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Valuation of Stocks and Bonds

3.1 Bonds and Bonds Valuation

1
What is Bond ?
 A long-term debt instrument in which a borrower agrees to
make payments of principal and interest, on specific dates,
to the holders of the bond.
 A bond is a security that obligates the issuer to make
specified interest and principal payments to the holder on
specified dates.
• Coupon rate
• Face value (or par)
• Maturity (or term)
 Bonds are sometimes called fixed income securities.
 Bond is normally an interest-only loan, meaning that the
borrower will pay the interest every period, but none of the
principal will be repaid until the end of the loan.          2
Key Features of a Bond
   Par value or face value – face amount of the bond, which
is paid at maturity (assume \$1,000).
   Bond that sells for its par value is called a par value bond
   Coupon interest rate – stated interest rate (generally fixed)
paid by the issuer. Multiply by par to get dollar payment of
interest.
   Because the coupon is constant and paid every year, the
type of bond we are describing is sometimes called a level
coupon bond.
   Maturity date – years until the bond must be repaid.
   Issue date – when the bond was issued.
   Yield to maturity (YTM) - rate of return earned on
a bond held until maturity (also called the “promised yield”). 3
Characteristics of Bonds
 Bonds pay fixed coupon (interest) payments at fixed intervals
(usually every 6 months) and pay the par value at maturity.

\$I       \$I        \$I      \$I     \$I     \$I+\$M

0                  1                 2      ...      n
example: AT&T 9s of 2018
par value = \$1000
coupon = 9% of par value per year.
= \$90 per year (\$45 every 6 months).
maturity = 20 years.
issued by AT&T.                                                   4
Example: AT&T 9s of 2018

par value = \$1000
coupon = 9% of par value per year.
= \$90 per year (\$45 every 6 months).
maturity = 20 years.
issued by AT&T.

\$45       \$45      \$45      \$45 \$45            \$45+\$1000

0                 1                 2          ...      20

5
Types of Bonds

 Pure Discount or Zero-Coupon Bonds (Zeroes)
• Pay no coupons prior to maturity.
• Pay the bond’s face value at maturity.
• Priced at a deep discount.
 Coupon Bonds
• Pay a stated coupon at periodic intervals prior to maturity.
• Pay the bond’s face value at maturity.
 Perpetual Bonds (Consols)
• No maturity date.
• Pay a stated coupon at periodic intervals.

6
Types of Bonds
   Self-Amortizing Bonds
 Pay a regular fixed amount each payment period over the life of
the bond.
 Principal repaid over time rather than at maturity.
   Debentures –
• unsecured bonds.
   Subordinated debentures –
• unsecured “junior” debt.
   Mortgage bonds –
• secured bonds.
   Junk bonds –
• speculative or below-investment grade bonds; rated BB and
below.                                                          7
Types of Bonds
   Eurobonds - bonds denominated in one currency and sold in
another country. (Borrowing overseas).
   example - suppose Disney decides to sell \$1,000 bonds in France.
These are U.S. denominated bonds trading in a foreign country.
Why do this?
• If borrowing rates are lower in France,
• To avoid SEC regulations.

8
Other types (features) of bonds
   Convertible bond – may be exchanged for common stock
of the firm, at the holder’s option.
   Warrant – long-term option to buy a stated number of
shares of common stock at a specified price.
   Putable bond – allows holder to sell the bond back to the
company prior to maturity.
   Income bond – pays interest only when income is earned
by the firm.
   Indexed bond – interest rate paid is based upon the rate of
inflation.

9
Bond markets
   Bond market is bigger in value than stock market.
   Largest securities market in the world is not NYSE but U.S.
Treasury Market.
   Primarily traded in the over-the-counter (OTC) market.
   This means that there’s no particular place where buying and
selling occur.
   Instead dealers around the country (and around the world) stand
   Most bonds are owned by and traded among large financial
institutions.
   Full information on bond trades in the OTC market is not
published, but a representative group of bonds is listed and traded
on the bond division of the NYSE.                                   10
Bond markets (contd…)

   Because Bond market is almost entirely OTC, it has little or no
transparency.

