Ch 6: Bonds & Bond Valuation Learning Goals

1. Describe bond characteristics.

2. Apply the basic valuation model to bonds.

3. Understand the impact of changing market interest

rates on bond values.

4. Calculate yield to maturity (YTM) and explain its

meaning.

Corporate Bonds

• A bond is a long-term debt instrument that pays a fixed amount of interest for a specified period of time.

• The bond’s principal is reflected in its _______ value.

• The bond’s maturity date is the time at which a bond becomes due and the principal must be repaid.

• The bond’s coupon rate is the specified interest rate (as a percent of par) that must be paid periodically.

Interest Rates & Required Returns

• The interest rate or required return represents the cost of financing for the borrower.

• The interest rate is the rate of return for the lender.

• Over time, the level of interest rates is closely tied to ____________________, as shown on the next slide.

Interest Rates & Inflation

Interest Rates & Required Returns: Nominal Interest Rate

• The nominal rate of interest is the actual or stated rate of interest on a loan or liability.

• The nominal rate is affected by two factors:– Inflationary expectations – Issuer and issue characteristics such as default

_________________ and contractual provisions

Bond Risk and Bond Ratings

• The risk of corporate and municipal bonds is reflected

in the “rating” assigned by Moody’s, Standard & Poor’s

or other rating agencies.

• The top four categories of bond ratings are

“_________________________________ grade;”

lower ratings are “___________________ bonds.”

Corporate BondsBond Ratings

Risk Premiums: Issue and Issuer Characteristics

Legal Aspects of Corporate Bonds

• The bond indenture is a legal document that specifies the rights of the bondholders and the duties of the issuing corporation.

• The indenture includes:• __________________________ provisions • __________________________ covenants

Legal Aspects of Corporate Bonds

• Standard debt provisions specify certain record keeping and general business procedures that the issuer must follow (pay taxes, maintain assets, provide audited financial statements).

• Restrictive covenants place operating and financial constraints on the borrower.

Legal Aspects of Corporate Bonds (cont.)

• Common restrictive covenants include:– Minimum __________________________ levels– Prohibition against factoring receivables– Fixed asset restrictions– Constraints on subsequent __________________– Limitations on cash ________________________

• In general, violations of restrictive covenants give bondholders the right to demand immediate repayment.

Legal Aspects of Corporate Bonds (cont.)

• Sinking fund requirements are often included in bond indentures and provide for the systematic retirement of bonds prior to their maturity.

• The bond indenture identifies any collateral (security) pledged against the bond.

• A __________________________ acts as a third party to enforce the indenture and represent bondholders’ interests.

Bond Characteristics

• Face or par value ($_____________ for corporate bonds)

• _______________________ rate• Maturity date, or remaining years to maturity

Valuation Fundamentals

• The price, or value of any investment asset is the

present value of expected cash flows.

• To value a bond, we must:

– Determine the _____________________________

– Determine the _____________________________

Valuation Fundamentals

• The interest rate at which the cash flows are

discounted is the required return.

• The required return depends on:

– market conditions (including inflationary expectations)

– risk and other characteristics of the bond and the issuer.

• Higher risk results in a higher required return and

lower market values.

Bond Yield

• The required return on a bond is also referred to as

the “yield to maturity” (__________________).

Bond Yields and Bond Prices

• Bond prices and yields (required rates of return) are Bond prices and yields (required rates of return) are inverselyinversely related. related. – When yields are high, bond price is lowWhen yields are high, bond price is low– When yields are low, bond price is highWhen yields are low, bond price is high

Bond Yields and Bond Prices

• If the required return on a bond equals the bond’s coupon rate, the bond price equals par.

• If the required return on a bond exceeds its coupon rate, the bond price will be less than par: it is a ________________________________ bond.

• If the required return is less than the coupon rate, the bond price is higher than par: it is a ________________________________ bond.

Bonds with Maturity Dates

Bond Yields and Bond Prices• As market interest rates change, bond yields change,

causing bond prices to move in the opposite direction.• Not all bond prices are equally sensitive to a change in

market interest rates. Prices of– _______________________________ bonds are more

responsive than ____________________________ bonds– Bonds with a low coupon rate are more sensitive than bonds

with a high coupon rate

Yield to Maturity• The bond’s yield-to-maturity (YTM) is the annual

percentage return, based on the bond price and

promised cash flows.

• The YTM is the bond’s IRR based on the current price,

if it is held to maturity.

• YTM equals the coupon rate if the bond is selling for its face value ($1,000).