THE BOND MARKET

PURPOSE OF CAPITAL MARKET

Firms and individuals use capital markets for long-term investments

CAPITAL MARKET PARTICIPANTS

Issuers of capital market securities are federal government, local government and corporations

Corporations sell both stock and bonds while governments sell only bonds

Largest buyer of capital market securities is households

Alternatively, individuals deposit funds in financial institutions that use the funds to purchase capital market instruments such as stock and bonds

CAPITAL MARKET TRADING

Primary market Secondary market

PRIMARY MARKET

New issues of stocks and bonds are introduced

Issues of the security receives the proceeds of sale

First issue of securities is Initial Public Offering

Investment funds, individuals and corporations are buyers

SECONDARY MARKETS

Sale of previously issued securities takes place

Two types of exchanges: Organized exchanges Over the counter exchanges

BONDS

A debt owed by the issuer to the investor

Bonds obligate the issuer to pay a specified amount at a given date, generally with periodic interest payments

Par, face, or maturity value of the bond is the amount that the issuer must pay at maturity

BONDS

Coupon rate is the rate of interest that the issuer must pay

Periodic interest payment is often called the coupon payment.

If the repayment terms of a bond are not met, the holder of a bond has a claim on the assets of the issuer

BONDS

Long-term bonds traded in the capital market include long-term government notes and bonds, municipal bonds, and corporate bonds

CORPORATE BONDS

Most corporate bonds have a face value of $1,000 and pay interest semi-annually

Bond indenture is a contract that states the lender’s rights and privileges and the borrower’s obligations

CHARACTERISTICS OF CORPORATE BONDS

Bearer bonds: Payments are made to whoever has physical possession of coupons

Registered bonds: Payments are made to registered owners

RESTRICTIVE COVENANTS

Rules and restrictions on managers designed to protect the bondholders’ interests

CALL PROVISION

Issuer has the right to force the holder to sell the bond back

Call provision usually requires a waiting period between the time the bond is initially issued and the time when it can be called

Price bondholders are paid for the bond is usually set at the bond’s par price or slightly higher (usually by one year’s interest cost)

CALL PROVISION

If interest rates fall, the price of the bond will rise

If rates fall enough, the price will rise above the call price, and the firm will call the bond

Because call provisions put a limit on the amount that bondholders can earn from the appreciation of a bond’s price, investors do not like call provisions.

CALL PROVISION

A second reason that issuers of bonds include call provisions is to make it possible for them to buy back their bonds according to the terms of the sinking fund

Sinking fund is a requirement in the bond indenture that the firm pay off a portion of the bond issue each year

CALL PROVISION

This provision is attractive to bondholders because it reduces the probability of default when the issue matures

Because a sinking fund provision makes the issue more attractive, the firm can reduce the bond’s interest rate

CALL PROVISION

A third reason firms usually issue only callable bonds is that firms may have to retire a bond issue if the covenants of the issue restrict the firm from some activity that it feels is in the best interest of stockholders

CALL PROVISION

Finally, a firm may choose to call bonds if it wishes to alter its capital structure

A maturing firm with excess cash flow may wish to reduce its debt load if few attractive investment opportunities are available.

CALL PROVISION

Because bondholders do not generally like call provisions, callable bonds must have a higher yield than comparable noncallable bonds.

Despite the higher cost, firms still typically issue callable bonds because of the flexibility this feature provides the firm.

CONVERSION

Some bonds can be converted into shares of common stock

This feature permits bondholders to share in the firm’s good fortunes if the stock price rises

Bond can be converted into a certain number of common shares at the discretion of the bondholder

TYPES OF CORPORATE BONDS

SECURED BONDS

Collateral attached

UNSECURED BONDS

Backed by only the general credit worthiness of the issuer

Carry a higher interest rate than comparable secured bonds

Subordinated debentures: carry a lower priority claim

Variable rate bonds: tied to another market interest rate

JUNK BONDS

Speculative grade bonds

FINDING THE VALUE OF COUPON BONDS

1. Identify the cash flows that result from owning the security

2. Determine the discount rate required to compensate the investor for holding the security

3. Find the present value of cash flows estimated in step 1 using the discount rate determined in step 2

YIELD TO MATURITY

The Yield to maturity (YTM) of a bond is the discount rate that equates the today’s bond price with the present value of the future cash flows of the bond

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THE BOND PRICING FORMULA

The price of a bond is found by adding together the present value of the bond’s coupon payments and the present value of the bond’s face value.

The formula is:

In the formula, C represents the annual coupon payments (in $), FV is the face value of the bond (in $), and M is the maturity of the bond, measured in years.

2M2M

2YTM1

FV

2YTM1

11

YTM

CPriceBond

CURRENT YIELD

Yield to maturity on coupon bonds

Current yield = yearly coupon payment / price of the coupon bonds

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PREMIUM AND DISCOUNT BONDS, I.

Bonds are given names according to the relationship between the bond’s selling price and its par value.

Premium bonds: price > par valueYTM < coupon rate

Discount bonds: price < par valueYTM > coupon rate

Par bonds: price = par valueYTM = coupon rate

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RELATIONSHIPS AMONG YIELD MEASURES

for premium bonds: coupon rate > current yield > YTM

for discount bonds:coupon rate < current yield < YTM

for par value bonds:coupon rate = current yield = YTM

INVESTING IN BONDS

Bear a lower risk than stocks

Suffer from interest rate risk