2. Chapter Bond

• the promised interest payments of a bond

• usually paid semianually but the frequency is specified in the bond certificate

• the amount paid is equal to

—> (coupon rate x face value) / (number of coupon payments per year)

• Companies can raise debt using different sources.

• Typical kinds of debt are public debt, which trades in a public market,

• private debt, which is negotiated directly with a bank or a small group of investors.

• The securities that companies issue when raising debt are called corporate bonds.

• states the term of the bond as well as the amounts and dates of all payments to be made

• Final repayment date of the bond

• Payments continue until this date

• The notional amount used to compute the the interest payment

• It is usually repaid on the maturity date

• also calles par value

The time remaining until the repayment date

• It is called “zero coupon Bond”

• Zero-coupon bonds make no coupon payments, so investors receive only the bond’s face value

• Calculation of yield to maturity of a zero coupon bond

• The risk-free interest rate for an investment until date n equals the yield to maturity of a risk-free zero-coupon bond that matures on date n.

• A plot of these rates against maturity is called the zero-coupon yield curve

• The rate of return of a bond is called its yield to maturity (or yield).

• The yield to maturity of a bond is the discount rate that sets the present value of the promised bond payments equal to the current market price of the bond

• The yield to maturity (YTM) for a coupon bond is the discount rate, y, that equates the present value of the bond’s future cash flows with its price

• A bond will trade at a premium if its coupon rate exceeds its yield to maturity.

• It will trade at a discount if its coupon rate is less than its yield to maturity.

• If a bond’s coupon rate equals its yield to maturity, it trades at par.

• As a bond approaches maturity, the price of the bond approaches its face value.

• Bond prices change as interest rates change. When interest rates rise, bond prices fall, and vice versa.

• Long-term zero-coupon bonds are more sensitive to changes in interest rates than short-term zero coupon bonds.

• The graphs illustrate changes in price and yield for a 30-year zero-coupon bond over its life. Panel (a) illustrates the changes in the bond’s yield to maturity (YTM) over its life.

• In Panel (b), the actual bond price is shown in blue. Because the YTM does not remain constant over the bond’s life, the bond’s price fluctuates as it converges to the face value over time.

• Also shown is the price if the YTM remained fixed at 4%, 5%, or 6%. Panel (a) shows that the bond’s YTM mostly remained between 4% and 6%. The broken lines in Panel (b) show the price of the bond if its YTM had remained constant at those levels.

• When a bond issuer does not make a bond payment in full, the issuer has defaulted.

• The risk that default can occur is called default or credit risk.

• United States Treasury securities are deemed to be free of default risk.

• The expected return of a corporate bond, which is the firm’s debt cost of capital, equals the risk-free rate of interest plus a risk premium.

• The expected return is less than the bond’s yield to maturity because the yield to maturity of a bond is calculated using the promised cash flows, not the expected cash flows.

• The difference between yields on Treasury securities and yields on corporate bonds is called the credit spread or default spread.

• The credit spread compensates investors for the difference between promised and expected cash flows and for the risk of default.

• Not just interest rates fluctuate over time, also spreads narrow and widen as investor´s “appetite for risk” is in constant flux

• For public offerings, the bond agreement takes the form of an indenture(Anleihe), a formal contract between the bond issuer and a trust company.

• Three types of corporate bonds are typically issued:

• debentures (Anleihen)

• mortgage bonds (hypothken anleihen)

• asset-backed bonds.

• Corporate bonds differ in their level of seniority.

• domestic bonds that trade in foreign markets

• foreign bonds that are issued in a local market by a foreign entity;

• Eurobonds that are not denominated in the local currency of the country in which they are issued

• global bonds that trade in several markets simultaneously.

• The give assurance through restrictions

• Covenants are restrictive clauses in the bond contract

• help investors by limiting the issuer’s ability to take actions that increase its default risk (lower the value)

• Issuing new debt: new debt must be subordinated to existing debt —> no new debt unless firm maintains specific leverage (Sicherheit) or interest coverage interest

• Dividends and share repurchases: payout can only be made from earnings generated after the bond issue —> Payouts can be made only if earnings exceed some treshold(Schwellenwert)

• Merges & Acquistions: Mergers are allowed only if the combined firm has a minimum ratio of net tangible assets to debt

• Asset disposition: Maximum amount of assets that can be sold, and/or minimum amount of assets that must be maintained. Restrictions on making loans or any other provision of credit

• Maintenance of accounting measures: Minimum retained earnings, working capital, and/or net assets —> max leverage ration

• A call provision gives the issuer of the bond the right (but not the obligation) to retire the bond after a specific date (but before maturity).

• A callable bond will generally trade at a lower price than an otherwise equivalent non-callable bond.

• The yield to call is the yield of a callable bond assuming that the bond is called at the earliest opportunity.

• Another way in which a bond is repaid before maturity is by periodically repurchasing part of the debt through a sinking fund.

• Some corporate bonds, known as convertible bonds, have a provision that allows the holder to convert them into equity.

• Convertible debt carries a lower interest rate than other comparable non-convertible debt.

• A financial manager will choose to exercise the firm’s right to call the bond only if the market price of the bond exceeds the call price.

• Naturally, investors view this possibility negatively and pay less for callable bonds than for otherwise identical non-callable bonds.

• Call Provisions in real life can be fairly sophisticated:

• Corporations have limited liability.

• If companies are unable to pay their debts, they can file for bankruptcy.

• Lenders are aware that they may receive less than they are owed, and that the expected yield on a corporate bond is less than the promised yield.

• Because of the possibility of default, the promised yield on a corporate bond is higher than on a government bond.

• This extra yield is the amount that you would need to pay to insure the bond against default.

• These policies are called credit default swaps.

• There are no free lunches in financial markets.

• the extra yield you get for buying a corporate bond is eaten up by the cost of insuring against default.

• The company’s option to default is equivalent to a put option.

• If the value of the firm’s assets is less than the amount of the debt, it will pay for the company to default and to allow the lenders to take over the assets in settlement of the debt.

• The spread between the yield on a corporate bond and the yield on a comparable government issue compensates for the possibility of default.

• Spreads can change rapidly as investors reassess the chances of default or become more or less risk-averse.

• When investors want a measure of the risk of a company’s bonds, they usually look at the rating that has been assigned by Moody’s, Standard & Poor’s, or Fitch.

• If the quality of the bonds deteriorates due to higher default risk, investors will demand a higher yield and the bond price will fall.