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Chapter06 Powered By Docstoc
					Finance BA385
Chapter 6

1.    Bonds and Bond Valuation
      A.    Terms
            1.      Coupon—stated interest payment made on bond
            2.      Coupon rate—stated interest rate on bond ( = annual payment divided by
                    face value
            3.      Face value (or par value)—principal repaid at maturity
            4.      Maturity—date on which principal is paid
            5.      yield to maturity (or yield)—rate required in market on bond
      B.    Cashflows on bonds
            1.      Example p. 155
            2.      Annuity component = periodic interest payments
            3.      Lump sum payment at end = repayment of principal
            4.      Bond Value = PV of cashflows discounted at market rates
                    a)       Bond value = PV of the coupons + PV of face amount
                             (1)      use formulas already learned to compute or see p. 149
                    b)       If market rates > coupon rate PV is less than face value—bond
                             sells at discount
                    c)       If market rates < coupon rate PV is greater than face value—bond
                             sells at a premium
                    d)       Semiannual payment example, p. 157
      C.    Interest rate risk
            1.      Risk due to fluctuating interest rates
                    a)       Longer time to maturity > risk
                             (1)      More cashflow so effect can be greater, graphic, p. 159
                    b)       lower the coupon rate > risk
                             (1)      higher coupon has less risk because cashflows occur earlier
      D.    Finding yield to maturity
            1.      Again no formula
                    a)       Use trial & error, calculator, spreadsheet
                    b)       Using a financial calculator, p. 161
                    c)       Using a spreadsheet, p. 162
2.    More on Bond Features—for typical corporations
      A.    Securities issued by Corporation
            1.      Equity securities
            2.      Debt securities—generally requires payments
            3.      Main differences
                    a)       Debt is not an ownership interest
                    b)       Interest payments are deductible for tax purposes
                    c)       Debt is a liability—creditors can legally claim assets
            4.      Corporations do issue unusual securities that are difficult to determine
                    a)       Legal/tax matter to determine
      B.    Long-Term debt basics
            1.      Short (1 year) or long (> 1 year) term depending on time to maturity
            2.      Called notes, debentures, bonds
            3.      Publicly issued versus private issue
            4.      More terms, p. 165 in graphic
            5.      Indenture—written agreement between the corporation and its creditors
                   a)      Legal document
                   b)      Bond administered by trust company
                   c)      Types
                           (1)     Registered form—trust company keeps records of who
                           (2)     Bearer form—payment is made to whoever holds the bond
                   d)      Security—classified according to collateral
                           (1)     Secured by company assets or stock
                           (2)     Mortgage security—like home loans secure
                           (3)     Debenture = unsecured bond > 10 years to maturity
                           (4)     Note = unsecured bond < 10 years to maturity
                           (5)     Most government issued bonds are debentures, meaning
                                   they are unsecured
                   e)      Seniority—preference in payment
                           (1)     Senior vs. junior
                           (2)     Subordinated (get paid later)
                   f)      Sinking fund—managed by trustee, company pays in amount to
                           retire principal early
                   g)      Call provision
                           (1)     Corporation has right to purchase back early
                           (2)     Call premium—extra amount paid
                           (3)     May not be able to call for 10 years—deferred call
                   h)      Protective covenants
                           (1)     Negative = thou shalt not
                                   (a)     limit dividends paid, can’t pledge assets
                           (2)     Positive = thou shalt
                                   (a)     Maintain working capital at level, must maintain
3.   Bond Ratings
     A.     Introduction
            1.     Moody’s and Standard & Poor’s do rating
            2.     Based on how likely to default
            3.     Not about interest rate risk—about risk of not paying
            4.     Example, p. 169
4.   Other Bonds
     A.     Government—biggest borrower in the world
            1.     US debt—6.8 trillion (9/03)
                   a)       Increasing rapidly due to Bush
                   b)       Link to actual figure
            2.     Most are ordinary coupon bonds
            3.     Exempt from state (not federal) taxes
            4.     Munis—issued by state/local/municipal governments
                   a)       Rated like corporate issues
                   b)       Exempt from federal tax
                   c)       Have lower yield due to tax effect
     B.     Zero coupon bonds
            1.     Has no coupons (no interest paid)
            2.     Initially priced at deep discount, table, p. 172
     C.     Floating rate bonds
            1.     Coupon payments are adjustable
             2.      Based on different factors
     D.      Other types
             1.      Disaster bonds, income bonds, convertible bond, put bond
5.   Bond Markets
     A.      How bought/sold
             1.      Most in the over the counter (OTC) market
             2.      Dealers buy and sell—connected electronically—becoming world market
                     a)        These are individual transactions
             3.      Number of bond issues far exceeds stock issues
                     a)        Normally corporation would have only one, maybe two, stock
                               issues, but may have many bond issues
                     b)        Government borrowing is gigantic—every little city borrows
             4.      No official prices like New York Stock Exchange so the bond market has
                     little transparency
             5.      Many sources for prices—must use variety of sources
     B.      Bond price reporting
             1.      Some bonds traded on New York Stock Exchange
                     a)        Small portion of bonds—mostly for retail customers
                     b)        Wall Street example, p. 177
                     c)        Current yield—bond’s coupon divided by closing price
                               (1)     Different than yield to maturity
             2.      US Treasuries
                     a)        OTC market
                     b)        T Bonds all make semiannual payments, face value of $1,000
                     c)        Bid = purchaser’s price, ask = seller’s price, difference goes to
                     d)        Wall Street example, p. 179
6.   Inflation and Interest Rates
     A.      Real vs. nominal rates
             1.      Nominal = not adjusted to eliminate inflation (rate in the market), this
                     represents the percentage change in the number of dollars you have
             2.      Real = inflation adjusted rate (effect of inflation removed), this represents
                     the percentage change in how much you can buy (%  in buying power)
             3.      Current dollars = inflation adjusted dollar amounts
     B.      Fisher effect
             1.      1  R  (1  r ) * (1  h) and (this is Fisher effect)
                     a)        Nominal rate = R, real rate = r, inflation rate = h
             2.       R  r  h  (r * h)
             3.      Third component small so
             4.       R  r  h (approximation of Fisher effect)
7.   Determinates of Bond Yields
     A.      Graphic of history, p. 183
     B.      3 components of rates
             1.      Real rate—basic component of rates
             2.      Inflation premium—represents potential loss due to anticipated inflation
             3.      Interest rate risk premium—represents return for potential loss due to
                     anticipated increase in interest rates
             4.      Examples, p. 184
     C.      Yield and yield curves
             1.      Treasury notes and bonds have different yields based on maturity
     a)     Example p. 185
2.   Treasuries are default free, taxable at federal level, highly liquid
3.   Additional risk components to consider
     a)     Default risk premium—part of nominal rate due to possible default
     b)     Taxability premium—part of nominal rate due to unfavorable tax
     c)     Liquidity premium—part of nominal rate due to not being liquid

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