   It is near to impossible to get the information on price and quantity
of transactions because transactions are privately negotiated
between parties, and there is little of no centralized reporting of
transactions.

11
Bond Issuers

   Federal Government and its Agencies
   Local Municipalities
   Corporations

12
U.S. Government Bonds
   Treasury Bills
 No coupons (zero coupon security)
 Face value paid at maturity
 Maturities up to one year
   Treasury Notes
 Coupons paid semiannually
 Face value paid at maturity
 Maturities from 2-10 years
   Treasury Bonds
 Coupons paid semiannually
 Face value paid at maturity
 Maturities over 10 years
 The 30-year bond is called the long bond.
13
Agencies Bonds

   Mortgage-Backed Bonds
 Bonds issued by U.S. Government
agencies that are backed by a pool of
home mortgages.
 Self-amortizing bonds.
 Maturities up to 20 years.

14
U.S. Government Bonds

•   No default risk. Considered to be riskfree.
•   Exempt from state and local taxes.
•   Sold regularly through a network of primary
dealers.
•   Traded regularly in the over-the-counter
(OTC) market.

15
Municipal Bonds (Munis)

•   Maturities from one month to 40 years.
•   Exempt from federal, state, and local taxes.
•   Riskier than U.S. Government bonds.
•   Rated much like corporate issues.
•   They are almost always callable.

16
Corporate Bonds

   Secured Bonds (Asset-Backed)
 Secured by real property
 Ownership of the property reverts to the
bondholders upon default.
•   Debentures
 General creditors
 Have priority over stockholders, but are
subordinate to secured debt.

17
Common Features of Corporate
Bonds

•   Senior versus subordinated bonds
•   Convertible bonds
•   Callable bonds
•   Putable bonds
•   Sinking funds

18
Convertibility

   Some bonds may be converted to
common stock.
   Can be swapped for a fixed number of
shares of stock anytime before maturity at
the holder’s option.
   Is this a benefit to the investor?

Yes !

19
Effect of a call provision

 Allows issuer to refund the bond issue if rates
decline (helps the issuer, but hurts the
investor).
 Borrowers are willing to pay more, and lenders
require more, for callable bonds.
 Most bonds have a deferred call and a

20
What is a sinking fund?

 Provision to pay off a loan over its life
rather than all at maturity.
 Similar to amortization on a term loan.
 Reduces     risk to investor, shortens
average maturity.
 But not good for investors if rates decline
after issuance.

21
Security Valuation
   In general,

The intrinsic value of an asset = the
present value of the stream of expected
cash flows discounted at an appropriate
required rate of return.

   Can the intrinsic value of an asset differ from the
market value?
YES
22
The value of financial assets

0                1            2              n
r                           ...
Value            CF1          CF2            CFn

CF1      CF2              CFn
Value                    ... 
(1  r) (1  r)
1        2
(1  r) n

23
Bond Valuation
   Determining the value of a bond requires:
• An estimate of expected cash flows
• An estimate of the required return
   Assumptions:
• The coupon interest rate is fixed for the term of the bond
• The coupon payments are made annually and the next coupon
payment is receivable exactly a year from now
• The bond will be redeemed at par on maturity.
• The bond is non-callable.

24
Bond Valuation (contd…)
n
C          M
P                
t 1 (1  r ) t (1  r ) n
Since the stream of coupon payment is an ordinary
annuity,
P  C  PIVFAr,n  M  PVIFr ,n
where,
P  value of bond
n  number of years to maturity
C  annual coupon payment (interest on bond)
r  periodic required return (yield required)
M  maturity value
t  time period when thepayment is received         25
Example 1
Consider a 10 year, 12 % coupon bond with a par value
of Rs 1000. Let the required yield on this bond is 13%.

