Bond Basics

- Typically, a
**bond**is an interest-only loan, but the debt contract can be customized to meet the needs of the company issuing the security. - Three required pieces:
- Face (par) value - the principal amount of a bond
- Coupon rate - the stated interest rate of a bond
- Maturity - the specified date on which the principal is repaid

Valuing a Bond

- You already know how to value a bond. Simply price the pieces and add them together.
- The lump sum repayment of the principal
- An annuity consisting of the coupon payments

- Bond Pricing Formula: $ Bond \ Value = C[\frac{1-\frac{1}{(1+r)^t}}{r}]+\frac{FV}{(1+r)^t} $
**Note:**$r$ is the required rate of return on the bond, not the coupon rate. This rate is often called the**yield to maturity (YTM)**.

Example

- 5 yr bond
- 14% yield
- 6% coupon
- $1000 par

Bond Relationships

- Value relative to par
- If the coupon rate and the discount rate are equal, then the bond value will equal par.
- If coupon rate < discount rate, then the bond will sell at a discount to par.
- If coupon rate > discount rate, then the bond will sell at a premium to par.

- Price and discount rate are inversely related.

Interest Rate Risk

- As a bondholder, you face
**interest rate risk**to the value of your bond as interest rates change in the market.- Interest rate risk increases with maturity.
- Interest rate risk decrease with coupon rate.

- See Figure 7.2

Bond Features

- Indenture - written agreement between the corporation and the lender detailing the terms of the debt issue
- Collateral - any asset pledged against a debt
- Seniority - preference in position over other lenders
- Call provision - agreement giving the corporation the option to repurchase a bond at a specified price prior to maturity
- Convertibility - a provision granting the bondholder the option to exchange the bond for a fixed number of shares of stock anytime before maturity
- Convenant - a provision limiting certain issuer actions

Types of Bonds

- Government vs. Corporate Bonds
- Zero Coupon Bonds
- Floating-Rate Bonds

Real vs. Nominal Interest Rates

- Nominal rate - rate that has not been adjusted for inflation (decrease in purchasing power)
- Real rate - rate that has been adjusted for inflation
- Fisher Effect: $R = (1+r)(1+h)–1$
- R is the nominal rate
- r is the real rate
- h is expected inflation rate

- If we require a 10% real return and we expect inflation to be 8%, what is the nominal rate?

Term Structure

- The term structure of interest rates is the relationship between maturity and yields.
- Since it is important to hold everything else constant, we usually associate government bonds with the term structure.
- No default risk
- No coupons

- Yield Curve - a graphical representation of the term structure of interest rates
- See Figure 7.6

Other Risks

- Default Risk - See Default Rates Wikipedia
- Tax Risk (Municipal Bonds)
- Liquidity Risk (On-the-run Treasuries)