Chapter 6 Bonds and Bond Pricing

1
Chapter 6Bonds and Bond Pricing

• Real Assets versus Financial Assets\
• Application of TVM Bond Pricing
• Semi-Annual Bonds
• Types of Bonds
• Finding Yield to Maturity of a Bond
• Bond Features
• Bond Ratings
• Quoting Conventions and Bond Markets

2
Real vs. Financial Assets

• Real Assets have physical characteristics that
  determine the value of the asset
• Size, Shape, Material, Color, etc.
• Price based on the benefits of the physical
  characteristics
• Financial Assets physical characteristics are
  inconsequential
• Value based on claim to promised or anticipated
  cash flows
• TVM concepts used to price financial assets

3
Application of TVM Bond Pricing

• Bond is a long-term debt instrument (long-term
  liability) of a company
• Bond promises a specific set of cash payments in
  the future
• Coupon (interest) payments
• Principal repayment
• Timing and amount of future cash payments stated
  on the bond

4
Application of TVM Bond Pricing

• Timeline for promised cash flows
• Example, Patel Corporation Bond
• 1,000 par value (principal)
• 8 annual coupon payments (interest)
• Twenty year bond
• Figure 6.2, Page 129
• Principal 1,000 due 12/31/23 is lump sum
• Coupons of 80 annually are annuity

5
Application of TVM Bond Pricing

• Steps to price a bond
• Determine annuity stream
• Coupon Rate times Par Value
• 8 x 1,000 80
• Find PV of annuity stream
• Find PV of principal repayment
• Add PVs together for bond price
• Patel Corporation Bond
• PV of coupons is 917.59
• PV of principal is 311.80
• Price of Patel Corporation bond is 1,229.39

6
Application of TVM Bond Pricing
7
Semi-Annual Bonds

• Corporations and governments elect how often they
  will make coupon payments
• Most common choice is every six months
• Consistent with interest rates from chapter 4
• Coupon rate is stated annually
• Coupon payment (Coupon Rate x Par Value) / 2
• Discount rate for TVM is the yield to maturity /
  2
• Number of periods (n) is years x 2
• Timeline of promised cash flows, Figure 6.5 page
  133

8
Semi-Annual Bond
9
Types of Bonds

• By Issuer
• Corporate Bonds Companies
• Treasury Bonds U.S. Government
• Municipal Bonds State and Local Governments
• By Features Table 6.1, page 137
• Standard, Semi-Annual, Floating Rate (coupon rate
  changes), Zero, Consol,
• Callable, Putable, Convertible

10
Types of Bonds

• Special Pricing Feature of Zero-Coupon Bond
• No coupon payments
• Priced as Semi-Annual Bond for Principal
  repayment
• Also know as deep discount bond
• Price of bond is the initial principal
• Difference between price and final payment is
  interest on bond
• Interest is implied each year as bond price
  changes using the original yield to maturity
• Amortization schedule (Table 6.2) shows implied
  interest payments each six months

11
Finding Yield to Maturity

• Yield to maturity return on the bond if held to
  maturity
• Discount rate for pricing the bond
• If price and cash flows are known you can find
  YTM
• Iterative Process can not isolate r in TVM
  formula
• Calculator or Spreadsheet fast and accurate
• Relationship of Coupon Rate and YTM

12
Bond Features

• Variables
• Price, Principal, YTM, Coupon Rate, Maturity
  Date, Frequency of Coupon Payments
• Need all but one variable to determine missing
  variable
• Indenture or Deed of Trust (Bond Contract)
• Collateral or Security of Bond
• Real Property is Collateral Mortgage Bond
• No Collateral - Debenture

13
Bond Features

• Senior Debt versus Junior Debt
• Older Issue is Senior
• Junior Debt paid off after Senior Debt
• Protective Covenants
• Prohibits actions of bond issuer
• Designed to protect bondholder
• Added Features to Bond (Options)
• Call, Put, Conversion
• Provides issuer or holder future choices

14
Bond Ratings

• Agencies Rate Bonds
• Ratings based on potential default
• Best rating AAA
• Categories based on ratings
• Investment Grade (AAA to BBB- or Baa3)
• Speculative Grade (BB or Ba1 to B- or B3)
• Also known as Junk Bonds
• Extremely Speculative (C rating group)
• Default (D rating by Standard and Poors)

15
Quoting Conventions and Markets

• Bonds usually trade in a dealer market
• Dealers state buying and selling prices
• Dealers usually in money center banks
• Some bonds listed on NYSE
• Bonds listed by issuing company
• Bonds coupon rate and maturity date part of the
  bond name
• Current yield
• Volume, Closing Price, and Net Change

16
Problems

• Problem 1 Pricing with Annual Coupons
• Problem 2 Pricing with Semi-Annual Coupons
• Problem 6 Yield on Semi-Annual Bonds
• Problem 10 Coupon Rates
• Problem 11 Pricing Semi-Annual Bond
• Problem 13 Zero Coupon Bond
• Problem 19 Conversion Option