The cash flows for this bond are as follows:
• 10 annual coupon payment of Rs 120
• Rs 1000 principal repayment 10 years from now

P  120  PIVFA 13%,10 y rs  1000  PVIF13%,10 y rs
 Rs 946.1
26
Bond Values with Semi-Annual Interest

2n    C
M
P           2 
t 1 (1 
r ) t (1  r ) 2 n
2          2
Since the stream of coupon payment is an ordinary
annuity,
P  C  PIVFA r ,2n  M  PVIFr , 2 n
2         2               2

where,
P  value of bond
2n  number of half yearly periods to maturity
C  semi - annual coupon payment (interest on bond)
2
r  periodic required return for half year period
2
t  time period when thepayment is received           27
Example 2

What is the market price of a U.S. Treasury bond that has a
coupon rate of 9%, a face value of \$1,000 and matures
exactly 10 years from today if the required yield to
maturity is 10% compounded semiannually?

0      6    12    18      24 ...   120       Months

45   45     45       45      1045

P  45  PVIFA   5%,20    1000  PVIF 5%,20  \$937 .69
28
Bond Valuation (contd…)

   To determine the value of a bond at a particular point in
time, we need to know:
• Number of periods remaining until maturity
• The Face Value of the Bond
• The Coupon (Interest)
• The market interest rate for bond with similar
features. (Yield To Maturity – YTM)
   Interest rate required in the market on particular bond
type is called the bond’s YTM or simply YIELD of the
bond.
29
Bond Yields and Prices
The case of coupon bonds

   Suppose you purchase the U.S. Treasury bond
described earlier (Example 2) and immediately
thereafter interest rates fall so that the new yield to
maturity on the bond is 8% compounded semiannually.
What is the bond’s new market price?
   Suppose the interest rises, so that the new yield is 12%
compounded semiannually. What is the market price
now?
   Suppose the interest equals the coupon rate of 9%.
What do you observe?
30
Bonds Yields and Prices

 New Semiannual yield = 8%/ 2 = 4%

 What is the price of the bond if the yield to
maturity is 8% compounded semiannually?

P  45  PVIFA   4%,20    1000  PVIF 4%,20  \$ 1067 .95

 Similarly:
• If r=12%: P =\$ 827.95
• If r= 9%: P =\$ 1,000.00
31
Exercise

   S’pose our firm decides to issue 20-year bonds
with a par value of \$1,000 and annual coupon
payments. The return on other bonds of similar
risk is currently 12%, so we decide to offer a
12% coupon interest rate.

   What would be a fair price for these bonds?

32
1000
120       120        120     ...   120

0        1         2          3     ...     20

Period/Yr = 1
N = 20
r% per year = 12
FV = 1,000
Coupon = 120
Solution:
P = \$1,000
Note: If the coupon rate = yield, the bond will
sell for par value.
33
Exercise (contd…)

   Suppose interest rates fall immediately after we
issue the bonds. The required return on bonds
of similar risk drops to 10% i.e. Yield falls to
10 %

   What would happen to the bond price?

34
Period/Yr = 1
N = 20
r% per Year = 10
Coupon = 120
FV = 1000
Solution:
P = \$1,170.27

Note: If the coupon rate > yield, the bond will sell
35
Exercise (contd…)

   Suppose interest rates rise immediately after we
issue the bonds. The required return on bonds of
similar risk rises to 14%.

   What would happen to the bond price?

36
Period/Yr = 1
N = 20
r% per year = 14
Coupon = 120
FV = 1000
Solution:
P = \$867.54

Note: If the coupon rate < yield, the bond will sell
for a discount.
37
Relationship Between Bond Prices
and Yields

   Bond prices are inversely related to interest rates
(or yields).
   A bond sells at par only if its coupon rate equals
the required yield.
   A bond sells at a premium if its coupon rate is
above the required yield.
   A bond sells at a discount if its coupon rate is
below the required yield.

