Chap 7:Notes to accompany the powerpoint transparencies

T 7-1 NB: Bond values depend in large part on interest rates.

Some good bond sites to visit are the following bonds.yahoo.com

investorguide.com and follow the investing bonds link
www.investinginbonds.com
www.nasdbondinfo.com
www.bondresources.com

T7-2 Bond: A long-term debt instrument. It is a promise extended by the issuer (borrower) to pay
specific cash flows (interest + principal) at specified future dates.

There are four main types of bonds:

1.Treasury or Government bonds are issued by the federal government. These bonds have no
default risk but some interest rate risk.
2.Corporate bonds: issued by corporations; exposed to default risk or credit risk.
NB: The larger the default risk, the higher the interest rate the issuer must pay.
3.Municipal bonds, or “Munis” issued by state and local governments. Interest earned on Munis is
tax exempt. They have default risk.
4.Foreign bonds: issued by foreign governments or foreign corporations. Exposed to default risk and
foreign exchange risk if the bonds are denominated in a currency other than that of the investor’s
currency.

T7-4 Basic Features of a Bond

Par value: Stated or face value of a bond = Principal = Maturity value.

It represents the amount of money the firm borrows and promises to repay at maturity date ex: $1,000.
Coupon interest rate: nominal rate: the stated annual rate of interest on a bond. Ex: 10%. It indicates
the percentage of the face value that will be paid on an annual basis.
Coupon payments: Periodic dollar interest payments that are determined by the coupon rate. Ex: 10%
x 1,000 = $100
Maturity date: a specified date on which the par value of a bond as well as the final interest payment
of a bond must be repaid.
Term to maturity: Original maturity: The number of years to maturity at the time a bond is issued.

Floating rate bond: specify coupon rates that are reset at specified points, relative to some reference
rate. This is done to reduce interest rate risk.

Coupon rate: annual coupon divided by the face value of the bond.
YTM: the rate required in the market on a bond

T7-6 NB: To determine value of a bond at a particular point in time ,we need to know the no of period
remaining until maturity, the face value ,the coupon and the market interest rate with similar features
(YTM)

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Kd=K*+IP+DRP+LP+MRP

Default risk depends on the financial strength of the company and the indenture(terms of the
contract)
T7-7 Remember the sign convention on the calculator. The easy way to remember it with bonds is we
pay the PV (-) so that we can receive the PMT (+) and the FV(+).

NB: this bond sells at less than par or is said to be a discount bond since it pays the investors only
10%(less than the going rate of 11%) to compensate for this is to lower the price to 963.04 so that the
investor has a built in gain ,an investor who purchased and kept the bond till maturity would get 100
per year and have a gain of 36.96 at maturity this gain compensates the lender for the below market
interest rate,

Or the bond is discounted by 36.96 because the 100 coupon is $10 below the coupon on a newly issued
par value bond based on current market conditions-> the bond would be worth 1,000 only if it had a
coupon of $110 dollar per year. In a sense an investor who buys and keeps the bonds gives up $10 per
year for 5years.At 11% this annuity stream is worth: PVA=$10x(1-1/1.115) / .11 =$36.96.

T7-8 Premium bond :as expected the bond would sell for more than $1,000 or at a premium this is
just the opposite of a discount bond ,the bond offers 10% when the market rate is only 8% -> investors
will pay this extra premium to get this extras coupon amount.
The total bond value is about $196.36 in excess of par value/> the coupon is now $20 too high ,based
on current market conditions the present value of $20 for 20 years at 8% is PVA=$20x(1-1/1.0820 )/.08
=$196.36

T7-9 Bond characteristics: Coupon rate = 8% with annual coupons; Par value = $1000; Maturity = 10
years

T7-10(conceptual) A bond sells at par when coupon rate = YTM (Kd) where YTM=Kd
A bond sells at discount when CR <YTM.(Kd)
A bond sells at premium when CR > YTM.(Kd)

There are the purely mechanical reasons for these results.

