3.
1 Bonds and Bonds Valuation
1

 A long-term debt instrument in which a borrower agrees to make payments of principal and interest, on specific dates, to the holders of the bond.
 A bond is a security that obligates the issuer to make specified interest and principal payments to the holder on specified dates.
• Coupon rate
• Face value (or par)
• Maturity (or term)
 Bonds are sometimes called fixed income securities .
 Bond is normally an interest-only loan, meaning that the borrower will pay the interest every period, but none of the principal will be repaid until the end of the loan.
2








Par value or face value – face amount of the bond, which is paid at maturity (assume $1,000).
Bond that sells for its par value is called a par value bond
Coupon interest rate – stated interest rate (generally fixed) paid by the issuer. Multiply by par to get dollar payment of interest.
Because the coupon is constant and paid every year, the type of bond we are describing is sometimes called a level coupon bond.
Maturity date – years until the bond must be repaid.
Issue date – when the bond was issued.
Yield to maturity (YTM) - rate of return earned on a bond held until maturity (also called the “promised yield”).
3


Bonds pay fixed coupon (interest) payments at fixed intervals
(usually every 6 months) and pay the par value at maturity.
$I $I $I $I $I $I+$M
0 1 2 example: AT&T 9s of 2018 par value = $1000 coupon = 9% of par value per year.
= $90 per year ($45 every 6 months).
maturity = 20 years.
issued by AT&T.
. . .
n
4

0 par value = $1000 coupon = 9% of par value per year.
= $90 per year ($45 every 6 months).
maturity = 20 years.
issued by AT&T.
$45 $45 $45 $45 $45 $45+$1000
1 2 . . .
20
5

 Pure Discount or Zero-Coupon Bonds (Zeroes)
• Pay no coupons prior to maturity.
• Pay the bond’s face value at maturity.
• Priced at a deep discount.

Coupon Bonds
• Pay a stated coupon at periodic intervals prior to maturity.
• Pay the bond’s face value at maturity.
 Perpetual Bonds (Consols)
• No maturity date.
• Pay a stated coupon at periodic intervals.
6



Self-Amortizing Bonds

Pay a regular fixed amount each payment period over the life of the bond.

Principal repaid over time rather than at maturity.
Debentures –
• unsecured bonds.
 Subordinated debentures –
• unsecured “junior” debt.
 Mortgage bonds –
• secured bonds.
 Junk bonds –
• speculative or below-investment grade bonds; rated BB and below.
7

 Eurobonds - bonds denominated in one currency and sold in another country. (Borrowing overseas).
 example - suppose Disney decides to sell $1,000 bonds in France.
These are U.S. denominated bonds trading in a foreign country.
Why do this?
• If borrowing rates are lower in France,
• To avoid SEC regulations.
8

Other types (features) of bonds
 Convertible bond – may be exchanged for common stock of the firm, at the holder’s option.
 Warrant – long-term option to buy a stated number of shares of common stock at a specified price.
 Putable bond – allows holder to sell the bond back to the company prior to maturity.
 Income bond – pays interest only when income is earned by the firm.
 Indexed bond – interest rate paid is based upon the rate of inflation.
9

 Bond market is bigger in value than stock market.
 Largest securities market in the world is not NYSE but U.S.
Treasury Market.


Primarily traded in the over-the-counter (OTC) market.
This means that there’s no particular place where buying and selling occur.
 Instead dealers around the country (and around the world) stand ready to buy and sell and they are connected electronically.
 Most bonds are owned by and traded among large financial institutions.
 Full information on bond trades in the OTC market is not published, but a representative group of bonds is listed and traded on the bond division of the NYSE.
10

 Because Bond market is almost entirely OTC, it has little or no transparency.
 It is near to impossible to get the information on price and quantity of transactions because transactions are privately negotiated between parties, and there is little of no centralized reporting of transactions.
11

 Federal Government and its Agencies
 Local Municipalities
 Corporations
12

n n n
Treasury Bills
 No coupons (zero coupon security)
 Face value paid at maturity
 Maturities up to one year
Treasury Notes
 Coupons paid semiannually
 Face value paid at maturity
 Maturities from 2-10 years
Treasury Bonds
 Coupons paid semiannually
 Face value paid at maturity
 Maturities over 10 years
 The 30-year bond is called the long bond .
13

