Corporate Bonds: They are More Complicated Than You Think

1. Corporate Bonds:They are More Complicated Than You Think Case 5 Team 1: Becca Massanova, Andrew Rosenman, Alex Villar, SharanKaur

2. Introduction • Jill Dougherty is an investment analyst for A.M. Smith Inc • A.M. Smith was recently hired by a large Utility company as its lead investment banker for corporate bonds • Most of their investors are used to stocks not bonds • Jill has to convince the investors of the relative safety and income potential of corporate bonds • She first must educate the investors on the bond features.

3. Coupon Rate & Bond Price • Coupon Rate- the interest rate stated on a bond expressed as a percentage of the principal • Bond Price- the amount of the bond when it becomes mature • Relationship • Depends on the current interest rate • The coupon rate also depends on the maturity and the riskiness of the bonds.

4. Bond Ratings • The ratings of bonds are determined by bond rating companies. • The largest and most well- known companies are Moody's, Standard & Poor's, and Fitch's • When ratings get adjusted downward, the bond loses attractiveness and its required rate of return goes up, reducing its price.

5. What is a Premium Bond • A bond that is trading above its par value. A bond will trade at a premium when it offers a coupon rate that is higher than prevailing interest rates. This is because investors want a higher yield, and will pay more for it. • Depending on the firm’s preferences for the coupon rate, bonds can be issued at a premium, at a discount, or at par value.

6. Effects of the Call Provision • A call provision allows firms to refinance debts at lower interest rates when interest rates fall. •  If there is a call provision in place, it will typically come with a time window under which the bond can be called, and a specific price to be paid to bondholders and any accrued interest are defined.  • Because the bond is liable to be called before its maturity, it increases the risk for the investor

7. Yield to Maturity • Annual rate the bond will pay if it is held until it matures • Includes the coupon rate, number of years until the bond matures, market price of bond, and risk

8. Rating Riskiness of Bonds • Sinking Fund- Less risky if it is one • YTM-Shorter the time the less risky • Rating-Less risky the higher the rating • Call Period- Shorter the time the less risky

10. Semi-annual coupon bonds • Reinvestment rate is half of coupon rate • Number of periods are double years to maturity • Coupon Payments are rate multiplied by Face value of the bonds • Calculate future value of coupon payments using coupon rate as reinvestment rate

11. With the future value of coupon payments we can now calculate the realized return rate on the bonds. • Equation used: • r=((FV+Face Value)/Price)^(1/N) – 1 • Realized returns are on semi-annual basis • Need to multiply by two to annualize rate of return • The amount of bonds bought does not matter because it does not affect the rate of return on the bonds. • Investor buys 10 bonds it only amplifies everything by 10 causing no percent change in the rate of return

12. Advantages of Bonds • Almost always receive money back from company • Bonds outperform stocks in certain economic cycles (recession) • Retirement • Predict with a greater degree of certainty how much income they will receive • Diversify risky portfolios • Safe and Conservative • Provide predictable stream of income