Bonds
Equity financing – ownership or part ownership
Debt – loans
Bonds – a fixed income instrument that represents loan forwarded by a lender to a
borrower. Coupon payments are the interest payments you receive from bonds
Bonds are issued by government (treasury bonds) and corporations (corporate
bonds). They have maturity dates at which point principal amount must be paid back
in full or risk default.
Borrower, bond issuers – needs money
Lender, bond holders – savers
Default risk – the chances that the borrower will not pay the money back
You can sell your bonds to get your principal back. You will then obviously not
receive the coupon payments.
Treasury Bonds
Government needs money to run the affairs. Their main income is taxes, often it is
not enough (budget deficit) so they raise money in the form of treasury bonds.
Treasury bonds are a longer term, treasury notes are short-term discount securities
redeemable at face value on maturity. They have shorter maturity than T-bonds.
These bonds have no default risk.
Treasury indexed bonds – government bonds that are adjusted for inflation. Principal
and coupon payments are both adjusted.
State government bonds – semi-government securities or “semis”. Their trading price
is lower than that for an otherwise identical Commonwealth Government Securities
(CGS), hence higher yield since they are not considered risk free.
Corporate bonds
Debt contracts that require borrowers to make periodic payments (interest) and
principal at maturity.
An unsecured note is a bond that has no specified security attached as collateral in
the case of default.
A debenture is a type of debt instrument that is not backed by any collateral and
usually has a term greater than 10 years. Debentures are backed only by the
creditworthiness and reputation of the issuer.
1. Coupon bonds: basic bond characteristics
2. Zero coupon bonds: no coupon payments(interest) single payment at the end.
Sold way below their face value
3. Convertible bonds: can be converted into ordinary shares at some predetermined ratio at the bondholder’s discretion. Bondholder pays premium for
conversion provision.
Bond Valuation. Price = Present Value of all future cash flows
1. Estimate the expected future cash flows
a. Coupon payment – Coupon ($) = Coupon rate x FV
b. FV face value
2. Determine the discount rate/market interest rate/yield to maturity
3. Calculate the present value of Future Value
Calculating PV in the case of annuity
𝑃𝑏𝑜𝑛𝑑 = 𝑃𝑉(𝐶𝑜𝑢𝑝𝑜𝑛 𝑝𝑎𝑦𝑚𝑒𝑛𝑡𝑠) + 𝑃𝑉(𝐹𝑉)
=
Sample Question
FV = $1000
Coupon rate CR = 5%
Market interest rate = 8%
𝐶
1
𝐹𝑉
[1 −
]+
𝑛
(1 + 𝑖)
(1 + 𝑖)𝑛
𝑖
Maturity = 10 years
Price = ?
1. Estimate the expected future cash flows
𝑎. 𝐹𝑉 = 1000
𝑏. 𝐶𝑜𝑢𝑝𝑜𝑛 𝑃𝑎𝑦𝑚𝑒𝑛𝑡𝑠($) = 𝐶𝑅 𝑥 𝐹𝑉
= 0.05 𝑥 1000
= $50
2. Determine the discount rate
𝑖 = 8% 𝑜𝑟 0.08
3. Calculate the price of the bond
𝐶
1
𝐹𝑉
𝑃𝑏𝑜𝑛𝑑 = [1 −
]
+
(1 + 𝑖)𝑛
(1 + 𝑖)𝑛
𝑖
50
1
1000
=
[1 −
]
+
(1 + 0.08)10
(1 + 0.08)10
0.08
1
1000
= 625 [1 −
]+
10
(1.08)
(1.08)10
1
1000
= 625 [1 −
]+
2.15892
2.15892
= 625[1 − 0.4631] + 463.19
= 625[0.5369] + 463.19
= 355.56 + 463.19
= $798.75
Par, premium, and discount bonds
i > coupon rate – the bond sells for a discount
i < coupon rate – the bond sells for a premium
i = coupon rate - the bond sells at par value
Interest rate risk
The price of the bond fluctuates with changes in interest rates, giving rise to interest
rate risk. Increased interest rate motivates the lender to invest in other places,
decreasing the price of bonds. Decreased interest rates will increase the price of
bonds.
Default
If a borrower does not keep their promise to make payments on their debt this is
called default. The default risk is the chance of this happening.
Default risk premium
The size of the premium has two components
- Compensation for the expected loss if a default occurs and
- Compensation for bearing the risk that a default could occur.
𝐷𝑅𝑃 = 𝑖𝑑𝑟 − 𝑖𝑟𝑓
Shares
Equity – ownership entitlement only by corporations
Shares/stocks – income you receive is called dividend (residuals), not fixed or
guaranteed
The performance of the share market is an important barometer of the country’s
economic health.
Primary market (initial public offering IPO) – new shares. Investors are not public,
big investors.
Secondary market – outstanding shares are bought and sold among investors,
public.
-
Direct search – no third party involved. Buyers and sellers must seek each
other out directly (word of mouth).
Brokered – brokers bring buyers and sellers together to earn a fee, a
commission.
Dealer – third party specialist, dealer owns shares buys shares in bulk at
cheap (bid price) and then sells them for a higher price (offer/ask price).
Auction – buyers and sellers confront each other directly and bargain over
price.
Types of shares
-
Ordinary shares/common stock
– no guaranteed dividends (profit).
– If profit is reinvested into the company, the value of your
investment/share’s increases.
– Residuals (lowest priority)
– Voting right (can affect management)
– No maturity, life is indefinite
-
Preference share
– Guaranteed dividends
– Priority (high over common stock)
– No voting rights
– Some preference shares are convertible into ordinary
– Often have credit ratings like bonds
– Most preference shares are not true perpetuities.