 Mortgage-Backed Bonds
 Bonds issued by U.S. Government agencies that are backed by a pool of home mortgages.
 Self-amortizing bonds.
 Maturities up to 20 years.
14

•
•
•
•
No default risk. Considered to be riskfree .
Exempt from state and local taxes.
Sold regularly through a network of primary dealers.
Traded regularly in the over-the-counter
(OTC) market.
15

•
•
•
•
•
Maturities from one month to 40 years.
Exempt from federal, state, and local taxes.
Riskier than U.S. Government bonds.
Rated much like corporate issues.
They are almost always callable.
16

•
 Secured Bonds (Asset-Backed)
 Secured by real property
 Ownership of the property reverts to the bondholders upon default.
Debentures
 General creditors
 Have priority over stockholders, but are subordinate to secured debt.
17

•
•
•
•
•
Senior versus subordinated bonds
Convertible bonds
Callable bonds
Putable bonds
Sinking funds
18




Some bonds may be converted to common stock.
Can be swapped for a fixed number of shares of stock anytime before maturity at the holder’s option.
Is this a benefit to the investor?
Yes !
19

 Allows issuer to refund the bond issue if rates decline (helps the issuer, but hurts the investor).
 Borrowers are willing to pay more, and lenders require more, for callable bonds.
 Most bonds have a deferred call and a declining call premium.
20

 Provision to pay off a loan over its life rather than all at maturity.
 Similar to amortization on a term loan.
 Reduces risk to investor, shortens average maturity.
 But not good for investors if rates decline after issuance.
21

 In general,
The intrinsic value of an asset = the present value of the stream of expected cash flows discounted at an appropriate required rate of return.
 Can the intrinsic value of an asset differ from the market value?
YES
22

0 r
Value
1
CF
1
2
...
CF
2
Value

(1
CF
1
 r)
1

(1
CF
2
 r)
2

...

(1
CF n
 r) n n
CF n
23

 Determining the value of a bond requires:
• An estimate of expected cash flows
• An estimate of the required return
 Assumptions:
• The coupon interest rate is fixed for the term of the bond
• The coupon payments are made annually and the next coupon payment is receivable exactly a year from now
• The bond will be redeemed at par on maturity.
• The bond is non-callable.
24

P
 t n 

1
C
( 1
 r ) t

M
( 1
 r ) n
Since the stream of coupon payment is an ordinary annuity,
P

C

PIVFA r, n

M

PVIF r , n where ,
P

value of bond n
 number of years to maturity
C
 annual coupon payment (interest on bond) r
 periodic required return (yield required)
M
 maturity v alue t

time period when the payment is received 25

Consider a 10 year, 12 % coupon bond with a par value of Rs 1000. Let the required yield on this bond is 13%.
•
•
The cash flows for this bond are as follows:
10 annual coupon payment of Rs 120
Rs 1000 principal repayment 10 years from now
P

120

PIVFA
13%,10 yrs

1000

PVIF
13 %, 10 yrs

Rs 946.1
26

P
 t
2  n

1
( 1

C
2 r
2
) t

( 1

M r
2
)
2 n
Since the stream of coupon payment is an ordinary annuity,
P
 C
2

PIVFA r
2
,2n

M

PVIF r
2
, 2 n where ,
P

value of bond
2n
 number of half yearly periods to maturity
C
2
 semi annual coupon payment (interest on bond) t r
2
 periodic

time period required
when the return for payment half is year period received 27

What is the market price of a U.S. Treasury bond that has a coupon rate of 9%, a face value of $1,000 and matures exactly 10 years from today if the required yield to maturity is 10% compounded semiannually?
0 6 12 18 24 ... 120
45 45 45 45 1045
Months
P

45

PVIFA
5 %, 20

1000

PVIF
5 %, 20

$ 937 .
69
28

 To determine the value of a bond at a particular point in time, we need to know:
• Number of periods remaining until maturity
• The Face Value of the Bond
• The Coupon (Interest)
• The market interest rate for bond with similar features. (Yield To Maturity – YTM)
 Interest rate required in the market on particular bond type is called the bond’s YTM or simply YIELD of the bond.
29

