk bonds

Bonds with a rating of BB or below are known; too risky to be investment grade

YTM vs. Current Yield

Current yield is a separate yield measure calculated by dividing the annual coupon payment by the present value. it is an oversimplification of YTM The YTM (yield to maturity) is the return you will actually receive if you hold the bond to maturity and it does not default.

T or F - A bond with a longer time to maturity will have less sensitivity to changes in interest rates.

False - Bonds with longer times to maturity have more sensitivity to changes in interest rates.

T or F - Bond A has 20 years to maturity while Bond B has 5 years to maturity. Bond A and Bond B have identical coupon rates. Given this information, Bond A will have the same yield to maturity as Bond B.

False - Holding everything else constant, Bond A is more risky because it has a longer time to maturity. Therefore, Bond A will have a higher yield than Bond B.

T or F - Suppose a bond has a duration of 3.5 and a yield to maturity of 10%. If interest rates increase 1%, the bond price is expected to decrease .35%.

False - If interest rates increase 1% then the bond price will decrease by the amount of duration in percentage terms, or 3.5%.

T or F - If interest rates increase then bond prices will also increase.

False - bond prices and interest rates are inversely related. The interest rate on the bond (or the yield to maturity) is the discount rate. As the discount rate gets larger, the price of the bond will decrease.

how do we calculate coupon rates?

For example, a $1,000 par value bond with a 9% coupon rate will pay $1,000 × .09 = $90 in interest annually.

inverse price-yield relationship

The YTM is higher than the coupon yield if the bond sells at a discount. The YTM is higher than the coupon yield because you get to buy the bond at $952, but you get $1,000 in the future in addition to 10% payments

waht type of bonds have the highest yield to maturity rates?

The classic finance tradeoff between risk and return states that greater risk demands greater reward. Thus debentures typically have higher yield to maturity rates than mortgage bonds because investors in the more risky debentures demand a higher return to invest their money there.

maturity

The number of years from when the bond is issued to when it expires is its maturity.

foreign bond

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

T or F - As the coupon rate increases, the bond price will increase.

True - Bond prices are calculated by taking the present value of the coupons and face value of bonds. If the coupons are larger, the present value of the coupons will also be larger. Therefore, price of the bond will be higher.

T or F - A bond with a face value of $1,000 will have a current price of $1,000 if the coupon rate is equal to the yield to maturity. TrueFalse

True - If the coupon rate is equal to the yield to maturity, the bond will be priced at par or face value.

T or F - A bond with a coupon rate that is less than the yield to maturity will be priced at a discount.

True - If the coupon rate is less than the yield to maturity, the bond must be priced at a discount.

T or F - Bond A has 20 years to maturity while bond B has 5 years to maturity. Given this information, if interest rates increase, then the price of Bond A will decrease more than the price of Bond B.

True - bonds with longer times to maturity are more sensitive to changes in interest rates.

what is an important calculator distinction when working with bonds?

With bonds we now have three dollar-denominated entries: PV, FV, and PMT. If we enter any one of these values as a negative number, we will get a solution, but we only get the correct solution when PV has the opposite sign of both FV and PMT.

If you are given the market price of a bond and are told to find the discount rate, this means you are looking for the . A. Face Value B. Present Value C. Coupon dollar amount D. Yield to maturity

YTM

bond indenture

a legal document that details all the conditions relating to a bond issue

what are the two parts taht make up a bond?

a stream of annual or semiannual interest payments (an annuity) and a final principal repayment (a lump sum). The diagram on the next page shows the cash flow pattern for a 3-year bond that makes semi-annual interest payments.

Bonds

basically a debt agreement with investors and savers that obligates the corporation to make certain payments to the investor in exchange for money the investor lends to the corporation today. It is like an IOU from a corporation to the holder of the bond

eurobond

bond denominated in a currency other than that of the country in which it is sold So, an American bond issued in Europe, that is payable in dollars, is a specific type of Eurobond called a Eurodollar bond.

mortgage

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

treasury bonds

bonds issued by the US federal government to support deficit spending Because treasuries are backed by the full faith/allegiance and, more importantly, the taxing power of the US federal government, treasuries are often used as risk-free investment

what is the difference between stocks and bonds?

bonds represent fixed income meaning that they pay a fixed interst payment each year while the dividends from stocks can vary

The rate is contractually set when the bond is issued and cannot be changed at any time during the life of the bond. A. Yield to Maturity B. Coupon C. Buying D. Current Yield

coupon

If returns required by bondholders have increased 1.5% from last year, we should expect bond prices to have _______________.

decreased

A bond rate AAA is more risky than a bond rated BBB.

false

If market interest rates increase, the price of existing bonds will also increase.

false

The interest on bonds vary year to year

false

The value of an asset = the future value of the stream of expected cash flows compounded at the required rate of return.

false

The yield to maturity is the same as the current yield.

false

some bonds can go on forever like perpeturities

false; bonds always have a start and end date

If coupon rate < discount rate, the bond will sell

for a discount

What is the written agreement between the bond issuer and its bondholders called?

indenture

coupon rate

interest rate of the bond and is also known as the coupon yield

The relation between bond prices and yields to maturity can best be described as:

inverse

In the bond market, firms raise debt financing directly from ________.

investors

The period of time for which a bond remains outstanding is called:

maturity

What are bonds issued by cities, counties, or states called?

muni bonds

can the coupon rate change?

no

Bond Covenant

promise; special provision in bond contract, usually included as protection to the lender affirmative; things the company promises to do negative; things the company will refrain from

debenture

risky type of bond because there is no collateral; you just put faith in the company that they will pay you back

If coupon rate > discount rate, the bond wil

sell for a premium

If coupon rate = discount rate, the bond wil

sell for par value

muni-bonds

short for municipal bonds, are floated by local governments (states, cities, counties) to usually fund infrastructure improvements; almost always exempt from taxation

par value aka face value

the amount that an investor pays to purchase a bond and that will be repaid to the investor at maturity we assume $1000

value of an asset

the present value of the stream of expected cash flows discounted at the required rate of return. 1. Determine the future cash flows from that asset. 2. Discount all future cash flows at the appropriate discount rate.

yield to maturity/promised yield

the rate of return a bondholder will receive if the bond is held to maturity

Bonds are also known as "fixed income."

true

Bonds are the backbone of the world's pension funds.

true

Bonds are the vehicles by which corporations raise debt capital

true

The two main reasons the text states for the importance of understanding bonds are the bond market is an important source of financing and bonds play a role in most personal investment plans.

true

zero coupon bonds

zeros pay no coupon payments—their coupon rate is 0%. They typically sell at deep discounts