Chapter 6

Lecturer: Abdelaziz mawlid

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 WHO ISSUES BONDS?
▪ A bond: is a long-term contract under which a borrower agrees to make
payments of interest and principal on specific dates to the holders of the
bond.

▪ Bonds are issued by corporations and government agencies that are

looking for long-term debt capital.

▪ For example, on January 3, 2009, Allied Food Products borrowed $50

million by issuing $50 million of bonds. For convenience, we assume that
Allied sold 50,000 individual bonds for $1,000 each.

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 Groups of bonds
1. Treasury bonds, generally called Treasuries and sometimes referred
to as government bonds, are issued by the federal government.

governments make good on their promised payments, so Treasuries

have no default risk. However, these bonds’ prices do decline when
interest rates rise; so they are not completely riskless.

2. Corporate bonds: are issued by business firms.

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▪ Corporate bonds are exposed to default risk if the issuing company
gets into trouble, it may be unable to make the promised interest and
principal payments and bondholders may suffer losses.

▪ Different corporate bonds have different levels of default risk.

3. Municipal bonds, are bonds issued by state and local governments.

Like corporates, are exposed to some default risk; but they have one
major advantage over all other bonds.

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4. Foreign bonds are issued by a foreign government or a foreign
corporation.

▪ All foreign corporate bonds are exposed to default risk, as are some
foreign government bonds.

▪ An additional risk exists when the bonds are denominated in a

currency other than that of the investor’s home currency.

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 KEY CHARACTERISTICS OF BONDS

▪ Although all bonds have some common characteristics, different

bonds can have different contractual features.

▪ For example, most corporate bonds have provisions that allow the
issuer to pay them off early (“call” features), but the specific call
provisions vary widely among different bonds.

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• Similarly, some bonds are backed by specific assets that must be
turned over to the bondholders if the issuer defaults, while other bonds
have no such collateral backup.

• Differences in contractual provisions and in the fundamental

underlying financial strength of the companies backing the bonds lead
to differences in bonds’ risks, prices, and expected returns.

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 Par Value
• The par value is the stated face value of the bond; for illustrative
purposes, we generally assume a par value of $1,000, although any
multiple of $1,000 (e.g., $5,000 or $5 million) can be used.

• The par value generally represents the amount of money the firm
borrows and promises to repay on the maturity date.

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 Coupon Interest Rate
• Allied Food Products’ bonds require the company to pay a fixed number of
dollars of interest each year. This payment, generally referred to as the
coupon payment, is set at the time the bond is issued and remains in force
during the bond’s life.

• Coupon Payment -The specified number of dollars of interest paid each

year.

• Coupon Interest Rate-The stated annual interest rate on a bond.

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• Fixed-Rate Bond-A bond whose interest rate is fixed for its entire life.

• Floating-Rate Bond -A bond whose interest rate fluctuates with shifts in

the general level of interest rates.

• Zero Coupon Bond-A bond that pays no annual interest but is sold at a
discount below par, thus compensating investors in the form of capital
appreciation.

• Original Issue Discount (OID) Bond -Any bond originally offered at a

price below its par value.

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 Maturity Date
▪ Bonds generally have a specified maturity date on which the par value
must be repaid.

▪ Maturity Date: A specified date on which the par value of a bond

must be repaid.

▪ Most bonds have original maturities (the maturity at the time the
bond is issued) ranging from 10 to 40 years, but any maturity is
legally permissible.
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 Call Provision
▪ Most corporate and municipal bonds, but not Treasuries, contain a call
provision that gives the issuer the right to call the bonds for redemption.

▪ Call Provision- A provision in a bond contract that gives the issuer the right
to redeem the bonds under specified terms prior to the normal maturity date.

▪ The call provision generally states that the issuer must pay the bondholders
an amount greater than the par value if they are called. The additional sum,
which is termed a call premium, is often equal to one year’s interest.

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 Sinking Funds
▪ Sinking Fund Provision-A provision in a bond contract that requires
the issuer to retire a portion of the bond issue each year.

▪ In most cases, the issuer can handle the sinking fund requirement in
either of two ways:
1. It can call in for redemption, at par value, the required $5 million
of bonds. The bonds are numbered serially, and those called for
redemption would be determined by a lottery administered by the
trustee.
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2. The company can buy the required number of bonds on the open
market.
Other Features
▪ Convertible Bond -A bond that is exchangeable at the option of the
holder for the issuing firm’s common stock.

▪ Warrant-A long-term option to buy a stated number of shares of

common stock at a specified price.

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▪ Putable Bond -A bond with a provision that allows its investors to sell
it back to the company prior to maturity when interest rates in the
market rise. investors will put the bonds back to the company and
reinvest in higher coupon bonds.

▪ Income Bond-A bond that pays interest only if it is earned.

▪ Indexed (Purchasing Power) Bond- A bond that has interest

payments based on an inflation index so as to protect the holder from
inflation.

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 BOND VALUATION

▪ The value of any financial asset—a stock, a bond, a lease, or even physical
assets such as apartment buildings or pieces of machinery—is simply the
present value of the cash flows the asset is expected to produce.

▪ The cash flows for a standard coupon-bearing bond, like those of Allied
Foods’, consist of interest payments during the bond’s 15-year life plus the
amount borrowed (generally the par value) when the bond matures.

