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 4, 2018, Allied Food Products borrowed $170
million by issuing $170 million of bonds. For convenience, we assume that
Allied sold 170,000 individual bonds for $1,000 each. Actually, it could
have sold one $170 million bond, 17 bonds each with a $10 million face
value, or any other combination that totaled $170 million. In any event,
Allied received the $170 million, and in exchange, it promised to make
annual interest payments and to repay the $170 million on a specified
maturity date.
• Treasury bonds - generally called Treasuries and sometimes referred
to as government bonds, are issued by the federal government.It is
reasonable to assume that the U.S. government will make good on its
promised payments, so Treasuries have no default risk. However,
these bonds’ prices do decline when interest rates rise; so they are
not completely riskless.
• Corporate bonds - issued by business firms. Corporates are exposed
to default risk—if the issuing company gets into trouble, it may be
unable to make the payments. Corporate bonds have different levels
of default risk depending on the issuing company’s characteristics and
the terms of the specific bond. Default risk is often referred to as
“credit risk,” the larger this risk, the higher the interest rate investors
demand.
• Municipal bonds, or munis bonds - issued by state and local
governments. Exposed to some default risk. The market interest rate
on a muni is considerably lower than on a corporate bond of
equivalent risk.
• Foreign bonds - issued by a foreign government or a foreign
corporation. All foreign corporate bonds are exposed to default risk,
as are some foreign government bonds.
Key Characteristics of Bonds
• 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., $10,000 or $10 million) can be used.
- The par value generally represents the amount of money the firm
borrows and promises to repay on the maturity date.
• COUPON INTEREST RATE
 Coupon Payment is the specified number of dollars of interest paid each
year.
 Coupon Interest Rate - the stated annual interest rate on a bond.
 -Fixed-Rate Bonds - Bonds whose interest rate is fixed for their entire
life
 Floating-Rate Bonds - Bonds whose interest rate fluctuates with shifts in
the general level of interest rates.
 Zero Coupon Bonds - Bonds that pay no annual interest but are 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.
• MATURITY DATE
A specified date on which the par value of a bond must be repaid.
Allied’s bonds, which were issued on January 4, 2018, will mature on
January 3, 2033; thus, they had a 15-year maturity at the time they
were issued.
Original Maturity - The number of years to maturity at the time a
bond is issued.
Allied’s bonds had a 15-year original maturity. But in 2019, a year later,
they will have a 14-year maturity; a year after that, they will have a 13-
year maturity; and so on.
• CALL PROVISIONS
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 1 year’s interest.
For example, the call premium on a 10-year bond with a 10% annual coupon
and a par value of $1,000 might be $100, which means that the issuer would
have to pay investors $1,100 (the par value plus the call premium) if it wanted
to call the bonds.
Also, although some bonds are immediately callable, in most cases, bonds are
often not callable until several years after issue, generally 5 to 10 years. This is
known as a deferred call, and such bonds are said to have call protection
Refunding Operation - a company sold bonds when interest rates
were relatively high. Provided the issue is callable, the company
could sell a new issue of low-yielding securities if and when interest
rates drop, use the proceeds of the new issue to retire the high-rate
issue, and thus reduce its interest expense.
• 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.
- Though, sinking fund provisions require the issuer to buy back a
specified percentage of the issue each year. A failure to meet the
sinking fund requirement constitutes a default, which may throw the
company into bankruptcy. Therefore, a sinking fund is a mandatory
payment.
Suppose a company issued $100 million of 20-year bonds and it is
required to call 5% of the issue, or $5 million of bonds, 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.
2. The company can buy the required number of bonds on the open
market.
Other Features
• Convertible Bonds - Bonds that are exchangeable at the option of the
holder for the issuing firm’s common stock.
• Warrants - Long-term options to buy a stated number of shares of
common stock at a specified price.
• Putable Bonds - Bonds with a provision that allows investors to sell
them back to the company prior to maturity at a prearranged price.
• 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.
Bond Valuation
• Discount Bond - A bond that sells below its par value; occurs
whenever the going rate of interest is above the coupon rate.
• Premium Bond - A bond that sells above its par value; occurs
whenever the going rate of interest is below the coupon rate.
Bond Yields
• The bond’s yield should give us an estimate of the rate of
return we would earn if we purchased the bond today and
held it over its remaining life.
• If the bond is not callable, its remaining life is its years to
maturity.
• If it is callable, its remaining life is the years to maturity if it is
not called or the years to the call if it is called.
YIELD TO MATURITY
• Yield to Maturity (YTM) - The rate of return earned on a bond if it is
held to maturity
• Suppose you were offered a 14-year, 10% annual coupon, $1,000 par
value bond at a price of $1,494.93. What rate of interest would you
earn on your investment if you bought the bond, held it to maturity,
and received the promised interest payments and maturity value?
YIELD TO CALL
• The rate of return earned on a bond when it is called before its
maturity date.
Assessing a Bond’s Riskiness
• Price (Interest Rate) Risk - The risk of a decline in a bond’s price due
to an increase in interest rates.
To illustrate, refer back to Allied’s bonds; assume once more that they
have a 10% annual coupon, and assume that you bought one of these
bonds at its par value, $1,000. Shortly after your purchase, the going
interest rate rises from 10% to 15%.10 As we saw in Section 7-3, this
interest rate increase would cause the bond’s price to fall from $1,000
to $707.63, so you would have a loss of $292.37 on the bond.11
Because interest rates can and do rise, rising rates cause losses to
bondholders; people or firms who invest in bonds are exposed to risk
from increasing interest rates.
• Price risk is higher on
bonds that have long
maturities than on
bonds that will mature
in the near future.
• This follows because
the longer the maturity,
the longer before the
bond will be paid off
and the bondholder can
replace it with another
bond with a higher
coupon.
• Reinvestment Risk - The risk that a decline in interest rates will lead to a
decline in income from a bond portfolio.
If interest rates fall, long-term investors will suffer a reduction in income.
For example, consider a retiree who has a bond portfolio and lives off the
income it produces. The bonds in the portfolio, on average, have coupon
rates of 10%. Now suppose interest rates decline to 5%. Many of the
bonds will mature or be called; as this occurs, the bondholder will have to
replace 10% bonds with 5% bonds. Thus, the retiree will suffer a
reduction of income.
Reinvestment risk is obviously high on callable bonds. It is also high on
short-term bonds because the shorter the bond’s maturity, the fewer the
years before the relatively high old coupon bonds will be replaced with
the new low-coupon issues
COMPARING PRICE RISK AND
REINVESTMENT RISK
• Price risk relates to the current market value of the bond portfolio,
while reinvestment risk relates to the income the portfolio
produces.
• If you hold long term bonds, you will face significant price risk
because the value of your portfolio will decline if interest rates rise,
but you will not face much reinvestment risk because your income
will be stable.
• On the other hand, if you hold short-term bonds, you will not be
exposed to much price risk, but you will be exposed to significant
reinvestment risk.
• Investment Horizon - The period of time an investor plans to hold a
particular investment.
• Duration - The weighted average of the time it takes to receive each
of the bond’s cash flows.
VARIOUS TYPES OF CORPORATE
BONDS
• Mortgage Bond - A bond backed by fixed assets. First mortgage bonds
are senior in priority to claims of second mortgage bonds.
All mortgage bonds are subject to an indenture, which is a legal
document that spells out in detail the rights of the bondholders and
the corporation.
Indenture - A formal agreement between the issuer and the
bondholders.
• Debenture - A long-term bond that is not secured by a mortgage on
specific property.
• Subordinated Debentures - Bonds having a claim on assets only after
the senior debt has been paid in full in the event of liquidation