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									 Transparency (2)
Types of bonds according to their issuer types:
1.Treasury bonds are issued by government
2. Corporate bonds issued by corporation
3. Municipal bonds issued by state and local governments (mainly this apply to the US)
4. Foreign bonds issued by foreign corporations and governments.

Transparency (3)
    1. Par value represent the amount of money the company borrow and promises to repay.
    2. Coupon rate is normally fixed which is a percentage of the face value. Multiply
         by par to get dollar payment of interest (coupon payment).
Floating rate bonds which the coupon payments vary over time, for example the coupon
rate is set for the initial six months period after which it is adjusted after six months based
on some market rates. Zero coupon rate they pay no coupons at all, but they are offered at
substantial discount below their par value.
Maturity date is the date at which the par value should be paid. Range from 10 to 40
years. Any maturity is legally permissible.
Issue date – when the bond was issued
We will see how to calculate the yield to maturity later.

Call premium: when the company call the bond it should pay the bondholder an amount
greater than the par value. This additional sum is the call premium. It is set to 1 year
interest payment if it is called during the first year and then it starts to decline. For
example the call premium on $1000 par value 10-year 10 percent bond is 100 if it is
called during the first year, 90 for the second year (so decreasing by one-tenth)
Those bonds are called Callable bonds

Refunding operation: suppose the company issue the bonds when interest rates are high.
If the bonds are callable and the interest rate declines over time, the company could sell
new issue at lower yield and use the proceeds to retire the high-rate issue so reducing the
interest expenses.

Since the callable option is beneficial to the borrower, so the company is willing to pay
more for callable bonds .

Deferred call; bonds are often called several years (5 to 10) after they were issued.

Some bonds include a sinking fund provision. The sinking fund is used to buy back a
certain percentage of the issue each year.

Sinking fund reduces the payments the company should pay at maturity so it reduce the
risk for investor and it cut the average maturity. At the same time, it hurts the investors if
interest rate declines because if the company called the bonds then the investor should
give up a bond that pays $100 of interest and reinvest in a bond that pays $75 of interest.
Companies either :

1. Call x% of the issue at par, for sinking fund purposes.Likely to be used if kd is below
the coupon rate and the bond sells at a premium.
2. Buy bonds in the open market. Likely to be used if kd is above the coupon rate and the
bond sells at a discount.

Companies will choose either to redeem the bonds at par or buy them on the market. The
company will choose the least cost method. If interest rate rises causing the bond prices
to decline then the company will buy the bonds at discount on the market, if interest rate
has fallen it will call the bonds.

Bonds should sell at par when they are initially issued, however their prices will change
according to the interest rate in the bond market.

Transparency ( 5)

A convertible bond gives the bondholder the option to convert the bond into a specified
number of ordinary shares at a specified conversion price. Convertibles have lower
coupon rate than nonconvertible but they offer investor a chance for capital gain in
exchange for lower coupon rate.

For example, assume we have a convertible bond that can be converted to 6 shares
(conversion ratio), so the holder of the bond can at any time surrender the bond to the
company and receive 6 shares, if the face value is $1000, so the conversion price is
$1000/6=$166.67 for a share. If the share price in the market is 200, so the investor can
covert the bond and sell the shares in the market and make a profit.

Some bonds are issued with Warrants long-term option to buy a stated number of shares
of common stock at a specified price, so it provides capital gain if stock price rises.

BONDS issued with warrants carry lower coupon rates than straight line bonds.
Putable bond – allows holder to sell the bond back to the company prior to maturity at
prearranged price. Putable bonds normally sell at a higher price than non-putable bonds.

Income bond – pays interest only when interest is earned by the firm.

Indexed bond – interest rate paid is based upon the rate of inflation, so the interest
payment rises automatically when inflation rate rises, so protecting the bondholders
against inflation.
Transparency( 6)

The value of any financial asset-stock, bond, a lease is simple the present value of the
cash flows the asset is expected to produce.
So if we want to value the bond we need to calculate the present value of its future cash
flows. So we need to determine
    1. Coupon payments
    2. Discount rate.
    3. Par value
We can see when coupon rate is the same as interest rate the bond is selling at par value.

NB:The vast majority of bonds pay the interest semiannually. To evaluate the semiannual
payment bonds we must do the following modification
Multiply years by 2 : number of periods = 2n.
Divide nominal rate by 2 : periodic rate (I/YR) = kd / 2.
Divide annual coupon by 2 : PMT = annual coupon/2


When bonds are issued they are issued at par, however, their prices will change as
economic conditions change.

When interest rate in the bond market fell, then the value of an outstanding bond would
increase. This is logical. The existing bond is paying $100, any new bond with the same
feature as the old one will be paying $70 since the interest would be 7%. The investor
will pay more for the old bond, and all investor will react similarly bidding the price up to
$1210.71, at which point the old bonds provides the same rate of return to a potential
investors as the new bonds, 7%

When interest rate in the bond market increase then the price of existing bonds in the
market will decrease because it is paying less interest compared to other bonds with
similar features. The bond prices will drop to a level that provides any potential investor
the same rate of return as the new bonds, 13%.

Transparency( 8)

When people talk about bond yields they normally refer to the yield to maturity.(YTM)
The yield to maturity is the same as the market rate of interest. It is the discount rate
which makes the discounted future payments equal to market price.