The case of coupon bonds
 Suppose you purchase the U.S. Treasury bond described earlier (Example 2) and immediately thereafter interest rates fall so that the new yield to maturity on the bond is 8% compounded semiannually.
What is the bond’s new market price?
 Suppose the interest rises, so that the new yield is 12% compounded semiannually. What is the market price now?
 Suppose the interest equals the coupon rate of 9%.
What do you observe?
30

 New Semiannual yield = 8%/ 2 = 4%
 What is the price of the bond if the yield to maturity is 8% compounded semiannually?
P

45

PVIFA
4 %, 20

1000

PVIF
4 %, 20

$ 1067 .
95
 Similarly:
• If r=12%: P =$ 827.95
• If r= 9%: P =$ 1,000.00
31


S’pose our firm decides to issue 20-year bonds with a par value of $1,000 and annual coupon payments. The return on other bonds of similar risk is currently 12%, so we decide to offer a
12% coupon interest rate.

What would be a fair price for these bonds?
32

120 120
1000
120 . . . 120
0 1 2 3 . . .
Period/Yr = 1
N = 20 r% per year = 12
FV = 1,000
Coupon = 120
Solution:
P = $1,000
20
Note: If the coupon rate = yield, the bond will sell for par value.
33

 Suppose interest rates fall immediately after we issue the bonds. The required return on bonds of similar risk drops to 10% i.e. Yield falls to
10 %
 What would happen to the bond price?
34

Period/Yr = 1
N = 20 r% per Year = 10
Coupon = 120
FV = 1000
Solution:
P = $1,170.27
Note: If the coupon rate > yield, the bond will sell for a premium.
35

 Suppose interest rates rise immediately after we issue the bonds. The required return on bonds of similar risk rises to 14%.
 What would happen to the bond price?
36

Period/Yr = 1
N = 20 r% per year = 14
Coupon = 120
FV = 1000
Solution:
P = $867.54
Note: If the coupon rate < yield, the bond will sell for a discount.
37

 Bond prices are inversely related to interest rates
(or yields).
 A bond sells at par only if its coupon rate equals the required yield.
 A bond sells at a premium if its coupon rate is above the required yield.
 A bond sells at a discount if its coupon rate is below the required yield.
38




Consider two bonds with 10% annual coupons with maturities of 5 years and 10 years.
The yield is 8%
What are the responses to a 1% yield change?
Yield
8%
9%
% Change
7%
% Change
Average
5-year bond 10-year bond
$1,079.85
$1,038.90
-3.79%
$1,123.01
4.00%
3.89%
$1,134.20
$1,064.18
-6.17%
$1,210.71
6.75%
6.46%
 The sensitivity of a coupon bond increases with the maturity
39

Bond Price
Longer term bonds are more sensitive to changes in (yields)
Interest rates than shorter term bonds.
Premium
Par
Discount
10% 12% 14%
Yield
40

The problem
 Consider the following two bonds:
• Both have a maturity of 5 years
• Both have yield of 8%
• First has 6% coupon, other has 10% coupon, compounded annually.
 Then, what are the price sensitivities of these bonds to a 1% increase
(decrease) in bond yields?
Yield 6%-Bond 10%-Bond
8% $920.15
$1,079.85
9% $883.31
$1,038.90
% Change -4.00% -3.79%
7% $959.00
$1,123.01
% Change 4.22% 4.00%
Average 4.11% 3.89%
 Lesser coupon rate bonds are more sensitive to change in yield.
41






The risk that arises for bond owners from fluctuating interest rates is called interest rate risk.
How much interest rate risk a bond has, depends on how sensitive its price is to interest rate changes.
This sensitivity directly depends on two things:
1. The time to maturity
2. The coupon rate.
All other things being equal, the longer the time to maturity, the greater the interest rate risk.
All other things being equal, the lower the coupon rate, the greater the interest rate risk.
42

What is interest rate (or price) risk?
Interest rate risk is the concern that rising r will cause the value of a bond to fall.
% change 1 yr r
+4.8% $1,048 5%
$1,000
-4.4% $956
10%
15%
10yr
$1,386
$1,000
$749
% change
+38.6%
-25.1%
The 10-year bond is more sensitive to interest rate changes, and hence has more interest rate risk.
43