We know that present values decrease as rates increase. Therefore, if we increase our yield above the
coupon, the present value (price) must decrease below par. On the other hand, if we decrease our yield
below the coupon, the present value (price) must increase above par.

There are more intuitive ways to explain this relationship. The yield-to-maturity is the interest rate
on newly issued debt of the same risk and that debt would be issued so that the coupon = yield. Then,
suppose that the coupon rate is 8% and the yield is 9%. Which bond would you be willing to pay more
for. You would pay more for the new bond. Since it is priced to sell at $1000, the 8% bond must sell
for less than $1000. The same logic works if the new bond has a yield and coupon less than 8%.

Another way to look at it is that return = “dividend yield” + capital gains yield. The “dividend yield”
in this case is just the coupon rate. The capital gains yield has to make up the difference to reach the
yield to maturity. Therefore, if the coupon rate is 8% and the YTM is 9%, the capital gains yield must
equal approximately 1%. The only way to have a capital gains yield of 1% is if the bond is selling for

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less than par value. (If price = par, there is no capital gain.) technically, it is the current yield, not the
coupon rate + capital gains yield, but from an intuitive standpoint, this helps remembering the
relationship and current yields and coupon rates are normally reasonably close.
NB: When people talk about bond yields they normally refer to the yield to maturity. (YTM) The yield
to maturity is the same as the market rate of interest. It is the discount rate which makes the discounted
future payments equal to market price.
NB: A bond’s yield to maturity should not be confused with its current yield = annual coupon/
current price
*Current yield is always less then the yield to maturity for a discount bond since it only takes the
coupon portion of return and does not consider the built in gain from the price discount.
*Current yield is always higher then the yield to maturity for a premium bond since it ignores the
built in loss of the premium between now and maturity.
YTM = Total expected rate of return = Promised rate.
YTM = current (interest) yield + a positive or negative capital gain yield.
Current yield: provides information regarding the amount of cash income the bond expect to generate
in a given year.
Zero coupon bond have CY of zero since there is no coupon payment. Current yield does not represent
the yield investors would earn from holding the bond.
NB: YTM for a bond that sells at par consists entirely of a current( interest) yield.

YTM changes with changes in interest rates and thus it will vary between purchase date and maturity
date.
YTM rate assumes that each of the cash flow must be reinvested at a rate = YTM
YTM assumes that a bond is held to maturity.

T7-13 Coupon rate = 14%, semiannual coupons

YTM = 16%
Maturity = 7 years
Par value = $1000

T7-14 Interest Rate & Reinvestment Risk (conceptual questions)

Interest rate risk or price risk : depends on how sensitive s bond’s price is to interest rate changes.
This sensitivity depends on two things: the time to maturity and the coupon rate.
(1) All other things being equal ,the longer the time to maturity ,the greater the interest rate risk.
(2) All other things being equal , the lower the coupon rate, the greater the interest rate risk.

Interest rate risk: is the most important risk for bondholders.

Duration: is a measure of interest rate sensitivity of a bond.

Bonds with longer duration are exposed to more interest rate risk.
Interest rate risk: reflects the length of time one is committed to a given investment.

Ex :if you bought 10 year bond yielding 10% ie a 100 per year and if interest rates go up you would be
stuck with this payment for 10 years ,whereas if you bought 1 year bond than you would have a low
return for only one year and at the end of the year you will get your money and reinvest in high yield
bond .

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Reinvestment risk: is the risk that coupon payments when received have to be reinvested at lower
yields.
NB: - Zero coupon bonds have no reinvestment risk but are subject to high interest rate risk.
-Reinvestment rate risk is high on callable bonds.
-Reinvestment rate risk is high on short maturity bonds.

