Characteristic of Bond: Financial Management 2

FINANCIAL MANAGEMENT 2
Characteristic of Bond
Bonds have a number of characteristics . All of these factors play a role in determining the value of a
bond and the extent to which it fits in your portfolio which are:-
1) Par value -The face value also known as the par value or principal is the amount of money
a holder will get back once at a maturity date. A newly issued bond usually sells at the par
value. Corporate bonds normally have a par value of $1,000, but this amount can be much
greater for government bonds. What confuses many people is that the par value is not the
price of the bond. A bond's price fluctuates throughout its life in response to a number of
variables. When a bond trades at a price above the face value, it is said to be selling at a
premium. When a bond sells below face value, it is said to be selling at a discount.
2) Coupon (The Interest Rate) -The coupon is the amount the bondholder will receive as
interest payments. It's called a "coupon" because sometimes there are physical coupons on the
bond that you tear off and redeem for interest. However, this was more common in the past.
Nowadays, records are more likely to be kept electronically. As previously mentioned, most
bonds pay interest every six months, but it's possible for them to pay monthly, quarterly or
annually. The coupon is expressed as a percentage of the par value. If a bond pays a coupon of
10% and its par value is $1,000, then it'll pay $100 of interest a year. A rate that stays as a
fixed percentage of the par value like this is a fixed-rate bond. Another possibility is an
adjustable interest payment, known as a floating-rate bond. In this case the interest rate is tied
to market rates through an index, such as the rate on Treasury bills.
3) Maturity -The maturity date is the date in the future on which the investor's principal will be
repaid. A bond that matures in one year is much more predictable and thus less risky than a
bond that matures in 20 years. Therefore, in general, the longer the time to maturity, the higher
the interest rate. Also, all things being equal, a longer term bond will fluctuate more than a
shorter term bond.
4) Bond ratings - The bond rating system helps investors determine a company's credit risk.
Think of a bond rating as the report card for a company's credit rating. Blue-chip firms, which
are safer investments, have a high rating, while risky companies have a low rating.
5) Claims on assets and income – in the case of solvency, claims of debt bonds are honored to
come ahead those of commonor prefrred stock.
BASIC OF VALUATION & BONDS VALUATION Page 1

6) Indenture – The bond contract between the firm and the bondholders. That indenture are
including the coupon rate,par value, the period until maturity,any special features which is
design to protect the bondholders.
7) Convertability – May allow the investors to exchange the bond for a predetermined numberof
the firm’s shares of common stock.
8) Call provisions –A provision that gives a corporation the option to redeem the bonds before
the maturity date. For instance, if the prevailing interest rate declines, the firm may want to
pay off the bonds early and reissue at amore favorable interest rate and issuer must pay the
bondholder a premium.
Types of Bonds
There are several types of bonds. Firstly, it is called debentures. What is debenture? Debenture is
a type of debt instrument that is not secured by physical asset or collateral. Debentures are backed only
by the general credit worthiness and reputation of the issuer. Both corporations and governments
frequently issue this type of bond in order to secure capital. Like other types of bonds, debentures are
documented in an indenture. Debenture is usually with maturity of 10 years or more. Apart from that,
it is viewed as more risky than secured bonds and provide a higher yield than secured bonds.
Secondly it is called subordinated debentures. A subordinated debenture (also known as subordinated
loan, subordinated bond, subordinated debt or junior debt) is debt which ranks after other debts should
a company fall into receivership or be closed. The most important thing is that it has lower priority for
payment than other debentures which are designated as senior. So, it means that it is more risky for the
lender of the money. It is unsecured and has lesser priority than that of an additional debt claim on the
same asset.
Next, it is mortgage bond. So what is mortgage bond? Mortgage bond is actually a bond secured by a
mortgage on one or more assets. These bonds are typically backed by real estate holdings and/or real
property such as equipment. In a default situation, mortgage bondholders have a claim to the
underlying property and could sell it off to compensate for the default.
After that, the next bond is called zero-coupon bond and it’s also known as accrual bond. Zero-coupon
bond is a debt security that doesn't pay interest (a coupon) but is traded at a deep discount,
rendering profit at maturity when the bond is redeemed for its full face value. Apart from that, some
zero-coupon bonds are issued as such, while others are bonds that have been stripped of their coupons
by a financial institution and then repackaged as zero-coupon bonds. Because they offer the entire
payment at maturity, zero-coupon bonds tend to fluctuate in price much more than coupon bonds.

Then, junk bond is also included in several types of bonds. It is also known as high-yield bond or
speculative bond. These are usually purchased for speculative purposes. Junk bonds typically offer
interest rates three to four percentage points higher than safer government issues.
Last but not least is Eurobond. Eurobond is an international bond. It is actually a bond issued
in a currency other than the currency of the country or market in which it is issued. Usually,
a eurobond is issued by an international syndicate and categorized according to the currency in which
it is denominated. A eurodollar bond that is denominated in U.S. dollars and issued in Japan by an
Australian company would be an example of a eurobond. The Australian company in this example
could issue the eurodollar bond in any country other than the U.S.
Eurobonds are attractive financing tools as they give issuers the flexibility to choose the country in
which to offer their bond according to the country's regulatory constraints. They may also denominate
their eurobond in their preferred currency. Eurobonds are attractive to investors as they have small par
values and high liquidity.
Bond Valuation: 5 important relationships

First relationship
Changes in the value of a bond are inversely related to changes in the rate of return.
- The higher the rate of return (i.e., yield to maturity (YTM)), the lower the bond value.
Second relationship
- If the yield to maturity for a bond is less than the bond's coupon rate, then the (clean) market
value of the bond is greater than the par value (and vice versa).
- If a bond's coupon rate is less than its YTM, then the bond is selling at a discount.
- If a bond's coupon rate is more than its YTM, then the bond is selling at a premium.
- If a bond's coupon rate is equal to its YTM, then the bond is selling at par
Third relationship
The market value of the bond approaches the par value when the maturity approaches.
Fourth relationship
Long-term bonds have greater interest rate risk
- There is a greater probability that interest rates will rise (increase YTM) and thus negatively
affect a bond’s market price, within a longer time period than within a shorter period.

Fifth relationship
The sensitivity of a bond's value to changing interest rates depends not only on the length of time
to maturity, but also on the pattern of cash flows provided by the bond

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FINANCIAL MANAGEMENT 2

BASIC OF VALUATION & BONDS VALUATION Page 1

BASIC OF VALUATION & BONDS VALUATION Page 2

Bond Valuation: 5 important relationships

BASIC OF VALUATION & BONDS VALUATION Page 3

BASIC OF VALUATION & BONDS VALUATION Page 4

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