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Chapter 5

Chapter 5. Bonds, Bond Valuation, and Interest Rates. Key Features of a Bond. Par or face value. Typically $1,000. Coupon rate. (Generally fixed.) Maturity. Options Imbedded in Bonds. Call feature: most corporate bonds have a deferred call and a declining call premium.

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Chapter 5

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  1. Chapter 5 Bonds, Bond Valuation, and Interest Rates

  2. Key Features of a Bond • Par or face value. Typically $1,000. • Coupon rate. (Generally fixed.) • Maturity.

  3. Options Imbedded in Bonds • Call feature: most corporate bonds have a deferred call and a declining call premium. • Convertible: some corporate bonds can be exchanged for shares of common stock.

  4. Bond Valuation • The value (price) of a bond is the present value of future cash flows. • Bond cash flows: • Periodic interest pmts • Par value • Discount rate (rd)

  5. If coupon rate < rd, bond sells at a discount. • If coupon rate = rd, bond sells at its par value. • If coupon rate > rd, bond sells at a premium. • Bond price is inversely related to changes in rd. • Price = par at maturity.

  6. Yield to Maturity (YTM) • YTM is the rate of return earned on a bond held to maturity. Also called “promised yield.” • It assumes the bond will not default.

  7. Yield to Call • Yield to call is calculated the same way as YTM, except: • Call price replaces par as FV • Call date replaces maturity

  8. In general, if a bond sells at a premium, then coupon rate > rd, so a call is likely. • So, investors expect to earn: • YTC on premium bonds. • YTM on par & discount bonds.

  9. Bond Ratings Provide One Measure of Default Risk

  10. Bond Ratings and Bond Spreads (YahooFinance, 2006)

  11. What factors affect default risk and bond ratings? • Financial performance • Debt ratio • Coverage ratios, such as interest coverage ratio or EBITDA coverage ratio • Current ratios

  12. Why Bad Bonds Get Good Ratings • Based on biased info • Cannot account for fraud • Not fully objective • Ratings based on past performance; cannot predict future

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