Ex: Suppose you just won $500,000 playing the lottery. You intend to invest the money and live off
the interest. You may invest in either a 10 year bond or a series of 10 1 year bond . Both 10 year and 1
year bond currently yield 10% .If you choose the one year bond strategy you receive 50,000 income
and have 500,000 to reinvest ,but if 1 year rate fall to 3%, your annual income would fall to 15,000 .If
you choose the 10 year bond strategy you can lock 10% interest and 50,000 annual income

Interest rate risk: relates to the value of the bonds in a portfolio.

Reinvestment rate risk: relates to the income the portfolio produces.
Reinvestment is the risk of an income decline due to a drop in interest rates.
So reinvestment risk is high on short term bonds.

V.imp so for short term bonds interest risk is low and reinvestment risk is high. At the same time we
saw before that long term bonds are more sensitive to interest rate, so for long term bond interest risk is
high and reinvestment risk is low.

T7-15 Conceptual questions:

NB: we compute and plot prices under different interest rate scenarios for 10% coupon bonds with
maturities of 1 year and 30 years.
Notice how the slope of the line connecting the prices to interest rates is much steeper for the 30 year
bond than the 10 year bond. The steeper the curve the more price sensitive is a bond to interest
rates changes.

This can be explained by the fact that a large portion of a bond’s value comes from the $1,000 face
amount. The present value of this amount is not greatly affected by a small change in interest if the
amount is to be received in one year. Whereas even for very small changes in interest rates when
compounded for 30 years can have a significant effect on the present value.
NB: note also that interest rate risk increases at a decreasing rate.

Lower coupon have greater interest rate risk -> two bonds with different coupon rates have the
same maturity than the one with lower coupon is proportionately more dependent on the face amount to
be received at maturity-> its value will fluctuate more as interest rates change., in other words the bond
with higher coupon has a larger cash flow early in its life so its value is less sensitive to changes in the
discount rate.

T7-16 Ans: 1. The zero coupon bond has a higher interest rate risk.
2. The 8% coupon bond has a higher reinvestment rate risk.

T7-18 NB: You should be able to recognize that the YTM is more than the coupon since the price is
less than par.
Since it is a discount bond the current yield is lower than the YTM (explained before in T 7-10)
Current yield =100/928.09=10.77% < 11%

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T 7-19 Since it is a premium bond the current yield is higher than the YTM (explained before in T 7-
10) Current yield =100/1197.93=8.35% > 8%

T7-21 This is the same information as the YTM calculation on slide 7.15. The YTM computed on that
slide was 8%

T7-23
ANS :Step 1: let us find the YTM which is the same for both bonds.

935.08=$100x(1-1/(1+r)12 )/r + 1,000/(1+r)12 -> r = 11%

Step 2: since the coupon rate for the second bond is higher than the YTM the bond will sell at a
premium,

in fact second bond value = $120x(1-1/1.1112/ .11) + 1,000/1.1112 =$1,064.92

T7-24 Please note that you have to have the analysis tool pack add-ins installed to access the PRICE
and YIELD functions. If you do not have these installed on your computer, you can use the PV and the
RATE functions to compute price and yield as well. Click on the TVM tab to find these calculations.
NB: the settlement date is the date you actually pay for the bond, and the maturity date is the date the
bond actually matures, in a spreasdhseet we enter the coupon and yield to maturity in annual terms and
explicitly provide the number of coupon payments per year.

T7-25 NB: one of the costs of issuing debt is the possibility of financial failure , this possibility
does not arise when equity is issued.
(The risks and benefits associated with owning debt are equity are different )

Debt securities are called notes, debentures or bonds-> issues with an original maturity of 10 years or
less are often called notes, longer term issues are called bonds

T7-26 NB: Indenture or deed of trust. A trustee (usually a bank ) is appointed by the corporation to
represent the bondholders.

