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Week 4: Debt Securities (Analyze cash flows of Bonds to find the intrinsic…
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Bond
Trustees Represent Bondholders
By means of an indenture (a contract), a bond-issuing body (a corporation, municipality, etc.) identifies and designates a “trustee”, who is the representative of the bondholders’ interests.
There will usually be many bondholders and it is not efficient for them to individually monitor the issuing firm.
Terminology
Coupons are periodic payments made to the holders of the bonds, annually or semi-annually
The amount that will be repaid at the end of the loan in addition to the last coupon is the par value (also known as the face value, or principal)
The annual coupon divided by the face (or par) value is called the coupon rate.
The interest rate required on a bond is called the bond’s yield to maturity (YTM). This is the discount rate at which TODAY the bond coupons and face value are priced
The time (in years, months, etc.) for the bond to make its final coupon and par value payment is called maturity
short-term (up to 5 years)
intermediate-term (from 5 to 12 years)
all the way to long-term (more than 12 years)
US Treasuries with maturities: up to 1 year are called T-Bills; typically of 2, 5 and 10 years are called T-Notes; and greater than 10 years are called T-Bonds.
Bonds and CovenantsA Bond is a legal contract obliging the issuer to make future payments. Bonds are also called Fixed Income Securities.
Bonds often have favorable tax treatment. Also, they may provide investors the assurance that the management is held accountable for poor performance and inability to repay investorsThe bond contract can include legal requirements, or Covenants to protect the interests of bond owners.
- Affirmative:
require the firm to pay coupons when due; maintain financial ratios; provide information to the Trustee, etc.
- Negative:
restrictions on dividend payments to equity holders; assigning specific assets as collateral for future bond issues, not issuing new debt that is senior to the issued debt, etc.
Types of Bonds
Bullet Bonds are bond issues consisting of bonds that all mature on the same date. A common example would be an issue by the US Treasury.
If the seller wants to space out the repayment, the issue may be broken into bonds having different repayment dates. These bonds are called Serial Bonds and are popular with sellers who cannot repay large amounts at one go, for example, municipalities
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Sinking Fund Provisions, Convertible Bonds & Embedded Options
Sinking Fund Provision
- Requires the firm to retire a portion of an issue every year
- Gradually paying down the issue reduce credit risk
- Pay money to the trustee equal to the par value of the bonds to be redeemed, followed by the trustee determining by lottery the bonds to be redeemed, or
- Purchase the required amount of bonds from the market and deliver the bonds to the trustee
Convertible Bonds
Convertible Bonds usually give the owner the option to convert the bonds into equity of the issuing firm
Embedded Options in BondsValuable to an issuer :
- right to an accelerated sinking fund;
- right to call;
- a cap on the interest rate for floaters.
Valuable to bondholders:
- right to put (sell bond back to the issuer)
- floor for a floater
- right to convert the bond to equity
A bond with an embedded put option would have its price fall less than an option-free bond as interest rates rise.
An increase in volatility increases the value of an embedded option in a bond.
Pricing bonds with embedded options involve: modeling the factors (interest rates, etc.) which will impact the decision of the options owners (issuer or bond buyer) whether to exercise; modeling the behavior of the options owners. Uncertainties about the validity and accuracy of models create “modeling risk” for bond investors.
Bond Pricing
Bond Price Equation
The bond price is calculated by adding the present value of the coupon payments to the present value of the face value of the bond.
Bond Pricing Facts
- Bond prices rise with falling market interest rates and fall with rising market interest rates.
- When a bond’s coupon rate is greater than/equal to/less than the market’s required return, the bond’s market value will be greater than/equal to/less than its par value.
Repayment of Bonds
A call provision for a bond allows the issuer to pay off the bond earlier than maturity. Call provisions (a type of embedded option) are valuable to the issuer.
A put provision for a bond allows the owner to return the bond for payment to the issuer earlier than at maturity. A put provision (also an embedded option) is valuable to the bondholder.
Callable Bonds
The call schedule specifies what price the bonds will be called at on different dates. Usually, earlier dates will have higher prices (par value plus premium). Provides investors some protection and with higher price.
Based on a “make-whole” premium. The issuer must pay a premium based upon a formula.
“Special Redemption” prices are usually at par value rather than the regular redemption prices. These prices benefit the issuer as they are lower than regular redemption prices
A refunding protection means that the bonds will not be refunded for a certain number of years or even the whole life of the issue
Call protection (though not absolute) is broader; it still disallows redemption in situations where refunding protection does not
A call protection is more valuable to bond owners than a refunding protection.
Prepayment is similar to a call, except that the firm (the borrower) pays off the bond at par value (rather than a call price according to a schedule).
Purchase of Bonds
Purchase of Bonds by Borrowing
margin buying arrangement part of the purchase money is borrowed by the buyer from the broker.
The broker charges the buyer an interest rate that equals the interest rate the broker pays to his bank plus a service charge. Under Regulations T and U, the U.S Federal Reserve has the power to set initial margin requirements for bonds purchased by borrowing.
repurchase agreement (repo)a bondholder sells a bond with a commitment to buy it back at a specified price and date.
Why execute repurchase agreements?
seller may have an immediate cash need and will receive cash to be able to repay on the later date.
Different Kinds of Bonds
Step Up Notes have coupon payments that increase with time
Zero Coupon bonds pay no coupons, but only par value at maturity. Therefore, they are often sold at a deep discount
Deferred Coupon bonds do not pay interest for a certain period of time, after which they pay interest and face value at maturity.