38
Volatility of Coupon Bonds
   Consider two bonds with 10% annual coupons with maturities of 5
years and 10 years.
   The yield is 8%
   What are the responses to a 1% yield change?
Yield       5-year bond      10-year bond
8%          \$1,079.85         \$1,134.20
9%          \$1,038.90         \$1,064.18
% Change         -3.79%            -6.17%
7%          \$1,123.01         \$1,210.71
% Change          4.00%             6.75%
Average           3.89%             6.46%

   The sensitivity of a coupon bond increases with the maturity   39
Bond Prices and Yields

Bond Price
Longer term bonds are more
sensitive to changes in (yields)
Interest rates than shorter term
bonds.
Par
Discount

Yield
10% 12% 14%
40
Bond Yields and Prices
The problem
 Consider the following two bonds:
• Both have a maturity of 5 years
• Both have yield of 8%
• First has 6% coupon, other has 10% coupon, compounded
annually.
 Then, what are the price sensitivities of these bonds to a 1% increase
(decrease) in bond yields?
Yield  6%-Bond        10%-Bond
8%    \$920.15        \$1,079.85
9%    \$883.31        \$1,038.90
% Change  -4.00%          -3.79%
7%    \$959.00        \$1,123.01
% Change  4.22%           4.00%
Average   4.11%           3.89%

41
Interest Rate (Price) Risk
   The risk that arises for bond owners from fluctuating
interest rates is called interest rate risk.
   How much interest rate risk a bond has, depends on how
sensitive its price is to interest rate changes.
   This sensitivity directly depends on two things:
1. The time to maturity
2. The coupon rate.
   All other things being equal, the longer the time to maturity,
the greater the interest rate risk.
   All other things being equal, the lower the coupon rate, the
greater the interest rate risk.
42
What is interest rate (or price) risk?

Interest rate risk is the concern that rising r will cause the
value of a bond to fall.

% change 1 yr            r         10yr % change
+4.8% \$1,048           5%       \$1,386 +38.6%
\$1,000          10%      \$1,000
-4.4%  \$956            15%       \$749  -25.1%

The 10-year bond is more sensitive to interest rate changes,
and hence has more interest rate risk.

43
Interest Rate Risk (contd…)
   Reason that longer-term bonds have greater interest rate
sensitivity:
• A large portion of a bond’s value comes from the discounting of
face value at maturity,
• The PV of this amount isn’t greatly affected by a small change
in interest rates if the amount is to be received in smaller years
to maturity,
• Even a small change in the interest rate, however, once it is
compounded for greater years to maturity, can have a
significant effect on the present value.
   Interest rate risk, increases at a decreasing rate.
• Diff of interest rate risk betn 1 yr bond and 10 yr bond is
greater, but this diff is not that greater between 20 yr bond and
30 yrs bond
44
Interest Rate Risk (contd…)
   Reasons that the bonds with lower coupons have greater
interest rate risk:
• Value of the bond depends on the PV of coupons and the
PV of the face value.
• Value of one with the lower coupon is proportionately
more dependent on the discounted value of face value.
• The bond with higher coupon has a larger cash flow early
in its life, so its value is less sensitive to the changes in the
discount rate.

45
What is reinvestment rate risk?
   Reinvestment rate risk is the concern that r will fall, and
future CFs will have to be reinvested at lower rates, hence
reducing income.

EXAMPLE: Suppose you just won
\$500,000 playing the lottery. You
intend to invest the money and
live off the interest.

46
Reinvestment rate risk example
 You may invest in either a 10-year bond or a series of ten
1-year bonds. Both 10-year and 1-year bonds currently
yield 10%.

 If you choose the 1-year bond strategy:
• After Year 1, you receive \$50,000 in income and have
\$500,000 to reinvest. But, if 1-year rates fall to 3%, your
annual income would fall to \$15,000.

 If you choose the 10-year bond strategy:
• You can lock in a 10% interest rate, and \$50,000 annual
income.

47
reinvestment rate risk

Short-term AND/OR   Long-term AND/OR Low
High coupon bonds       coupon bonds

Interest
rate risk               Low                   High
Reinvestment
rate risk               High                  Low

CONCLUSION: Nothing is riskless!
48
Bond values over time
   At maturity, the value of any bond must equal its
par value (assuming that there’s no risk of default)
   A bond that is redeemable for Rs 1,000 (which is
its par value) after 5 years when it matures, will
have a price of Rs 1,000 at maturity, no matter
what the current price is.
   If r (yield) remains constant:
» The value of a premium bond would decrease over
time, until it reached \$1,000.
» The value of a discount bond would increase over time,
until it reached \$1,000.
» A value of a par bond stays at \$1,000.
49
The price path of a bond
   What would happen to the value of this bond
if its required rate of return remained at
10%, or at 13%, or at 7% until maturity?
P

1,372                                   r = 7%.
1,211
1,000              r = 10%.

