1 Requirements for a bond IPO The borrower issues a bond to the lender for some amount of cash The issuer must make specified payments to the bondholder on specified dates Typical coupon bond obligates the issuer to make semiannual payments of interest coupon payments for the life of the bond When the bond matures the issuer repays the debt by paying the bond s par value Bond indenture Contract between the issuer and the bondholder Coupon rate Determines the interest payment Annual payment equals the coupon rate times the bond s par value 2 Premium Discount Bonds Premium Bonds Bonds selling above par value Coupon rate exceeds the market interest rate The interest income by itself is greater than that available elsewhere in the market Investors will bid up the price of these bonds above their par values Discount Bonds Bonds selling below par value Coupon rate is less than the market interest rate The discount from par value provides an anticipated capital gain that makes up for the below market coupon rate 3 Calculate Current Yield Current Yield of a Bond Bond s annual coupon payment Bond Price The bond price you divide by is the price the bond is selling for Coupon rate can be greater than bond selling at a premium or less than bond selling at a discount current yield because the coupon rate divides the coupon payments by par value rather than by bond price 4 Bond Price Quotes Quoted prices are not actually the prices that investors pay for the bond Quoted prices don t include the interest that accrues between coupon payment dates If a bond is purchased between coupon payments the buyer must pay the seller for accrued interest Invoice Price Amount the buyer actually pays for a bond Invoice Price Quoted Price Accrued Interest Accrued Interest Annual Coupon Payment 2 x Days since last coupon payment Days separating coupon payments 5 Attributes of a Municipal Bond A debt security issued by a state municipality or county to finance its capital expenditures Interest payments are tax free 6 Types of Secured Unsecured Bonds Collateral A specific asset pledged against possible default on a bond Secured Bonds are issued with collateral behind them Because they are safer secured bonds offer lower yields than general debentures Types of Secured Bonds Mortgage Bond Collateral is property Collateral Trust Bond Collateral takes the form of other securities held by the firm Equipment Obligation Bond The collateral is equipment Types of Unsecured Bonds Debenture A bond not backed by specific collateral 1 Bond risk depends on the general earning power of the firm 7 Fixed vs Floating Rate Bonds Floating Rate Bonds Bonds with coupon rates periodically reset according to a specified market rate Ex Current T bill rate plus 2 1 If T bill rate was 4 the coupon rate would be 6 Bond always pays approximately current market rates Major risk involved has to do with changing credit conditions 1 The yield spread is fixed over the life of the security If the financial health of the firm worsens investors will demand a greater yield premium than is offered by the security Price of the bond will fall 2 Coupon rate on floaters adjusts to changes in the general level of market interest rates it doesn t adjust to changes in the financial condition of the firm Fixed Rate Bonds Coupon rate does not change 8 Put Call Features in Bonds Callable Bonds Bonds that may be repurchased by the issuer at a specified call price during the call period Usually have a period of call protection in which the bond is not callable Refunding After calling a bond with a high coupon rate a firm may issue new bonds at a lower coupon rate The proceeds from the new bond issue are used to pay for the repurchase of the existing higher coupon bonds at the call price Option to call the bond is valuable to a firm allowing it to buy back the bonds and refinance at lower interest rates when market rates fall To compensate investors for this risk callable bonds are issued with higher coupons and promised yields to maturity than noncallable bonds Put Bond A bond that the holder may choose either to exchange for par value at some date or to extend for a given number of years 9 Price Yield Coupon Relationships to Bonds Premium Bonds interest rate Price Selling above par value because coupon rate is above the market Coupon Rate Greater than the current yield coupon payments par value Greater than market interest rate Current Yield Less than coupon rate coupon payments bond price Greater than yield to maturity Discount Bonds Price Selling below par value because the coupon rate is below the market interest rate Coupon Rate Less than the current yield Less than market interest rate Current Yield Greater than coupon rate Less than yield to maturity Yield to Maturity The discount rate that makes the present value of a bond s payments equal to its price Often viewed as a measure of the average rate of return that will be earned on a bond if it s bought now and held until maturity To calculate solve the bond price equation 10 below for the interest 10 Calculate Present Value PV of a Bond rate given the bond s price Bond Value Present Value of Coupons Present Value of Par Value r Discount Rate T Maturity Date Higher interest rate PV of the payments to be received by the bondholder is lower Bond prices fall as interest rates rise PV of the payments to be received by the bondholder is higher Bond prices rise as interest rates fall Lower interest rates Convexity A property of bond prices Called this because of the convex shape of the bond price curve Curvature reflects the fact that progressive increases in the interest rate result in progressively smaller reductions in the bond price 11 Correlation Coefficient Risk Measures Portfolio risk depends on the correlation between the returns of the assets in the Portfolio risk is reduced most when the returns of assets most reliably offset each Use covariance and the correlation coefficient to measure the tendency of the returns on two assets to vary either in tandem or in opposition to each other Covariance A measure of the average tendency of the asset returns to vary in tandem Obtained after computing the probability weighted average of the products across all scenarios portfolio other r rate of return of a product mean rate of return of a product 1 2 3 S total number of scenarios 4 i Particular scenario Negative value indicates the two assets vary inversely Correlation Coefficient 1 2 Correlation Coefficient