Reason that longer-term bonds have greater interest rate sensitivity:
• A large portion of a bond’s value comes from the discounting of face value at maturity,
• The PV of this amount isn’t greatly affected by a small change in interest rates if the amount is to be received in smaller years to maturity,
• Even a small change in the interest rate, however, once it is compounded for greater years to maturity, can have a significant effect on the present value.
Interest rate risk, increases at a decreasing rate.
• Diff of interest rate risk betn 1 yr bond and 10 yr bond is greater, but this diff is not that greater between 20 yr bond and
30 yrs bond
44

 Reasons that the bonds with lower coupons have greater interest rate risk:
• Value of the bond depends on the PV of coupons and the
PV of the face value.
• Value of one with the lower coupon is proportionately more dependent on the discounted value of face value.
• The bond with higher coupon has a larger cash flow early in its life, so its value is less sensitive to the changes in the discount rate.
45

What is reinvestment rate risk?
 Reinvestment rate risk is the concern that r will fall, and future CFs will have to be reinvested at lower rates, hence reducing income.
EXAMPLE: Suppose you just won
$500,000 playing the lottery. You intend to invest the money and live off the interest.
46

Reinvestment rate risk example
 You may invest in either a 10-year bond or a series of ten
1-year bonds. Both 10-year and 1-year bonds currently yield 10%.
 If you choose the 1-year bond strategy:
• After Year 1, you receive $50,000 in income and have
$500,000 to reinvest. But, if 1-year rates fall to 3%, your annual income would fall to $15,000.
 If you choose the 10-year bond strategy:
• You can lock in a 10% interest rate, and $50,000 annual income.
47

Conclusions about interest rate and reinvestment rate risk
Interest rate risk
Reinvestment rate risk
Short-term AND/OR
High coupon bonds
Long-term AND/OR Low coupon bonds
Low
High
High
Low
48

 At maturity, the value of any bond must equal its par value (assuming that there’s no risk of default)
 A bond that is redeemable for Rs 1,000 (which is its par value) after 5 years when it matures, will have a price of Rs 1,000 at maturity, no matter what the current price is.
 If r (yield) remains constant:
» The value of a premium bond would decrease over time, until it reached $1,000.
» The value of a discount bond would increase over time, until it reached $1,000.
» A value of a par bond stays at $1,000.
49

l
What would happen to the value of this bond if its required rate of return remained at
10%, or at 13%, or at 7% until maturity?
P
1,372
1,211
1,000
837
775 r = 10%.
r = 7%.
30 25 20 15 10 r = 13%.
5
Years
0 to Maturity
50

l l
The average annual rate of return investors expect to receive on a bond if they hold it to maturity.
Mathematically:
YTM of a bond is the interest rate that makes the present value of the cash flows receivable from owning the bond equal to the price of the bond.
P = $A (PVIFA r, n
) + $M (PVIF r, n
)
51

Suppose we paid $898.90 for a $1,000 par 10% coupon bond with 8 years to maturity and semi-annual coupon payments.
What is our yield to maturity?
52

Period/YR = 2
N = 16
PV = 898.90
Coupon per period = 50
FV = 1000
898.90 = 50 (PVIFA r, 16
) + 1000 (PVIF r, 16
)
Solution: r %= 12%
53

YTM

C

M
M

P

P n




Use the same formula with annual coupon and n as no. of years even if the coupon payment is semiannual.
(To find out approx
YTM)
54

Consider a Rs 1,000 par value bond, carrying a coupon rate of 9%, maturing after 8 years. The bond is currently selling for Rs 800. What is YTM on this bond ? The YTM is the value of r in the following equation:
800

90

PIVFA r,8 yrs

1000

PVIF r , 8 yrs
Hit and Trial Method:
 Try r = 12%, RHS = Rs 851.0


Try r = 14%, RHS = Rs 768.1
Try r = 13%, RHS = Rs 808.0
Thus, value of r lies between 13% and 14%.
Use linear interpolation to find exact value of r = 13.2%
55

YTM

0
90
.
4


( 1000
1000


0 .
800 )
6
8

800

13 .
1 %
The YTM calculation considers the current coupon income as well as the capital gain or loss the investor will realize by holding the bond to maturity. In addition, it takes into account the timing of the cash flows.
56

Approx YTM






C

M
M

3 n
P
2P




 or
Approx YTM






C

M
M
2
 n
-
P
P





Use the same formula with annual coupon and n as no. of years even if the coupon payment is semiannual.
(To find out approx
YTM)
57

