Bond Features and Prices
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A bond is a form of interest-only loan; the loan principal is called the face or par value, and the periodic interest payments are called coupons. The coupon rate is the coupon amount divided by the par value. The number of years until the face value is paid is the bond's maturity.
Bond Values and Yields
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The market value of a bond is equal to the present value of all of the promised payments discounted at the bond's yield to maturity (YTM). The YTM, in turn is the market's required rate of return on the bond. True or False: You are considering a bond for which the market's required rate of return is equal to its coupon rate; the market value of the bond must be equal to its face value. CONCEPT CHECK
Interest Rate Risk
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is the fluctuation in the market value of a bond resulting from changes in market interest rates. Interest rate risk is positively related to time to maturity, and negatively related to coupon rate. True or False: You believe market rates will fall sharply in the near future. To maximize the increase in the value of your bond holdings, you should hold longer-term, lower-coupon bonds. CONCEPT CHECK
Finding the Yield to Maturity: More Trial and Error Computing YTM is a time-value problem: the current market value of a bond is the present value of the future coupons plus the present value of the principal. Click here
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for an example.
More on Bond Features
Is it Debt or Equity?
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Main differences between debt and equity: (1) Debt does not represent an ownership interest in the firm, while equity generally does represent a share of ownership, (2) Interest paid on debt is tax-deductible, dividends paid on equity is not, and (3) Unpaid debt is a legal liability of the firm, common equity has no maturity and need not be repaid.
Long-Term Debt: The Basics Generally speaking, short-term debt is issued with a maturity with 1 year or less; intermediate-term debt has a maturity of 1 to 10 years, and long-term debt has a maturity of more than 10 years. More information on bond basics is available at the web site of the Bond Market Association.
The Indenture
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The bond indenture is the written agreement between the corporation and the lender detailing the terms of the debt issue. A typical indenture contains provisions detailing the basic terms (KEY TERM) of the issue, the security (KEY TERM) or collateral (if any), the seniority (KEY TERM) of the issue, the sinking fund (KEY TERM) provision (if any), the call provision (KEY TERM) (if any), and the protective covenants (KEY TERM) of the contract.
Bond Ratings Issuers frequently pay independent third parties to develop an opinion as to the creditworthiness of the issue. Two of the biggest rating agencies are Moodys and the Standard and Poors Corporation.
Some Different Types of Bonds
Government Bonds
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Governmental entities - federal, state, and local - all issue debt securities to finance their operations. U.S. Treasury issues are debt instruments of the federal government, while municipal bonds ("muni's") are offerings by state and local governments.
Zero Coupon Bonds
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are bonds that make no coupon payments. The interest earned is the difference between the purchase price and the maturity value.
Floating-Rate Bonds
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have coupon payments that are adjustable.
Other Types of Bonds
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Several other types of bonds exist (and more are created every day!).
Bond Markets
How Bonds are Bought and Sold Most bonds are sold "over the counter" (OTC); i.e., they are not traded on one of the organized exchanges.
Bond Price Reporting Prices and volumes for exchange-traded bonds are reported daily in The Wall Street Journal. Corporate bond quotes are displayed in Figure 6.3
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, and Treasury issues are displayed in Figure 6.4
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. Price quotes can also be found at numerous sites on the Internet, including Bondsonline.com.
Inflation and Interest Rates
Real versus Nominal Rates The nominal rate on an investment is the percentage change in the number of dollars you have; the real rate on an investment is the percentage change in how much you can buy with your dollars. Current market interest rates are available at http://www.bankrate.com.
The Fisher Effect
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states that the nominal rate is approximately equal to the sum of the real rate and the expected inflation rate.
Determinants of Bond Yields
The Term Structure of Interest Rates
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is the relationship between nominal rates on default-free, pure-discount securities and time to maturity. The shape of the term structure is a function of (1) the real rate of interest, (2) the expected rate of inflation, and (3) the interest rate risk premium (KEY TERM).
Bond Yields and the Yield Curve: Putting it all Together The Treasury yield curve plots yields on U.S. Treasury yields against time to maturity and is published in the "Credit Markets" section of The Wall Street Journal daily.
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