7.Bonds and Bond Valuation

Question 1

What is Bond

Answer 1

• A bond is a form of loan or IOU (which stands for I Owe You):
o the holder of the bond is the lender (creditor),
o the issuer of the bond is the borrower (debtor).
• The holder can be any individual or entity.
• The issuer can be a government, a financial institution or a
corporation.
• Bonds provide the issuer (i.e. borrower) with external funds to finance long-term investments, or, in the case of government bonds, to finance current expenditure.

Question 2

Differences between loans and bonds

Answer 2

Loans: Non-tradable
lenders are banks
borrowers are corporations or businesses of any size
short term and long term
higher rate of interest compared to bonds

Bonds:
Tradable 
Lenders can be any person or entity
Borrowers are corporations and government
Mainly long term
Lower rate of interest compared to loans

Question 3

General characteristics of bonds

Answer 3

• Bonds: debt securities or “fixed income” securities (= a securitised
loan).
• Par value (face value): the principal amount that is repaid at the end of the term.
• Coupon payment: regular interest payments made by a bond.
• Coupon rate: interest rate that the bond will pay. Can be
calculated as annual coupon / face value.
• Maturity date: date on which the principal is repaid.
• Yield or Yield to maturity: interest rate currently required in the market for a bond.

Question 4

There are five main types of bonds:

Answer 4

• Straight Fixed-Rate Bond
• Floating-Rate Note
• Convertible Bond
• Zero Coupon Bond
• Consol

Question 5

Fixed Rate Bonds

Answer 5

• Bonds with a fixed coupon rate.
Coupon payment is a percentage of the face value.
• Maturity is fixed.
• Face value is paid back at maturity

Question 6

Floating Rate Notes

Answer 6

• Bonds with a variable coupon rate.
• Interest rate is reset every 3 or 6 months.
Reasons for issuing a floating-rate note:
• Issuer expects decreasing interest rates in the future.
Reasons for buying a floating-rate note:
• Investor/lender expects increasing interest rates in the future.

Question 7

Convertible Bonds

Answer 7

• Bond can be converted to a specified number of shares of the firm of
the issuer.
• Conversion can be made at any time until maturity.

Question 8

Reasons for issuing a convertible

Answer 8

Maintaining the financial strength of the firm.
• Debt issue weakens firm’s financial strength.
• Conversion of debt into shares automatically improves firm’s
financial strength.
• Bond interest is tax deductible.
Firm needs capital but profits are low.
• Issue of shares is difficult.
• Issue of a convertible is easier.

Question 9

Zero Coupon Bonds

Answer 9

• Bonds with no coupon payment over the lifetime.
• Maturity is fixed.
• Face value is paid back at maturity.
• Zeros are sold at a large discount from face value.
• The large discount represents the accumulated interest payment.
• Reasons for issuing zero-coupon bonds:
 No cash flow until maturity.
 Bond might be attractive to investors.

Question 10

Consol

Answer 10

•	 Short for consolidated annuities. 
It has the following characteristics: 
o	 Fixed rate coupon payment. 
o	  No maturity date. 
o	 Coupons are paid four times a year and indefinitely i.e. forever.

Question 11

Straight Fixed-Rate Bond

Answer 11

• Bond Value = PV of coupons + PV of par value = PV annuity + PV of lump sum
• Note: Bond values are fluctuating with changes in interest rates
• As interest rates increase, the PVs decrease
• So, as interest rates increase, bond prices decrease and vice versa.
C = Coupon
F = Face value
r = Market interest rate (or Yield to maturity, YTM) v = 1/(1+r) = Discount factor
T = Time to maturity

Question 12

Relationship Between Priceand YTM

Answer 12

• If YTM = coupon rate, then bond price = par value
• Suchabondissaidtobe‘atpar’oraparbond.
• If YTM > coupon rate, then bond price < par value
• In this case, the bond is selling at a discount.
• It is called a discount bond.
• If YTM < coupon rate, then par value < bond price
• In this case, the bond is selling at a premium.
• It is called a premium bond.

Question 13

Zero Coupon Bond

Answer 13

• Make no periodic interest payments (coupon rate = 0%).
• The entire yield-to-maturity comes from the difference between the
purchase price and the par value.
• One cannot sell for more than par value.
• Interest “payments” are deductible for the issuer, although no interest is actually paid during the

Question 14

A bond indenture is a legal contract between the issuer (seller) and the bondholders (buyers) and includes

Answer 14

1. The basic terms of a bond
2. The total amount of bonds issued
3. A description of property used as security, if applicable
4. Seniority specification
5. Sinking fund provisions
6. Call provisions
7. Details of protective covenants

Question 15

The Required Rate of Return

Answer 15

The value of a bond depends the yield to maturity, which must be comparable to the required rate of return.

Question 16

Factors that affect the required rate of return are:

Answer 16

1. Real rate of interest
2. Expected future inflation
3. Interest rate risk
4. Default risk premium(remember bond ratings)
5. Taxability premium (tax-free interest versus taxable)
6. Liquidity premium (bonds that have frequent trading will generally have lower required returns)
   Anything else that affects the risk of the cash flows to the bondholders, will affect the required rate of return.