Bonds

Question 1

Principles applied in bond valuation

Answer 1

1. Money has time value.
2. Risk requires reward.
3. Market prices are generally right.

Question 2

Definition bonds

Answer 2

Type of debt or long-term promissory note, issued by a borrower, promising to its holder a predetermined and fixed amount of interest per year and repayment of principal at maturity.

Question 3

Types of bonds (5)

Answer 3

1. Debentures
2. Subordinated bonds
3. Mortgage bonds
4. Eurobonds
5. Convertible Bonds

Question 4

Definition debenture

Answer 4

• unsecured long-term debt
• for issueing firms, debetures provide the benefit of not tying up property as collateral
• for bondholders, debentures are more risky than secured bonds and provide a higher yield

Question 5

Definition subordinated debenture

Answer 5

• hierarchy of payout in case of insolvency
• claims of subordinated debentures are honored only after the claims of secured debt and unsubordinated debentures have been satisfied

Question 6

Definition mortgage bond

Answer 6

• secured by a lien on real property

- value of the real property is usually greater than that of the bond itself

Question 7

Definition eurobonds

Answer 7

• securites (bonds) issued in a country different from the one whose in whose currency the bond is denominated
• e.g. a bond issued by an American corporation in Japan that pays interest and principal in dollars

Question 8

Definition convertible bonds

Answer 8

debt securities that can be convertey int o a firm’s stock at a pre-specified price

Question 9

Bond terminology: claims on assets an income

Answer 9

seniority in claims: in case of insolvency, claims of debt, including bonds are honored before those of common or preferred stock

Question 10

Bond terminology: par value

Answer 10

• face value of the bond, returned to the bondholder at maturity
• bonds will return the par value at maturity, regardless of the price paid at the time of purchase

Question 11

Bond terminology: coupon interest rate

Answer 11

• percentage of the par value of the bond that will be paid periodically in the form of interest
• some bonds are zero-coupon bonds

Question 12

Bond terminology: maturity

Answer 12

length of time until the bond issuer returns the par value to the bondholder and terminates or redeems the bond

Question 13

Bond terminology: call provision

Answer 13

• Call provision (if it exists on a bond) gives corporation the option to redeem the bonds before the maturity date.
• For example, if the prevailing interest rate declines, the firm may want to pay off the bonds early and reissue at a more favorable interest rate.
• Issuer must pay the bondholders a premium.
• There is also a call protection period where the firm cannot call the bond for a specified period of time.

Question 14

Bond terminology: indenture

Answer 14

• An indenture is the legal agreement between the firm issuing the bond and the trustee who represents the bondholders.
• It provides for specific terms of the loan agreement -(such as rights of bondholders and issuing firm).
• Many of the terms seek to protect the status of bonds from being weakened by managerial actions or by other security holders.

Question 15

Bond terminology: bond ratings

Answer 15

• bond rating reflect the future risk potential of a bond

- lower bond ratings indicate higher probability of default

Question 16

Favorable factors affecting bond rating

Answer 16

• greater reliance on equity a opposed to debt in financing the firm
• profitable operations
• low variability in past earnings
• large firm size
• minimal use of subordinated debt

Question 17

Bond terminology: junk bonds

Answer 17

• high risk bonds with ratings of BB or below

- also referred to as high-yield bonds as they pay high interest rates

Question 18

Definition book value

Answer 18

value of an asset as shown on a firm’ s balance sheet

Question 19

Definition: liquidation value

Answer 19

Dollar sum that cozuld be realized if an asset were sold individually and not as part of a going concern

Question 20

Definition: market value

Answer 20

the observed value for the asset in the marketplace

Question 21

Definition: intrinsic or economic value

Answer 21

• also called fair value

- the present value of the asset’s expected future cash flows

Question 22

What affects value? (3)

Answer 22

• amount and timing of the asset’s expected future cash flows
• riskiness of the cash flows
• investor’s required rate of return for undertaking the investment

Question 23

Value of a bond (V) =

Answer 23

( C1/(1+r)^1 ) + ( C2/(1+r)^2) … + ( Cn/(1+r)^n )

C: future expected cash flows in the form of interest and repayment of principal

n: time to maturity
r: the investor’s required rate of return

Question 24

Definition: yield to maturity (YTM)

Answer 24

• rate of return the investor will earn if the bond is held to maturity

Question 25

to find YTM, we need:

Answer 25

1. current price
2. time left to maturity
3. par value
4. annual interest payment

Question 26

Definition: current yield

Answer 26

• ratio of the interest payment to the bond’s current market price
• annual interest payment/ current market price

Question 27

three important relationships: #1

Answer 27

the value of a vond is inversely related to changes in the investor’s present required rate of return
- a interest rate increases, the value of the bond decreases and vice versa

Question 28

three important relationships: #2

Answer 28

the market value of a bond will be less than the par value if the investor’s required rate of return is above the coupon interest rate (discount) and vice versa (premium)

Question 29

three important relationships: #3

Answer 29

• long-term bonds have greater interest rate risk than short-term bonds
• a change in interest rate will have a relatively greater impact on long-term bonds

Question 30

main risks for bond holders

Answer 30

1. changes in current interest rates
2. default risk (no or partial payment in case of bankruptcy)
3. call risk (if bonds are called before maturity date