ISBN: 0-03-028931-9
Chapter 8
This chapter described the different types of bonds governments and corporations issue, explained how bond prices are established, and discussed how investors estimate the rates of return they can expect to earn. The key concepts covered are summarized below.
A bond is a long-term promissory note issued by a business or governmental unit. The issuer receives money in exchange for promising to make interest payments and to repay the principal on a specified future date.
A Treasury bond is issued by the federal government and is sometimes referred to as government bonds. Corporate bonds are issued by corporations, and unlike Treasuries, are subject to default risk. Municipal bonds are issued by state and local governments. Foreign bonds are issued by either foreign governments or foreign corporations.
Some recent innovations in long-term financing include zero coupon bonds, which pay no annual interest but which are issued at a discount; floating rate debt, whose interest payments fluctuate with changes in the general level of interest rates; and junk bonds, which are high-risk, high-yield instruments issued by firms which use a great deal of financial leverage.
A call provision gives the issuing corporation the right to redeem the bonds prior to maturity under specified terms, usually at a price greater than the maturity value (the difference is a call premium). A firm will typically call a bond if interest rates fall substantially below the coupon rate.
A sinking fund is a provision which requires the corporation to retire a portion of the bond issue each year. The purpose of the sinking fund is to provide for the orderly retirement of the issue. A sinking fund typically requires no call premium.
A convertible bond is exchangeable, at the option of the holder, for common stock in the issuing firm. A warrant is a long-term option to buy a stated number of shares of common stock at a specified price. An income bond pays interest only if the interest is earned. Indexed bonds make interest payments based on an inflation index so as to protect the holder from inflation.
The value of a bond is found as the present value of an annuity (the interest payments) plus the present value of a lump sum (the principal). The bond is evaluated at the appropriate periodic interest rate over the number of periods for which interest payments are made.
The equation used to find the value of an annual coupon bond is:
An adjustment to the formula must be made if the bond pays interest semiannually: divide INT and kd by 2, and multiply N by 2.
The return earned on a bond held to maturity is defined as the bond's yield-to-maturity (YTM). If the bond can be redeemed before maturity, it is callable, and the return investors receive if it is called is defined as the yield-to-call (YTC). The YTC is found as the present value of the interest payments received while the bond is outstanding plus the present value of the call price (the par value plus a call premium).
Furthermore, the return on a bond can be broken down into two components, the current yield and the capital gains yield. The current yield is the annual coupon payment divided by the current price. The capital gains yield is the change in price of the bond over the year divided by the price at the beginning of the period.
The longer the maturity of a bond, the more its price will change in response to a given change in interest rates; this is called interest rate risk. However, bonds with short maturities expose investors to high reinvestment rate risk, which is the risk that income will decline because cash flows received from bonds will be rolled over at lower interest rates.
Corporate and municipal bonds have default risk. If an issuer defaults, investors receive less than the promised return on the bond. Therefore, investors should evaluate a bond's default risk before making a purchase.
There are many different types of bonds. They include mortgage bonds, debentures, convertibles, bonds with warrants, income bonds, and purchasing power (indexed) bonds. The return required on each type of bond is determined by the bond's riskiness.
Bonds are assigned ratings which reflect the probability of their going into default. The highest rating is AAA, and they go down to D. The higher a bond's rating, the lower its risk and its interest rate.
Two related issues are discussed in detail in Appendixes 7A and 7B: zero coupon bonds and bankruptcy. In recent years many companies have used zeros to raise billions of dollars, while bankruptcy is an important consideration for both companies that issue debt and investors.
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