1. Topics Covered Domestic Bonds and International Bonds Bond Valuation
The Bond Contract
Security and Seniority
Asset-Backed Securities
Repayment Provisions
Restrictive Covenants
Private Placements
Innovation in the Bond Market

2. Bond Terminology
Foreign bonds - Bonds that are sold to local investors in another country's bond market.
Yankee bond- a bond sold publicly by a foreign company in the United States.
Samurai - a bond sold by a foreign firm in Japan.
Eurobond market - by European and American multinationals to tap into international markets for capital.

3. Bond Terminology
Indenture or trust deed - the bond agreement between the borrower and a trust company.
Registered bond - a bond in which the Company's records show ownership and interest and principal are paid directly to each owner.
Bearer bonds - the bond holder must send in coupons to claim interest and must send a certificate to claim the final payment of principle.

4. Valuation of Bonds and Stock Chapter 5 revisited
First Principles:
Value of financial securities = PV of expected future cash flows
To value bonds and stocks we need to:
Estimate future cash flows: size (how much) and timing (when)
Discount future cash flows at an appropriate risk-adjusted rate

5. Pure Discount Bonds
Information needed for valuing pure discount bonds:
Time to maturity (T) = Maturity date - today’s date
Face value (F)
Discount rate (r)
… T
| | | …------| F
Value of a pure discount bond:
PV = F / (1 + r)T

6. Level-Coupon Bonds Information needed to value level-coupon bonds:
Coupon payment dates and Time to maturity (T)
Coupon (C) per payment period and Face value (F)
Discount rate
… T
| | | … |
Coupon Coupon Coupon + F
Value of a Level-coupon bond:
PV = F / (1 + r)T + C x {1/r - 1 / [r x (1 + r)T]}
= PV of face value + PV of coupon payments

7. Yield to Maturity Example
A $1000 treasury bond expires in 5 years. It pays a coupon rate of 10.5%. If the market price of this bond is , what is the YTM?

8. YTM, Discount Rate and Bond Value
Bond Value and Discount Rate
1800
1600
1400
Bond Value
1200 $
1000
800
0.01
0.02
0.03
0.04
0.05
0.06
0.07
0.08
0.09
0.1
YTM and Discount Rate

9. Some Tips on Bond Pricing
1. Bond prices and market interest rates move in opposite directions.
2. When coupon rate = YTM, price = par value.
When coupon rate > YTM, price > par value (premium bond)
When coupon rate < YTM, price < par value (discount bond)
3. A bond with longer maturity has higher relative (%) price change than one with shorter maturity when interest rate (YTM) changes. All other features are identical.
4. A lower coupon bond has a higher relative (%) price change than a higher coupon bond when interest rate (YTM) changes. All other features are identical.

10. Term Structure Year Spot Rate - The actual interest rate today (t=0)
YTM (r)
1981
1987 & present
1976
Year
Spot Rate - The actual interest rate today (t=0)
Forward Rate - The interest rate, fixed today, on a loan made in the future at a fixed time.
Future Rate - The spot rate that is expected in the future.
Yield To Maturity (YTM) - The IRR on an interest bearing instrument.

11. Bond Terminology
Accrued interest - the amount of accumulated interest since the last coupon payment
Debentures - long-term unsecured issues on debt
Mortgage bonds - long-term secured debt often containing a claim against a specific building or property
Asset-backed securities - the sale of cash flows derived directly from a specific set of bundled assets

12. Valuation of Bonds and Stock
First Principles:
Value of financial securities = PV of expected future cash flows
To value bonds and stocks we need to:
Estimate future cash flows: size (how much) and timing (when)
Discount future cash flows at an appropriate risk-adjusted rate

13. Pure Discount Bonds
Information needed for valuing pure discount bonds:
Time to maturity (T) = Maturity date - today’s date
Face value (F)
Discount rate (r)
… T
| | | …------| F
Value of a pure discount bond:
PV = F / (1 + r)T

14. Level-Coupon Bonds Information needed to value level-coupon bonds:
Coupon payment dates and Time to maturity (T)
Coupon (C) per payment period and Face value (F)
Discount rate
… T
| | | … |
Coupon Coupon Coupon + F
Value of a Level-coupon bond:
PV = F / (1 + r)T + C x {1/r - 1 / [r x (1 + r)T]}
= PV of face value + PV of coupon payments

15. Yield to Maturity Example
A $1000 treasury bond expires in 5 years. It pays a coupon rate of 10.5%. If the market price of this bond is , what is the YTM?

16. YTM, Discount Rate and Bond Value
Bond Value and Discount Rate
1800
1600
1400
Bond Value
1200 $
1000
800
0.01
0.02
0.03
0.04
0.05
0.06
0.07
0.08
0.09
0.1
YTM and Discount Rate

17. Some Tips on Bond Pricing
1. Bond prices and market interest rates move in opposite directions.
2. When coupon rate = YTM, price = par value.
When coupon rate > YTM, price > par value (premium bond)
When coupon rate < YTM, price < par value (discount bond)
3. A bond with longer maturity has higher relative (%) price change than one with shorter maturity when interest rate (YTM) changes. All other features are identical.
4. A lower coupon bond has a higher relative (%) price change than a higher coupon bond when interest rate (YTM) changes. All other features are identical.

18. Term Structure Year Spot Rate - The actual interest rate today (t=0)
YTM (r)
1981
1987 & present
1976
Year
Spot Rate - The actual interest rate today (t=0)
Forward Rate - The interest rate, fixed today, on a loan made in the future at a fixed time.
Future Rate - The spot rate that is expected in the future.
Yield To Maturity (YTM) - The IRR on an interest bearing instrument.

19. Term Structure What Determines the Shape of the TS?
1 - Unbiased Expectations Theory
2 - Liquidity Premium Theory
3 - Market Segmentation Hypothesis
Term Structure & Capital Budgeting
CF should be discounted using Term Structure info.
Since the spot rate incorporates all forward rates, then you should use the future spot rate that equals the term of your project.

20. Bond Terminology
Sinking fund - a fund established to retired debt before maturity.
Callable bond - a bond that may be repurchased by a the firm before maturity at a specified call price.
Defeasance - a method of retiring corporate debt involving the creation of a trust funded with treasury bonds.

21. Straight Bond vs. Callable Bond
Value of
Straight bond
bond
100
bond callable
at 100 75 50 25
Value of
straight bond 25 50 75
100
125
150

22. Bond Terminology
Restrictive covenants - Limitations set by bondholders on the actions of the Corporation.
Positive or Negative Pledge Clause - the processing of giving unsecured debentures protection to prevent bankruptcy
Pay in kind (PIK) - a bond that makes regular interest payments, but in the early years of the bonds life the issuer can choose to pay interest in the form of either cash or more bonds with an equivalent face value.

23. Covenants Debt ratios: Security: Dividends Event risk
Senior debt limits senior borrowing
Junior debt limits senior & junior borrowing
Security:
Negative pledge
Dividends
Event risk
Positive covenants:
Working capital
Net worth