Key Features of a Bond

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A.What are the key features of a bond?

answer:if possible, begin this lecture by showing students an actual bond certificate. We show a real coupon bond with physical coupons. These can no longer be issued--it is too easy to evade taxes, especially estate taxes, with bearer bonds. All bonds today must be registered, and registered bonds don't have physical coupons.

1.Par or face value. We generally assume a $1,000 par value, but par can be anything, and often $5,000 or more is used. With registered bonds, which is what are issued today, if you bought $50,000 worth, that amount would appear on the certificate.

2.Coupon rate. The dollar coupon is the "rent" on the money borrowed, which is generally the par value of the bond. The coupon rate is the annual interest payment divided by the par value, and it is generally set at the value of k on the day the bond is issued. To illustrate, the required rate of return on one of southern bell's bonds was 11 percent when they were issued, so the coupon rate was set at 11 percent. If the company were to float a new issue today, the coupon rate would be set at the going rate today (october 1998), which would be about 7.4%.

3.Maturity. This is the number of years until the bond matures and the issuer must repay the loan (return the par value). The southern bell bonds had a 30-year maturity when they were issued, but the maturity declines by 1 year each year after their issue.

4.Issue date. The southern bell bonds were issued in 1977, when interest rates were higher than they are today.

5.Default risk is inherent in all bonds except treasury bonds--will the issuer have the cash to make the promised payments? Bonds are rated from aaa to d, and the lower the rating the riskier the bond, the higher its default risk premium, and, consequently, the higher its required rate of return, k. Southern bell is rated aaa.

B.What are call provisions and sinking fund provisions? Do these provisions make bonds more or less risky?

Answer:a call provision is a provision in a bond contract that gives the issuing corporation the right to redeem the bonds under specified terms prior to the normal maturity date. The call provision generally states that the company must pay the bondholders an amount greater than the par value if they are called. The additional sum, which is called a call premium, is typically set equal to one year's interest if the bonds are called during the first year, and the premium declines at a constant rate of int/n each year thereafter. A sinking fund provision is a provision in a bond contract that requires the issuer to retire a portion of the bond issue each year. A sinking fund provision facilitates the orderly retirement of the bond issue. The call privilege is valuable to the firm but potentially detrimental to the investor, especially if the bonds were issued in a period when interest rates were cyclically high. Therefore, bonds with a call provision are riskier than those without a call provision. Accordingly, the interest rate on a new issue of callable bonds will exceed that on a new issue of noncallable bonds.

Although sinking funds are designed to protect bondholders by ensuring that an issue is retired in an orderly fashion, it must be recognized that sinking funds will at times work to the detriment of bondholders. On balance, however, bonds that provide for a sinking fund are regarded as being safer than those without such a provision, so at the time they are issued sinking fund bonds have lower coupon rates than otherwise similar bonds without sinking funds. D.How is the value of a bond determined? What is the value of a 10-year, $1,000 par value bond with a 10 percent annual coupon if its required rate of return is 10 percent?

Answer:a bond has a specific cash flow pattern consisting of a stream of constant interest payments plus the return of par at maturity. The annual coupon payment is the cash flow:...
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