837
775                                    r = 13%.
Years
to Maturity
30   25       20     15   10    5         0
50
Yield To Maturity (YTM)
 The average annual rate of return investors expect to
receive on a bond if they hold it to maturity.
Mathematically:
 YTM of a bond is the interest rate that makes the
present value of the cash flows receivable from owning
the bond equal to the price of the bond.

P = \$A (PVIFA r, n) + \$M (PVIF r, n)

Just solve for r = YTM !!!
51
YTM Example

Suppose we paid \$898.90 for a \$1,000 par 10% coupon
bond with 8 years to maturity and semi-annual coupon
payments.

What is our yield to maturity?

52
Solution
Period/YR = 2
N = 16
PV = 898.90
Coupon per period = 50
FV = 1000
898.90 = 50 (PVIFA r, 16 ) + 1000 (PVIF r, 16 )
Solution:
r %= 12%
53
An Approximation

C ( M  P)
YTM             n
0.4M  0.6 P
where,
C  annual coupon payment        Use the same formula
with annual coupon
M  maturity value of the bond   and n as no. of years
even if the coupon

P  present price of the bond
payment is semiannual.
(To find out approx
YTM)
n  years to maturity
54
Exercise
Consider a Rs 1,000 par value bond, carrying a coupon rate
of 9%, maturing after 8 years. The bond is currently selling
for Rs 800. What is YTM on this bond ? The YTM is the value
of r in the following equation:
800  90  PIVFA r,8 y rs  1000  PVIF r ,8 y rs
Hit and Trial Method:
 Try r = 12%, RHS = Rs 851.0
 Try r = 14%, RHS = Rs 768.1
 Try r = 13%, RHS = Rs 808.0

Thus, value of r lies between 13% and 14%.
Use linear interpolation to find exact value of r = 13.2%   55
Using approximate formula

90  (1000  800)
YTM                     8  13.1%
0.4 1000  0.6  800
The YTM calculation considers the current
coupon income as well as the capital gain or loss
the investor will realize by holding the bond to
maturity. In addition, it takes into account the
timing of the cash flows.
56
Another Approximate Formula

    M-P 
 C
Approx YTM        n 
M  2P 
         
    3    
Use the same formula
or                         with annual coupon
   M-P      and n as no. of years

C  n 
even if the coupon
payment is semiannual.
Approx YTM  
MP        (To find out approx
            YTM)
   2                                 57
For Callable Bond

    Call Price - P       C     =     annual
 C                       coupon payment
Approx YTC             n
Call price  2P 
   n = term to call

                   
   Call price can be
         3                sometimes.
or                                      Eg.    Call    to
    Call Price - P        means, bond will

C 
be called at the
n               value 9% greater
Approx YTC  
Call Price  P           than the face
                          value
        2                                  58
Bond Yields

Annual coupon payment
Current yi (CY) 
eld
Current price

Change in price
Capital gains yield (CGY) 
Beginning price

 Expected  Expected
Expectedtotal return  YTM  
 CY        CGY 
         
                   
59
An example:
Current and capital gains yield

Find the current yield and the capital gains yield for
a 10-year, 9% annual coupon bond that sells for
\$887, and has a face value of \$1,000.

Current yield      = \$90 / \$887

= 0.1015
= 10.15%

60
Calculating capital gains yield

Find YTM = 10.91 %

YTM = Current yield + Capital gains yield
CGY = YTM – CY
= 10.91% - 10.15%
= 0.76%

Could also find the expected price one year from now
and divide the change in price by the beginning price,
which gives the same answer.                          61
Zero Coupon Bonds

No coupon interest payments.       The bond
holder’s return is determined entirely by the
price discount.
Suppose you pay \$508 for a bond that has 10 years left
to maturity. What is your yield to maturity?