Sinking funds :an account managed by the bond trustee for early bond redemption. Sinking Fund
Provision: a provision in a bond contract that requires the issuer to retire a portion of the bond issue
each year.
Sinking Funds ensure that an issue is retired in an orderly fashion and therefore protect bondholders.
However, they are faced with reinvestment risk.
Companies either :
1. Call x% of the issue at par, for sinking fund purposes. Likely to be used if kd is below the coupon
rate and the bond sells at a premium.
2. Buy bonds in the open market. Likely to be used if kd is above the coupon rate and the bond sells at
a discount.
Companies will choose either to redeem the bonds at par or buy them on the market. The company
will choose the least cost method. If interest rate rises causing the bond prices to decline then the
company will buy the bonds at discount on the market, if interest rate has fallen it will call the bonds.

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Bonds should sell at par when they are initially issued, however their prices will change according to
the interest rate in the bond market.

Since they are safer than similar bonds without such a provision, sinking funds bond have lower
coupon rates.

Callable bonds: have a feature “call provision” which allows the issuer to retire all or part of the
issue if cheaper financing is available.
Callable feature is the benefit to the issuer who will have a strong incentive to exercise the call
provision when interest rates go down.
Investors who are faced with “Reinvestment risk” are offered a call premium i.e. they are offered an
amount greater than the par value if they are called. The call premium is usually set to 1 year interest
payment if it is called during the first year and then it starts to decline. For example the call premium
on $1000 par value 10-year 10 percent bond is 100 if it is called during the first year, 90 for the second
year (so decreasing by one-tenth)
NB: in general if a bond sells at a premium then coupon rate >YTM a call is more likely, so expect a
YTC on premium bonds and YTM on par and discount bonds. To find YTC Plug N=time to call
called FV= (face value +call premium) ,PV = price of bond and PMT=coupon payment..

Deferred call (or call protection) rules out retiring the bonds until a specific first call date, which is
usually a few years (5 to 10) after the issue date.

Refunding of a bond issue: means that the original issue will be retired using the proceeds from a
generally lower cost new issue.
Refunding operation: suppose the company issue the bonds when interest rates are high. If the bonds
are callable and the interest rate declines over time, the company could sell new issue at lower yield
and use the proceeds to retire the high-rate issue so reducing the interest expenses.

Other bonds features;

Convertible bonds: provide the bondholder with the right to convert the bonds for a specified no of
common stock in the issuing company. Convertibles offer capital gains in exchange of a lower
coupon rate than straight bonds.
Ex :assume we have a convertible bond that can be converted to 6 shares (conversion ratio) so the
holder at any time can surrender the bond to the company and receive 6 shares ,if the FV is 1000
conversion price =1000/6 =166.67.If the share price in the market is 200 ,the investor can convert the
bond and sell the shares in the market and make a profit.

Warrants: a long term option to buy a stated no of shares of common stock at a specified price. Bonds
that are issued with warrants carry a lower coupon rate than straight bonds.

Income bonds: or) revenue bond)rely on revenues generated by the project that is being funded.

Indexed bonds: (or purchasing power bonds) has interest payments based on an inflation index so as
to protect bondholder from inflation.

Putable bond: allow holder to sell the bond back to the company at prearranged price.

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Protective covenants: is part of the indenture that limits certain actions a company might otherwise
wish to take during the term of the loan. Protective covenants can be classified into negative covenants
and positive or (affirmative) covenants.
Negative covenants: limits or prohibits actions that the company might take ex: the firm cannot pledge
any assets to other lenders. ,the firm cannot merge with another firm, the firm cannot issue additional
long term debt,limits the amount of dividends and corporate officer’s salaries.
A positive covenant :specifies an action that the company agrees to take or a condition that the
company must abide by Ex: the company must maintain its working capital at or above some specified
minimum level, the firm must periodically provide audited financial statements to the lender.

T7-27 This is standard terminology in the US – but it may not transfer to other countries. For example,
debentures are secured debt in the United Kingdom.
Registered form :the company has a registrar who will record the ownership of each bond and record
any changes in ownership. Interest and principal are paid directly to the owner of record.
Bearer form : the certificate is the basic evidence of ownership (ownership is not recorded).

