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Learning OutcomesChapter 6

Describe the basic characteristics of debt and some of the different types of debt that exist.

Discuss bond ratings and the information that they provide to investors.

Explain how bond prices are determined.

Explain how bond yields (market rates) are determined.

Describe the relationship between bond prices and interest rates, and explain why it is important for investors to understand this relationship.

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Debt Characteristics

Principal Value, Face Value, Maturity Value, and Par Value

Interest Payments

Maturity Date

Priority to Assets and Earnings

Control of the Firm

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Types of Debt – Short-Term Debt

Treasury BillsDiscounted securities issued by U.S. government to

finance operations

Repurchase AgreementOne firm sells financial asses to another firm with the

promise to repurchase the securities later at a higher price

Federal FundsOvernight loans from one bank to another

Banker’s Acceptance“A postdated check”

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Types of Debt – Short-Term Debt

Commercial PaperA type of promissory note issued by large financially sound

firms

Certificate of DepositRepresents a time deposit at a bank or other financial

intermediary

Eurodollar DepositA deposit in a bank outside the U.S. that is not converted

to the currency of the foreign country

Money Market Mutual Funds Investment funds pooled and managed by investment

companies

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Long-Term Debt

Term LoansLoans obtained from a bank or insurance

company, on which the borrower agrees to make a series of payments, consisting of interest and principal, on specific dates

Bonds A long-term contract where a borrower

agrees to make payments of interest and principal on specific dates to the bondholder (investor)

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Common Bonds

Government Bond

Corporate Bond

Mortgage Bond A bond backed by fixed assets

Debenture An unsecured bond

Subordinated DebentureA bond having a claim on assets only after the senior

debt has been paid off in the event of liquidation

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Types of Corporate BondsIncome BondA bond that pays interest to the holder only if the firm

earns interest

Putable BondBond that can be redeemed at the bondholder’s option

Indexed (Purchasing Power) BondA bond that has interest payments based on an

inflation index to protect the holder from inflation

Floating-rate bondsRates “float’ with market interest rates rather than

with the inflation rate

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New Debt Instruments - 1980’s

Zero (or Very Low) Coupon Bonds - Bonds that pays no annual interest but is sold at a discount below par

Junk Bonds - High-yield, high-risk bonds used to finance mergers, leveraged buyouts, and troubled companies

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Bond Contract Features

Indenture - A formal agreement between the issuer of a bond and the bondholdersTrustee - An official who ensures that the

bondholders’ interests are protected and the terms of the indenture are carried out

Restrictive Covenant - a provision in a debt contract that constrains the actions of the borrower

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Bond Contract Features

Call Provision - A provision in a bond contract that gives the issuer the right to redeem the bonds under specified terms prior to the normal maturity dateRefunding: retiring an existing bond issue

with the proceeds of a newly issued bond

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Bond Contract Features

Sinking Fund - A required annual payment designed to amortize a bond or preferred stock issueFirms may handle the sinking fund in either

of two ways:• Call in for redemption a certain percentage of the

bonds each year• Buy the required amount of bonds on the open

market

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Bond Contract Features

Convertible FeaturePermits the bondholder to convert the bond

into shares of common stock at a fixed price

Investors cannot convert the stocks back to bonds

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Bond Ratings

Triple-A and Double-A Bonds are extremely Safe

Investment Grade Bonds - The lowest-rated bonds that many banks and other institutional investors may hold by law

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Bond Rating Criteria

Financial strength of the company

Collateral provisions

Seniority of the debt

Restrictive covenants

Sinking fund or deferred call

Litigation possibilities

Regulation

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Importance of Bond Ratings

A bond’s rating is an indicator of its default risk.

Most bonds are purchased by institutional investors who are legally restricted to investment-grade securities.

Changes in ratings affect a firm’s ability to borrow long-term capital and the cost of that capital.

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Basic Valuation

From “The Time Value of Money” we realize that the value of anything is based on the present value of the cash flows the asset is expected to produce in the future.

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The Basic Bond Valuation Model

rd = required rate of return on a debt instrumentN = number of years before the bond maturesINT = dollars of interest paid each year (Coupon rate x Par value)M = par or face, value of the bond to be paid off at maturity

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Basic Valuation

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Valuation of Bonds

Principal Amount, Face Value, Maturity Value, Par Value: The amount of money the firm borrows and promises to repay at some future date, often at maturity.

Coupon Payment: The specified number of dollars of interest paid each period, generally each six months, on a bond.

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Bond Value

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Numerical solution:

Genesco 10%, 15-year, $1,000 Bonds

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Genesco 10%, 15-year, $1,000 bonds

Financial Calculator Solution:

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Bond Value with Semiannual Compounding

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Genesco 8%, 14-year, $1,000 BondsCompounded Semi-annually

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Yield to MaturityYTM is the average rate of return earned on a bond if it is held to maturity.

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Yield to CallYTC is the average rate of return earned on a bond if it is held until the first call date. Call price in four years is $1,080.

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Changes in Bond Values Over Time

Whenever the going rate of interest, rd, equals

the coupon rate, a bond will sell at its par value

An increase in interest rates will cause the price of an outstanding bond to fall.

A decrease in interest rates will cause the price to rise.

The market value of a bond will always approach its par value as its maturity date approaches, provided the firm does not go bankrupt.

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Bond Yield = Current (interest) yield + Capital gains yield

Changes in Bond Values Over Time

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Interest Rate Risk on a Bond

Interest Rate Price RiskThe risk of changes in bond prices to which

investors are exposed due to changing interest rates.

Interest Rate Reinvestment Rate RiskThe risk that income from a bond portfolio

will vary because cash flows have to be reinvested at current (presumably lower) market rates.

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Value of Long and Short-Term10% Annual Coupon Rate Bonds

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Bond Prices in Recent Years