Approx YTC






C

Call
Call price
3
Price n

-
2P
P




 or
Approx YTC






C

Call
2
Price n
Call Price

-
P
P




 l l l l
C = annual coupon payment n = term to call
Call price can be on premium sometimes .
Eg.
Call to premium of 9% means, bond will be called at the value 9% greater than the face value
58

Current yi eld (CY) 
Annual coupon payment
Current price
Capital gains yield (CGY) 
Change in
Beginning price price
Expected total return  YTM 


Expected
CY





Expected
CGY


59

An example:
Current and capital gains yield
Find the current yield and the capital gains yield for a 10-year, 9% annual coupon bond that sells for
$887, and has a face value of $1,000.
Current yield = $90 / $887
= 0.1015
= 10.15%
60

Find YTM = 10.91 %
YTM = Current yield + Capital gains yield
CGY = YTM – CY
= 10.91% - 10.15%
= 0.76%
Could also find the expected price one year from now and divide the change in price by the beginning price, which gives the same answer.
61

No coupon interest payments.
The bond holder’s return is determined entirely by the price discount.
Suppose you pay $508 for a bond that has 10 years left to maturity. What is your yield to maturity?
$508 $1000
0 10
PV = FV (PVIF r, n
)
508 = 1000 (PVIF r, 10
)
62

Period /Yr = 1
N = 10
P = 508
FV = 1000
Solution: r% per year = 7%
63

What is the current market price of a U.S. Treasury strip that matures in exactly 5 years and has a face value of $1,000. The yield to maturity is r=7.5%.
1000
5

$696 .
56
What is the yield to maturity on a U.S. Treasury strip that pays $1,000 in exactly 7 years and is currently selling for $591.11?
591 11

1000
1
 r
7
64

The case of zero coupon bonds
 Consider three zero-coupon bonds with maturity of 1 yr, 3 yrs and 5 yrs, all with
» face value of F=100
» yield to maturity of r=10%, compounded annually.
We obtain the following table:
Bond 1 Bond 2 Bond 3
Time / Bond value 10% $90.91
1 100
2
$75.13
0
0
$62.09
0
0
100 3
4
5
0
0
100
65

 Suppose the yield would drop suddenly to 9%, or increase to 10%. How would prices respond?
Yield Bond 1 Bond 2 Bond 3
1 Year
$90.91
3 Year
$75.13
5 Year
$62.09
10%
9% $91.74
% change 0.91%
$77.22
2.70%
$64.99
4.46%
11% $90.09
% change -0.91%
$73.12
-2.75%
$59.35
-4.63%
 Bond prices move up if the yield drops, decrease if yield rises
 Prices respond more strongly for higher maturities
66

 If an issuer defaults, investors receive less than the promised return. Therefore, the expected return on corporate and municipal bonds is less than the promised return.
 Influenced by the issuer’s financial strength and the terms of the bond contract.
67

Evaluating default risk:
Bond ratings
Moody’s
S & P
Investment Grade
Aaa Aa A Baa
AAA AA A BBB
Junk Bonds
Ba B Caa C
BB B CCC D
 Bond ratings are designed to reflect the probability of a bond issue going into default.


Bond ratings are an assessment of the creditworthiness of the bond issuer.
Bond ratings don’t address the issue of interest rate risk
68

Ba
B
Caa
Ca
C
Moody’s
Aaa
Aa
A
Baa
D
BB
B
CCC
CC
C
S&P
AAA
AA
A
BBB
-
Quality of Issue
Highest quality. Very small risk of default.
High quality. Small risk of default.
High-Medium quality. Strong attributes, but potentially vulnerable.
Medium quality. Currently adequate, but potentially unreliable.
Some speculative element. Long-run prospects questionable.
Able to pay currently, but at risk of default in the future.
Poor quality. Clear danger of default .
High specullative quality. May be in default.
Lowest rated. Poor prospects of repayment.
In default.
69

Factors affecting default risk and bond ratings l
Financial performance
» Debt ratio
» TIE ratio
» Current ratio l
Bond contract provisions
» Secured vs. Unsecured debt
» Senior vs. subordinated debt
» Guarantee and sinking fund provisions
» Debt maturity
70

Other factors affecting default risk l l l l l l
Earnings stability
Regulatory environment
Potential antitrust or product liabilities
Pension liabilities
Potential labor problems
Accounting policies
Want to know more about it ?
Visit: www.standardandpoors.com
www.moodys.com
www.fitchinv.com
71

 Indenture is the written agreement between the corporation (the borrower) and its creditors detailing the terms of the debt issue.