Security: Debt securities are classified according to collateral and mortgages used to protect
bondholders.
Secured debt issue: contain some form of collateral specifically pledged to make sure that debt will be
repaid.
Collateral :frequently means securities (bonds and stocks) that are pledged as security for payment of
debt,however collateral is commonly used to refer to any asset pledged on a debt.
Mortgage bond: a bond backed by fixed assets. So if the company default on the bonds the
bondholders can sell the assets to satisfy their claims.
First mortgage bonds: are senior in priority to claims of second or junior mortgage bonds. So second
mortgage bonds would have claim against the assets until the first mortgage bonds have been paid off
in full.

First mortgage bonds carries lower rates of interest than junior long-term debt.
All mortgage bonds are subject to an indenture a trust deed: a formal agreement between the issuer of
a bond and a bondholder.
Debentures: unsecured bonds. They do not contain any specific pledge of collateral on property.
Debenture are issued by extremely strong companies who do not need to put up property as security for
their debt.
Subordinated debentures: a bond having a claim on assets only after the senior debt has been paid
off in the event of liquidation.
Debenture holders only have a claim on property not other wise pledged ,that remains after mortgages
and collateral are taken into account.

Seniority: indicates preference in position over other lenders ,debts are often labeled as senior or junior
to indicate seniority .(subordinated debenture) but debt cannot be subordinated to equity.

T7-28
ANS: Debenture: secured debt is less risky because the income from the security is used to pay it off
first

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Subordinated debenture: will be paid after the senior debt

Bond without sinking fund: company has to come up with substantial cash at maturity to retire debt
and this is riskier than systematic retirement of debt through time

Callable – bondholders bear the risk of the bond being called early, usually when rates are lower. They
don’t receive all of the expected coupons and they have to reinvest at lower rates.

T7-29 Bond rating are only concerned with the possibility of default and not with interest rate risk
ex: the price of a highly rated bond can still be quite volatile.
NB: a large part of corporate borrowing takes the form of low grade or junk bonds they are rated
below investment grade bonds that are rated at least BBB by S&P or Baa by Moody’s.(medium
grade obligations)
Bond rating are constructed from information supplied by the corporation. A bond’s credit rating can
change as the issuer’s financial strength improves or deteriorates.
When a bond is downgraded from investment grade to junk bond status due to the firm’s increased use
of financial leverage and increased costs these bonds are called fallen angels.
Credit ratings are important because defaults do occur and when they do investors lose a lot.

T-30 NB: Debt rated in these categories is regarded as speculative with respect to capacity to pay
interest and principal in accordance with the terms of the obligation. Issues rated C by Moody’s are
typically in default.

T7-31 US treasury issues unlike all other bonds have no default risk. Treasury issues are exempt from
state income taxes in other words the coupons you receive on a treasury note or bonds are taxed only
at the federal level.
NB: coupon rates on munis are exempt from federal income taxes (though not necessarily state income
taxes) which makes them attractive to high income high tax bracket investors.
Because of the enormous tax break they receive , the yields on municipal bonds are much lower
than the yields on taxable bonds.

T7-32 NB:A bond that pays no coupons at all must be offered at a price that is much lower than is
stated value .ie at a deep discount. . As with any other zero-coupon bond, reinvestment risk is
eliminated.

T-33 NB; Unlike the conventional bonds where coupon rates are set as fixed percentages of the par
value, Coupon payments are adjustable the adjustments are tied to an interest rate index such as the
treasury bill interest rate or the 30 year treasury bond rate. Whereas there is less price risk, there is
greater reinvestment (or refinancing) risk.
The value of a floating rate bonds depends on exactly how the coupon payment adjustments are
defined. In most cases the coupon adjusts with a lag to some base rate.
The majority of the floaters have the additional features :
1-the holder has the right to redeem the note at par on the coupon payment date after some specified
amount of time. This is called a put provision.
2-the coupon rate has a floor and a ceiling meaning that the coupon is subject to a min and a max.The
coupon rate is said to be capped and the upper and lower rates are sometimes called the collar.

