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Chapter 7

Chapter 7. Characteristics of Bonds. Bonds pay fixed coupon (interest) payments at fixed intervals (usually every 6 months) and pay the par value at maturity. example: AT&T 8 24. par value = $1000 coupon = 8% of par value per year. = $80 per year ( $40 every 6 months).

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Chapter 7

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  1. Chapter 7

  2. Characteristics of Bonds • Bonds pay fixed coupon (interest) payments at fixed intervals (usually every 6 months) and pay the par value at maturity.

  3. example: AT&T 8 24 • par value= $1000 • coupon= 8% of par value per year. = $80 per year ($40 every 6 months). • maturity= 24 years (matures in 2024). • issued by AT&T.

  4. Types of Bonds • Debentures- unsecured bonds. • Subordinated debentures- unsecured “junior” debt. • Mortgage bonds- secured bonds. • Zeros- bonds that pay only par value at maturity; no coupons. (example: Series EE government savings bonds.)

  5. The Bond Indenture • The bond contract between the firm and the trustee representing the bondholders. • Lists all of the bond’s features: coupon, par value, maturity, etc. • Listsrestrictive provisionswhich are designed to protect bondholders. • Describes repayment provisions.

  6. Value • Book Value: value of an asset as shown on a firm’s balance sheet; historical cost. • Liquidation value: amount that could be received if an asset were sold individually. • Market value: observed value of an asset in the marketplace; determined by supply and demand. • Intrinsic value: economic or fair value of an asset; the present value of the asset’s expected future cash flows.

  7. Security Valuation • In general, the intrinsic value of an asset = the present value of the stream of expected cash flows discounted at an appropriate required rate of return. • Can the intrinsic value of an asset differ from its market value? (YES!)

  8. Bond Valuation • Discount the bond’s cash flows at the investor’s required rate of return. • the coupon payment stream(an annuity). • the par value payment(a single sum).

  9. Bond Example • Suppose our firm decides to issue 20-year bonds with a par value of $1,000 and annual coupon payments. The return on other corporate bonds of similar risk is currently 12%, so we decide to offer a 12% coupon interest rate. • What would be a fair price for these bonds?

  10. 1000 120 120 120 . . . 120 0 1 2 3 . . . 20 Note: If the coupon rate = discount rate, the bond will sell for par value. N = 20 I%YR = 12 FV = 1,000 PMT = 120 Solve PV = -$1,000

  11. Suppose interest rates fall immediately after we issue the bonds. The required return on bonds of similar risk drops to 10%. • What would happen to the bond’s intrinsic value?

  12. N = 20 I%YR = 10 PMT = 120 FV = 1000 Solve PV = -$1,170.27 Note: If the coupon rate > discount rate, the bond will sell for a premium.

  13. Suppose interest rates rise immediately after we issue the bonds. The required return on bonds of similar risk rises to 14%. • What would happen to the bond’s intrinsic value?

  14. N = 20 I%YR = 14 PMT = 120 FV = 1000 Solve PV = -$867.54 Note: If the coupon rate < discount rate, the bond will sell for a discount.

  15. Yield To Maturity • The expected rate of return on a bond. • The rate of return investors earn on a bond if they hold it to maturity.

  16. YTM Example • Suppose we paid $898.90 for a $1,000 par 10% coupon bond with 8 years to maturity and semi-annual coupon payments. • What is our yield to maturity?

  17. YTM Example N = 16 PV = -898.90 PMT = 50 FV = 1000 Solve I%YR = 6% 6%*2 = 12%

  18. Current Yield • Current yield: the ratio of the interest payment to the bond’s current market price. • Calculated by dividing the annual interest payment by the market price of the bond • A $1,000 bond with 10% coupon rate and market price of $700 Current yield = $100 / $700 = 14.286 %

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