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FINE230 Chap 2 - Bonds

Bonds are debt securities issued by corporations, governments, and other entities that pay periodic interest payments and return the principal at maturity, with the main types being fixed-rate bonds, variable-rate bonds, zero-coupon bonds, and junk bonds that are rated based on their risk level. Bonds can be secured by collateral like mortgages or unsecured, with a minimum denomination of $1,000, and their prices are affected by factors like coupon payments, maturity date, and yield. Various entities issue bonds to raise funds for purposes like infrastructure projects, with municipal bonds issued by state and local governments offering potential tax benefits for investors.

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46 views12 pages

FINE230 Chap 2 - Bonds

Bonds are debt securities issued by corporations, governments, and other entities that pay periodic interest payments and return the principal at maturity, with the main types being fixed-rate bonds, variable-rate bonds, zero-coupon bonds, and junk bonds that are rated based on their risk level. Bonds can be secured by collateral like mortgages or unsecured, with a minimum denomination of $1,000, and their prices are affected by factors like coupon payments, maturity date, and yield. Various entities issue bonds to raise funds for purposes like infrastructure projects, with municipal bonds issued by state and local governments offering potential tax benefits for investors.

Uploaded by

Mandy Khoury
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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BONDS

Issued by
- Corporations
- Federal Governments
- State and Local Governments

- Bonds are debt securities


- Bonds are long term securities
- Bonds have
coupon payments (yearly or semiannually)
Par value (Face value)
Types of Bonds:
 Fixed Interest Bonds
Fixed coupon payments
 Variable Rate Bonds
Coupon rate changes during the bond’s maturity
 Zero Coupon Bond
Investor only receives the par at maturity
 Junk Bonds
Highly risky

Bonds are rated according to risk. (Standard & Poor, Moody’s, Fitch)
 Some bonds are secured by mortgage
 Some bonds are unsecured (Debentures)
 Minimum denomination of the par value is $1,000.

PV = coupon payment(PVIFA%,p) + par(PVIF%,M)

PV > Par (Bond traded at a premium)


PV < Par (traded at a discount)
PV = Par (Coupon rate is equal to Rd)
Which bond is always traded at a discount?
A certain organization wants to issue a bond
Maturity: 7 years
Coupon rate: 12% (annually)
Par: $1 million
The organization segments the bond into 8 separate bonds
Objective is to facilitate sale
Bond is referred to as Strips
Usually for Treasury bonds.
 What type of bonds are they?
DURATION:
How long until investor recovers the amount they invested.
D = ∑(PV of CF x t) / price of bond)

Example:
Maturity = 4 years
Coupon rate = 8% annually
Par = $1,000
Rd = 8% (Rd is also referred to as Yield to Maturity, YTM)
Duration?
t CF PV @ 8% PVxt/price
1 80 74.07 0.074
2 80 68.58 0.137
3 80 63.5 0.191
4 1,080 793.8 3.175
3.577

It will take 3.58 years to recover the cost.


PROBLEM:
Maturity of the bond = 4 years
Coupon rate = 8% (semiannually)
YTM = 10%
Par value is not given, so take it to be $1,000
Duration?
Solution:
PV = 40 (PVIFA5%,8p) + 1,000 (PVIF5%,8p) = $935.33
t CF PV @5% (PVxt) / price
0.5 40 38.1 0.02
1 40 36.28 0.039
1.5 40 34.55 0.055
2 40 32.91 0.07
2.5 40 31.34 0.084
3 40 29.85 0.096
3.5 40 28.43 0.106
4 1,040 703.87 3.01
3.48 years
All bonds have a duration less than maturity.
EXCEPT ONE TYPE OF BOND
Which one?
Answer: The Zero Coupon bond

As coupon rate increases, the duration of the bond decreases. Will take less time
for the investor to recover the cost of the bond.
As the maturity of the bond increases, the duration of the bond will also
increase.
MUNICIPALS (MUNIS)
 Issued by the State & Local Governments
 Why do S&L Governments need funds?

 Tax exempt
 Rate on a corporate bond is 12%
Rate of a municipal is 9%
Tax rate is 30%
Disregarding risk, which bond will you invest in?
For corporate bond, the investor will receive 12(1-0.3) = 8.4%
In this case, it is better for the investor to invest in the municipal.
When will the investor be indifferent between the two?
rM = rC (1-T), investor is indifferent

rM / rC > 1-T preference for municipal

rM / rc < 1-T preference for corporate bond

Question:
Can municipals default?
Current yield:
(Coupon payment / price of bond) x 100
Current yield is annual

Suppose coupon rate is 8% and bond is traded at $1,200


Current yield = 80 / 1,200 x 100 = 6.67%

Suppose the coupon rate of 8% is semiannual


Current yield = 6.67%

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