Usually a trustee (a bank, perhaps) is appointed by the corporation to represent the bondholders.
Trust company’s jobs:
• Making sure that the terms of the indenture are obeyed.
• Managing the sinking fund
• Representing the bondholders in default
72

 Bond indenture is a legal document and can run several hundred pages.
 Includes:
1. The basic terms of the bonds
2. The total amount of bonds issued
3. A description of property used as security
4. The repayment arrangements
5. The call provisions
6. Details of protective covenants
73

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Face Value / Par Value / Principal Value
Corporate bonds are usually in registered form.
This means that the company has a registrar who will record the ownership of each bond and changes on ownership.
For eg, it might read as:
Interest is payable semiannually on July 1 and January 1 of each year to the person in whose name the bond is registered at the close of business on June 15 or December 15 respectively.
A corporate bond may be registered and have attached
“coupon”
Alternatively, the bond could be in bearer form.
 Difficult to recover if they are lost or stolen
 Company cannot notify bondholders of important events.
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Debt securities are classified according to the collateral and mortgages used to protect the bondholder.
Collateral – general term that frequently means securities (for eg. Bonds and Stocks) that are pledged as security for payment of debt. However, the term collateral is commonly used to refer to any asset pledged on a debt.
 Mortgage securities are secured by a mortgage on the real property of the borrower.
 The property involved is usually real estate.
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 The legal document that describes the mortgage is called a mortgage trust indenture or trust deed.
 A blanket mortgage pledges all the real property owned by the company.
 A debenture is an unsecured bond, for which no specific pledge of property is made.
 Debenture holders only have a claim on property that remains after mortgages and collateral trusts are taken into account.
 Note is an unsecured debt usually with a maturity under 10 years.
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 Seniority indicates preference in position over other lenders and debts are sometimes labeled as senior or junior to indicate seniority.
 Some debt is subordinated
 The subordinated lenders will be paid off only after the specified creditors have been compensated.
 However, debt cannot be subordinated to equity.
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 Can be repaid at maturity.
 The may be repaid in part or in entirely before maturity.
 Early repayment in some form is more typical and is often handled through a sinking fund.
 A sinking fund is an account managed by the bond trustee for the purpose of repaying the bonds.
 The company makes annual payments to the trustee, who then uses the funds to retire a portion of debt.
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 The trustee does this by either buying up some of the bonds in the market or calling in a fraction of outstanding bonds (Call Provision)
 There are many different kinds of sinking fund arrangements:
• Some sinking fund start about 10 years after the initial issuance.
• Some sinking fund establish equal payments over the life of the bond.
• Some high quality bond issues establish payments to the sinking fund that are not sufficient to redeem the entire issue. As a consequence, there is the possibility of a large “balloon payment” at maturity.
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 Allows the company to repurchase or “call” part or all of the bond issue at the stated price over a specific period.
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Corporate bonds are usually callable.
Generally the call price is above the bond’s stated value (par value)
 The difference between the call price and the stated value is the call provision.
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The amount of the call premium usually becomes smaller over time.
Deferred call provision – Call protected bond – prohibited form calling the bonds for the first few years.
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 The part of indenture or loan agreement that limits certain actions a company might otherwise wish to take during the term of the loan.
 Classified into two types:
1. Negative Covenants
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2. Positive Covenants (affirmative)
A negative covenant is a “thou shalt not” type of covenant.
A positive covenant is “thou shalt” type of covenant.
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1.
The firm must limit the amount of dividends it pays according to some formula.
2.
The firm cannot pledge any assets to other lenders.
3.
The firm cannot merge with another firm.
4.
The firm cannot sell or lease any major assets without approval of the lender.
5.
The firm cannot issue additional long-term debt.
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1.
The company must maintain its working capital at or above some specified minimum level.
2.
The company must periodically furnish audited financial statements to the lender.
3.
The firm must maintain any collateral or security in good condition.
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3.
1 Bonds and Bonds Valuation
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