\$508                                \$1000

0                                 10
PV = FV (PVIF r, n )
508 = 1000 (PVIF r, 10 )
62
Zero Example (contd…)

Period /Yr = 1
N = 10
P = 508
FV = 1000
Solution:
r% per year = 7%

63
Valuing Zero Coupon Bonds
What is the current market price of a U.S. Treasury
strip that matures in exactly 5 years and has a face
value of \$1,000. The yield to maturity is r=7.5%.

1000
5    \$696.56
1.075
What is the yield to maturity on a U.S. Treasury strip
that pays \$1,000 in exactly 7 years and is currently
selling for \$591.11?

1000
591.11              7
1 r
64
Bond Yields and Prices
The case of zero coupon bonds

    Consider three zero-coupon bonds with maturity of 1 yr, 3 yrs
and 5 yrs, all with
» face value of F=100
» yield to maturity of r=10%, compounded annually.
We obtain the following table:
Bond 1   Bond 2    Bond 3
Time / Bond value 10%         \$90.91   \$75.13    \$62.09
1                      100       0          0
2                                0          0
3                               100         0
4                                           0
5                                         100
65
The Impact of Price Responses
   Suppose the yield would drop suddenly to 9%, or increase
to 10%. How would prices respond?
Yield      Bond 1      Bond 2       Bond 3
1 Year      3 Year       5 Year
10%        \$90.91      \$75.13       \$62.09
9%        \$91.74      \$77.22       \$64.99
% change      0.91%       2.70%        4.46%
11%        \$90.09      \$73.12       \$59.35
% change     -0.91%      -2.75%       -4.63%
   Bond prices move up if the yield drops, decrease if yield
rises
   Prices respond more strongly for higher maturities          66
Default risk

   If an issuer defaults, investors receive less than the
promised return. Therefore, the expected return on
corporate and municipal bonds is less than the
promised return.

   Influenced by the issuer’s financial strength and the
terms of the bond contract.

67
Evaluating default risk:
Bond ratings

Moody’s        Aaa Aa A Baa          Ba B Caa C

S&P            AAA AA A BBB          BB B CCC D

   Bond ratings are designed to reflect the probability of a
bond issue going into default.
   Bond ratings are an assessment of the creditworthiness of
the bond issuer.
   Bond ratings don’t address the issue of interest rate risk

68
Bond Ratings
Moody’s   S&P                           Quality of Issue
Aaa      AAA      Highest quality. Very small risk of default.

Aa       AA       High quality. Small risk of default.

A        A       High-Medium quality. Strong attributes, but potentially
vulnerable.
Baa      BBB      Medium quality. Currently adequate, but potentially
unreliable.
Ba       BB       Some speculative element. Long-run prospects
questionable.
B       B        Able to pay currently, but at risk of default in the future.
Caa       CCC      Poor quality. Clear danger of default .

Ca       CC       High specullative quality. May be in default.

C        C        Lowest rated. Poor prospects of repayment.

D         -       In default.
69
Factors affecting default risk and bond ratings

   Financial performance
» Debt ratio
» TIE ratio
» Current ratio

   Bond contract provisions
» Secured vs. Unsecured debt
» Senior vs. subordinated debt
» Guarantee and sinking fund provisions
» Debt maturity

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Other factors affecting default risk

   Earnings stability
   Regulatory environment
   Potential antitrust or product liabilities
   Pension liabilities
   Potential labor problems
   Accounting policies

