Bonds and Their Valuation
After reading this chapter, students should be able to:
• List the four main classifications of bonds and differentiate among them.
• Identify the key characteristics common to all bonds.
• Calculate the value of a bond with annual or semiannual interest payments.
• Explain why the market value of an outstanding fixed-rate bond will fall when interest rates rise on new bonds of equal risk, or vice versa.
• Calculate the current yield, the yield to maturity, and/or the yield to call on a bond.
• Differentiate between interest rate risk, reinvestment rate risk, and default risk.
• List major types of corporate bonds and distinguish among them.
• Explain the importance of bond ratings and list some of the criteria used to rate bonds.
• Differentiate among the following terms: Insolvent, liquidation, and reorganization.
• Read and understand the information provided on the bond market page of your newspaper
Characteristics of Bonds
A bond is a long-term contract under which a borrower (the issuer) agrees to make payments of interest and principal, on specific dates, to the holders (creditors) of the bond.
Bearer bond - Bonds that are not registered on the books of the issuer. Such bonds are held in physical form by the owner, who receives interest payments by physically detaching coupons from the bond certificate and delivering them to the paying agent.
Registered bond - A bond whose issuer records ownership and interest payments. Differs from a bearer bond, which is traded without record of ownership and whose possession is the only evidence of ownership.
Par value - Also called the maturity value or face value; the amount that an issuer agrees to pay at the maturity date.
Coupon interest rate - With bonds, notes, or other fixed income securities, the stated percentage rate of interest, usually paid twice a year (semiannually). Coupon payments - A bond's dollar interest payments.
Maturity date - Date on which the principal amount of a bond or other debt instrument becomes due and payable.
Call provision - An embedded option granting a bond issuer the right to buy back all or part of an issue prior to maturity.
Bond indenture - Contract that sets forth the promises of a corporate bond issuer and the rights of investors.
Sinking fund - A fund to which money is added on a regular basis that is used to ensure investor confidence that promised payments will be made and that is used to redeem debt securities or preferred stock issues.
Sinking fund provision - A condition included in some corporate bond indentures that requires the issuer to retire a specified portion of debt each year.
Convertible bond - General debt obligation of a corporation that can be exchanged for a set number of common shares of the issuing corporation at a prestated conversion price.
Warrant - A security entitling the holder to buy a proportionate amount of stock at some specified future date at a specified price, usually one higher than current market price. Warrants are traded as securities whose price reflects the value of the underlying stock. Corporations often bundle warrants with another class of security to enhance the marketability of the other class. Warrants are like call options, but with much longer time spans-sometimes years. And, warrants are offered by corporations, while exchange-traded call options are not issued by firms.
The value of any financial asset -– a stock, a bond, etc., or even a physical asset -– is simply the present value of the cash flows (discounted at the asset’s required rate of return) which the asset is expected to generate over its lifetime. VALUE = PV = [pic].
kd = the bond’s market rate of interest or required rate of return; also called the yield to maturity (YTM); (can
change many times over the bond’s...
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