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Ex :An interesting type of floating rate bond is an inflation linked bond: coupons are adjusted
according to the raste of inflation. TIPS(treasury inflation Protected Securities.)

T7-34 Disaster bonds – issued by property and casualty companies. Pay interest and principal as
usual unless claims reach a certain threshold for a single disaster. At that point, bondholders may lose
all remaining payments Higher required return

Warrant: gives the buyer of the bond the right to purchase shares of stock in the company at a fixed
price..Such a right would be very valuable if the stock price rose substantially .Because of this feature
bonds with warrants are often issued at a very low coupon rate.

Income bonds – coupon payments depend on level of corporate income. If earnings are not enough to
cover the interest payment, it is not owed. Higher required return

Convertible bonds – bonds can be converted into shares of common stock at the bondholders
discretion Lower required return

Put bond – bondholder can force the company to buy the bond back prior to maturity Lower required
return.The put feature is just the reverse of the call provision.

T7-35 NB: Riba: Arabic term for interest .is forbidden as interest is considered exploitative. Riba is
the amount added to a loan however small it might be as a function of loan amount and time to
principal repayment.
The islamic finance system is based on a notion of profit and loss sharing .Although an Islamic bank
does not charge interest on an extended loan but it participates in the profits the borrower’s generate
with the bank’s funds. Risk taking is encouraged and deserves an adequate profit. However a fine line
is drawn between risk taking and speculation.
Every loan is to be asset backed (securitization of debt),Sukuk is a certificate of indebtedness that is
collateralized by tangible assets. Sukuk can be issued on the basis of already existing assets or to buy
particular assets .Sukuk provide returns to investors in the form of cash flows originating from these
assets.(which cannot be predetermined with certainty and therefore are risky.)The proceeds from asset
backed securities are reserved for the investors that hold claim to them. With a lower risk of capital
loss comes a lower risk premium. Consequently the return required for sukuk tends to be lower to
a debenture of similar quality.
Since the return to the investor is the cost to the issuer, issuing sukuk as opposed to a conventional
bond may lower a company’s cost of capital. Sukuk can be overcollateralized or it can be guaranteed
by a third party or covered by takaful(insurance).

Mudarabah: is a two party contract where one party provides the capital ,similar to a silent partner
who does not interfere in the business operations, while the other provides the management skills and
time effort. Profits are shared equally but losses are borne only by the providers of capital, financial
institutions or general investors. This is the most important difference to conventional bonds where
interest payments(short of the issuer’s default ) are not contingent upon the investment success.

Ijarah: the transfer of the usage of assets and properties is the basis for sukuk al Ijarat.The holder of
this sukuk may enjoy the profits ,benefits and advantages that come with the assets and properties as its
temporary owner in return for predetermined payments(ujrah).Subject to Ijarah can be the

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securitization of land ,roads hospitals or other assets related to an economy’s infrastructure. The
concept of Ijarah is similar to leasing. Ijarah is considered particularly attractive to small and medium
sized companies.

 Al Salam: similar to a conventional forward or futures contract. Sukuk AL-Salam is an

agreement between two parties to set a price for a good or a commodity that is to be delivered
in the future. Payment is made upon entering the contract and potentially involves the sale of a
good that does not already exists. As such it would generally not be Sharia’a compliant unless
the parties involved Have a genuine interest in the underlying commodity.

 Istisna’a: is a financing method similar to a construction loan where one party pays another
party to build or manufacture a particular good. It is similar to Al –Salam in that the price of the
good is determined before the good exists or is completed. the basic difference is the timing of
the cash flows as Istina’a payments are usually made in installments related to the progress of
the work. Upon completion , ownership is transferred immediately against the receipt of the last
installment.

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