FIN3403 LECTURE GUNTER Monday September 29th 2014 1 Disclaimer These notes were prepared by a student enrolled in Melody Gunter s FIN3403 Fall 2014 course and were compiled for Exam 2 These notes contain all materials discussed during lecture on September 29th 2014 and aim to serve as a partial conceptual review for strictly Exam 2 Studying these notes alone will not guarantee you a passing grade It is highly recommended you combine the review of these notes with the review of notes from other lecture dates that you may have missed in addition to extensive practice using your TI BA II Plus on calculation problems Happy studying Bond jargon cont An important note Throughout these notes I will be using the terms lender bondholder interchangeably and borrower bond issuer interchangeably A large part of the bond market is made up of government bonds Most government bonds are issued for big projects such as for construction of Foreign government bonds are sometimes referred to as sovereign bonds public buildings and other amenities Interest payments on bonds issued by state governments or municipalities are not taxed at the federal level o Money borrowed by the government from the sale of these bonds must be used for governmental projects o Lower interest rates because governments don t tend to default as easily or as frequently as corporations i e government bonds are lower risk to bondholders Zero coupon or pure discount bonds no coupon payments shorter term bonds o Since bondholders lenders are not receiving interest payments throughout the life of the bond these bonds tend to sell at a value that is less than the face The difference between the face value and the amount paid by the bondholder would be considered the interest or compensation for lending If you are reading this from the preview screen purchase these notes to continue studying If you are reading this after purchase scroll down to continue studying 2 FIN3403 LECTURE GUNTER Monday September 29th 2014 Floating bonds o Interest rate floats with some specified index i e interest rate is not fixed o This information is described in the indenture o Think of it as floating with the market Convertible bonds o Bonds that can be exchanged for stocks within a corporation o Debt holders become equity holders they gain ownership in the company o These terms are clearly stated within the indenture o Cannot convert to equity at any time usually a time frame is defined that allows for this action o When determining if a convertible bond should be exchanged for ownership within the corporation a bond holder needs to take into account the value of future stock prices and other factors Is the company performing well Will I see stable increases in stock price over time Will losing interest payments on these bonds be ok for me Do I understand that the company is not obligated to pay me Put bonds dividends o Lender bondholder can call up the corporation requiring the corporation to pay back principal now instead of at the specified maturity date in the future o Since this is advantageous to the lender the corporation pays a lower interest rate on the coupons o Lender is considered to be in control o Opposite of callable bonds Remember from the previous lecture that callable bonds are bonds that can be called in early by the corporation allowing the corporation to pay back the principal and a predetermined call fee now instead of at the specified maturity date in the future Since this means that the bondholder is losing all of the future coupon payments on the bond and that the corporation will be most likely FIN3403 LECTURE GUNTER Monday September 29th 2014 3 borrowing money from another source since interest rates are lower and they will be getting a better deal on their borrowed funds callable bonds are riskier for bondholders Higher coupon rate Borrower corporation issuing the bonds is in control Stock Market vs Bond Market o Stock market is much more computerized than person to person You can look up stock prices at any time from the comfort of your living room using an internet connection and a laptop o Bond market is almost completely person to person Individuals or institutions interested in purchasing bonds go through large financial institutions Bond dealers are located in banks to sell to individuals You can t just call up a dealer broker or look up information on the internet concerning the valuation of bonds for specific entities This type of market is referred to as an Over the Counter Market Some people think this type of market keeps large financial institutions in power of market prices etc How do we value bonds o An important note When we talk about the value of a bond we are considering the present value of the bond We use the word value and the concept of present value interchangeably o Clean Price the price of a bond that does not consider accrued interest at the resale point o Dirty Price the price of a bond based on the PV of cash flows clean price plus accrued interest up until the point of resale When you purchase a bond you are most likely purchasing the bond during a particular coupon period meaning that the seller of the bond is technically entitled to some of the accrued interest for that period Since the seller can t rely on you to pay him or her that portion of the coupon they deserve the seller charges you as the buyer of the bond a dirty price a price that includes a portion of the coupon they would have received for that period had they held onto the bond Example A bond pays semiannual interest payments to the bondholder with each coupon payment being 40 Let s say the bond was purchased issued 50 days ago by the original bondholder and you are now purchasing that bond from that individual What would be the amount added to the clean price to make up the dirty price you would pay Since semiannual means 2 times a year we can split a year 365 days into two periods each being made up of 182 days Since 50 days have passed in the period 50 182 would be 4 FIN3403 LECTURE GUNTER Monday September 29th 2014 multiplied by the coupon payment of 40 to give you an addition of 10 99 to the clean price That 10 99 represents the portion of the coupon for that period that the current bondholder is entitled to Thus they will add this accrued interest charge to the price of the bond to make the dirty price o For the purposes of this class we will mostly focus on valuing the clean price of bonds o An important note Ratings
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