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The Bond Indenture (Deed of Trust)
   Indenture is the written agreement between the
corporation (the borrower) and its creditors
detailing the terms of the debt issue.
   Usually a trustee (a bank, perhaps) is appointed
by    the    corporation    to    represent  the
bondholders.
   Trust company’s jobs:
• Making sure that the terms of the indenture are
obeyed.
• Managing the sinking fund
• Representing the bondholders in default
72
The Bond Indenture (contd…)
   Bond indenture is a legal document and can run
several hundred pages.
   Includes:
1. The basic terms of the bonds
2. The total amount of bonds issued
3. A description of property used as security
4. The repayment arrangements
5. The call provisions
6. Details of protective covenants
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Terms of Bond
   Face Value / Par Value / Principal Value
   Corporate bonds are usually in registered form.
   This means that the company has a registrar who will record
the ownership of each bond and changes on ownership.
   For eg, it might read as:
Interest is payable semiannually on July 1 and January 1 of each year to
the person in whose name the bond is registered at the close of
business on June 15 or December 15 respectively.
   A corporate bond may be registered and have attached
“coupon”
   Alternatively, the bond could be in bearer form.
 Difficult to recover if they are lost or stolen
 Company cannot notify bondholders of important events.
74
Security
   Debt securities are classified according to the
collateral and mortgages used to protect the
bondholder.
   Collateral – general term that frequently means
securities (for eg. Bonds and Stocks) that are
pledged as security for payment of debt. However,
the term collateral is commonly used to refer to any
asset pledged on a debt.
   Mortgage securities are secured by a mortgage on
the real property of the borrower.
   The property involved is usually real estate.
75
Security (contd…)
   The legal document that describes the mortgage is
called a mortgage trust indenture or trust deed.
   A blanket mortgage pledges all the real property
owned by the company.
   A debenture is an unsecured bond, for which no
specific pledge of property is made.
   Debenture holders only have a claim on property
that remains after mortgages and collateral trusts
are taken into account.
   Note is an unsecured debt usually with a maturity
under 10 years.
76
Seniority

   Seniority indicates preference in position over
other lenders and debts are sometimes labeled as
senior or junior to indicate seniority.
   Some debt is subordinated
   The subordinated lenders will be paid off only after
the specified creditors have been compensated.
   However, debt cannot be subordinated to equity.

77
Repayment
   Can be repaid at maturity.
   The may be repaid in part or in entirely before
maturity.
   Early repayment in some form is more typical and is
often handled through a sinking fund.
   A sinking fund is an account managed by the bond
trustee for the purpose of repaying the bonds.
   The company makes annual payments to the
trustee, who then uses the funds to retire a portion
of debt.
78
Repayment (contd…)
   The trustee does this by either buying up some of
the bonds in the market or calling in a fraction of
outstanding bonds (Call Provision)
   There are many different kinds of sinking fund
arrangements:
• Some sinking fund start about 10 years after the initial
issuance.
• Some sinking fund establish equal payments over the life
of the bond.
• Some high quality bond issues establish payments to the
sinking fund that are not sufficient to redeem the entire
issue. As a consequence, there is the possibility of a
large “balloon payment” at maturity.
79
The Call Provision
   Allows the company to repurchase or “call” part or all of the
bond issue at the stated price over a specific period.
   Corporate bonds are usually callable.
   Generally the call price is above the bond’s stated value (par
value)
   The difference between the call price and the stated value is
the call provision.
   The amount of the call premium usually becomes smaller
over time.
   Deferred call provision – Call protected bond – prohibited
form calling the bonds for the first few years.

80
Protective Covenants
   The part of indenture or loan agreement that limits
certain actions a company might otherwise wish to
take during the term of the loan.
   Classified into two types:
1. Negative Covenants
2. Positive Covenants (affirmative)
   A negative covenant is a “thou shalt not” type of
covenant.
   A positive covenant is “thou shalt” type of
covenant.
81
Examples of Negative Covenants

1.   The firm must limit the amount of dividends it
pays according to some formula.
2.   The firm cannot pledge any assets to other
lenders.
3.   The firm cannot merge with another firm.
4.   The firm cannot sell or lease any major
assets without approval of the lender.
5.   The firm cannot issue additional long-term
debt.
82
Examples of Positive Covenants

1.   The company must maintain its working
capital at or above some specified minimum
level.
2.   The company must periodically furnish
audited financial statements to the lender.
3.   The firm must maintain any collateral or
security in good condition.

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End of section

3.1 Bonds and Bonds Valuation

84

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