To calculate the YTM one can use financial calculator, spread sheet or trial and error.
YTM changes whenever interest rate changes.
Transparency( 9)

Current yield: provides information regarding the amount of cash income the bond
expect to generate in a given year. Zero coupon bond have CY of zero since there is no
coupon payment. Current yield does not represent the yield investors would earn from
holding the bond.

NB: If the bond sells at par the YTM consists entirely of current/interest yield since capital gain is
zero, but if it sells at a price other than its price it consists of current/interest yield plus positive or
negative capital gain.

Transparency (10)

We said before that the firm can call the bonds. Solving for the YTC is identical to
solving for YTM, except the time to call is used for N and the call premium is FV.
The bond’s yield to maturity can be determined to be 9%.
If coupon rate > Kd then the firm could raise money by selling new bonds which pay
less coupon per year. So investors who have callable bond should expect a call, and to
earn the YTC rather than the YTM.

Transparency (11) (conceptual)

Now we discuss the riskiness of the bonds. There are several types of risk.
Interest rate risk: the longer the maturity of the bond the more sensitive its price to changes
in interest rates.
The logical explanation for this is as follows:
If you bought 10-year bond yielding 10%, i.e. $100 per year, and if interest rates increase
then you would be stuck with this payment for 10 years. Whereas if you bought 1-year
bond , then you would have low return for only one year and at the end of the year you
will get your money and reinvest in high yield bond.

Transparencies (12,13& 14) (conceptual questions)

Reinvestment is the risk of an income decline due to a drop in interest rates.
So reinvestment risk is high on short term bonds.

V.imp so for short term bonds interest risk is low and reinvestment risk is high. At the
same time we saw before that long term bonds are more sensitive to interest rate, so for
long term bond interest risk is high and reinvestment risk is low.

Reinvesment risk is also high on callable bonds.

Nothing is riskless
Transparency (15)

We talked about interest risk and reinvestment risk now we will discuss default risk.
Default risk is the risk that the company will not pay its obligation. No default risk on
treasury securities but there is a substantial on corporate and municipal bonds.

Bonds with higher default risk have higher yield because investors will pay less for
these bonds.

Terms of the bond contract especially whether collateral has been pledge to secure the

Transparency (16)
So as we said the default risk is influenced by the terms of contract of the bond. Different
types of bond have different term

   1. Mortgage bonds: a bond backed by a fixed assets. So if the company default on
      the bonds the bondholders can sell the assets to satisfy their claims. First
      mortgage bonds are senior in priority to claims of second mortgage bonds. So
      second mortgage bonds would have claim against the assets until the first
      mortgage bonds have been paid off in full.
   2. Debentures: a long-term bond that is unsecured by a mortgage on specific
      property. Debenture are issued by extremely strong companies who do not need to
      put up property as security for their debt. Sometimes they are also issued by small
      companies who have put most of their assets as collateral for mortgage loans.
   3. Subordinate debentures are inferior to senior debt. So holders of subordinate
      bonds have claim on the assets only after the senior debt holder has been paid off
      in the event of liquidation.

Transparency (17)

Bonds have been assigned quality rating that reflect their probability of going into
default. These are the rating of two main credit rating agencies Moody’s investor service
and Standard and Poor’s corporation.
Companies issuing debt will have to pay a fee to the credit agencies. In return the credit
rating agencies will track the quality of the issue over its life-time. Debt instruments are
rated from AAA (or Aaa for Moody’s) and AA for the highest possible (are extremely
safe) creditworthiness, single A and Triple B are also considered safe enough to be called
investment grade bonds and this is the lowest rated bonds that many banks and other
institutional investors are permitted by law to hold. Double B and lower are considered
speculative and are called Junk bonds or high-yield bonds.
Further categories exist for issues in default and with substantial risk.

AA+ Aa1
AA       Aa2
AA- Aa3
A+       A1
A        A2
A-       A3
BBB+ Baa1
…        …
A credit rating suffixed with a letter ‘r’ is a debt instrument which has a significant non-
credit risk, e.g a bond linked or indexed to an equity, a currency.

Virtually all US debt instruments have a credit rating. However, a lot of European issues
are still lacking a credit rating (e.g. Pirelli, Porsche and Carrefour have issued bonds
without even applying for a credit rating!).

Tranparency (18)

Financial performance: the better the ratios the higher the rating
Bonds contract provisions:
   1. secured versus unsecured: whether the bond is secured by a mortgage
   2. Senior debt will have higher rating.
   3. Some bonds are guaranteed by other firm (normally the parent company) in this
       case the bond is given the rating of the stronger company. Also sinking fund
       provision is plus since it ensure systematic repayment of the debt.
   4. Bonds with shorter maturity are judge to be less risky.

   Tranasparency (19)

   1. Regulatory environment: whether an adverse regulatory environment affect the
      economic position of the company. For instance, ban on adverts of cigarettes may
      affect the revenues of tobacco firms
   2. Product liability: are the company products are safe. For example tobacco
      companies today are under pressure and so are bond rating
   3. Pension liabilities: does the company have any unfunded pension liabilities.
   4. Is there any labor unrest which may affect the company position
   5. Accounting policies: if the firm is using conservative accounting policies then its
      reported earnings will be of higher quality than if it uses less conservative

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