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Market rate of interest

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Maturity date

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Interest Payments

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The Par

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 B. Reinvestment Rate Risk
▪ As we saw in the preceding section, an increase in interest rates
hurts bondholders because it leads to a decline in the current value of
a bond portfolio. But can a decrease in interest rates also hurt
bondholders? Actually, the answer is yes because if interest rates fall,
long-term investors will suffer a reduction in income.

▪ Reinvestment Rate Risk: The risk that a decline in interest rates will
lead to a decline in income from a bond portfolio.

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 Comparing Interest Rate and Reinvestment
Rate Risk
▪ Note that interest rate risk relates to the current market value of the
bond portfolio, while reinvestment rate risk relates to the income the
portfolio produces.

▪ If you hold long-term bonds, you will face significant interest rate
price risk because the value of your portfolio will decline if interest
rates rise, but you will not face much reinvestment rate risk because
your income will be stable.
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▪ On the other hand, if you hold short-term bonds, you will not be exposed
to much interest rate price risk, but you will be exposed to significant
reinvestment rate risk.

▪ Which type of risk is “more relevant” to a given investor depends critically

on how long the investor plans to hold the bonds—this is often referred to
as his or her investment horizon.

▪ Investment Horizon: The period of time an investor plans to hold a

particular investment.

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 Default Risk
▪ Potential default is another important risk that bondholders face. If the issuer
defaults, investors will receive less than the promised return. Higher the
probability of default, the higher the premium and thus the yield to maturity.
Default risk on Treasuries is zero, but this risk is substantial for lower-grade
corporate and municipal bonds.

▪ To illustrate, suppose two bonds have the same promised cash flows—their

coupon rates, maturities, liquidity, and inflation exposures are identical; but one

has more default risk than the other. Investors will naturally pay more for the

one with less chance of default.

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 Various Types of Corporate Bonds
▪ Default risk is influenced by the financial strength of the issuer and the
terms of the bond contract, including whether collateral has been pledged to
secure the bond. The characteristics of some key types of bonds are
described in this section.

1. Mortgage Bond: A bond backed by fixed assets. First mortgage bonds

are senior in priority to claims of second mortgage bonds.

2. Indenture: A formal agreement between the issuer and the bondholders.

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3. Debenture: is an unsecured bond; and as such, it provides no specific
collateral as security for the obligation. a debenture is also defined as a long-
term bond that is not secured by a mortgage on specific property. Therefore,
debenture holders are general creditors whose claims are protected by property
not otherwise pledged.

4. Subordinated Debenture: A bond having a claim on assets only after the

senior debt has been paid off in the event of liquidation. The term subordinate
means “below” or “inferior to”; and in the event of bankruptcy, subordinated
debt has a claim on assets only after senior debt has been paid in full.

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 Bond Ratings
▪ Since the early 1900s, bonds have been assigned quality ratings that reflect
their probability of going into default. The three major rating agencies are
Moody’s Investors Service (Moody’s), Standard & Poor’s Corporation
(S&P), and Fitch

▪ Investment-Grade Bond: Bonds rated triple-B or higher; many banks and

other institutional investors are permitted by law to hold only investment
grade bonds.

▪ Junk Bond: A high-risk, high-yield bond.

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 Bond Rating Criteria
Bond ratings are based on financial ratios such as those discussed in Chapter 4 and
on various qualitative factors.

Following is an outline of the determinants of bond ratings:

1. Financial Ratios. All of the ratios are potentially important, but the debt and
interest coverage ratios are key. The rating agencies’ analysts go through a financial
analysis and forecast future ratios along the lines described in the financial planning
and forecasting.

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2. Qualitative Factors: Bond Contract Terms. Every bond is covered by a contract,
often called an indenture, between the issuer and the bondholders. The indenture
spells out all the terms related to the bond.

3. Miscellaneous Qualitative Factors. Included here are issues like the sensitivity
of the firm’s earnings to the strength of the economy, the way it is affected by
inflation, a statement of whether it is having or likely to have labor problems, the
extent of its international operations, potential environmental problems, and
potential antitrust problems.

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 Importance of Bond Ratings
▪ Bond ratings are important to both firms and investors.

▪ First, because a bond’s rating is an indicator of its default risk, the rating has a
direct, measurable influence on the bond’s interest rate and the firm’s cost of debt.

▪ Second, most bonds are purchased by institutional investors rather than

individuals and many institutions are restricted to investment-grade
securities. Thus, if a firm’s bonds fall below BBB, it will have a difficult time
selling new bonds because many potential purchasers will not be allowed to buy
them.

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 Bankruptcy and Reorganization
▪ When a business becomes insolvent, it doesn’t have enough cash to meet its interest and
principal payments. A decision must then be made whether to dissolve the firm through
liquidation or to permit it to reorganize and thus continue to operate.

▪ The decision to force a firm to liquidate versus permitting it to reorganize depends on whether the
value of the reorganized business is likely to be greater than the value of its assets if they were sold
off piecemeal.

▪ In a reorganization, the firm’s creditors negotiate with management on the terms of a potential
reorganization. The reorganization plan may call for restructuring the debt, in which case the
interest rate may be reduced, the term to maturity lengthened, or some of the debt exchanged for
equity.

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 Bond Markets
▪ Corporate bonds are traded primarily in the over-the-counter market. Most bonds
are owned by and traded among large financial institutions (for example, life
insurance companies, mutual funds, hedge funds, and pension funds, all of which
deal in very large blocks of securities), and it is relatively easy for over-the-
counter bond dealers to arrange the transfer of large blocks of bonds among the
relatively few holders of the bonds.

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