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Bond Valuation > Understanding Bonds
Understanding Bonds
• The Nature of Bonds
• Duration
• Indenture
• Ratings
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Bond Valuation > Understanding Bonds
The Nature of Bonds
• A bond is an instrument of indebtedness of the bond issuer to the holders. The
issuer owes the holders a debt and, depending on the terms of the bond, is
obliged to pay them interest (the coupon) and/or to repay the principal at a later
date, termed the maturity.
• Bonds provide the borrower with external funds to finance long-term investments,
or, in the case of government bonds, to finance current expenditure.
• Bonds and stocks are both securities, but the major difference between the two is
that (capital) stockholders have an equity stake in the company (i.e. they are
owners), whereas bondholders have a creditor stake in the company (i.e. they are
lenders).
A bond from the Dutch East India Company
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Bond Valuation > Understanding Bonds
Duration
• A good approximation for bond price changes due to yield is the duration, a
measure for interest rate risk.
• The Macaulay duration is the name given to the weighted average time until cash
flows are received and is measured in years. It really makes sense only for an
instrument with fixed cash flows.
• The modified duration is the name given to the price sensitivity and is the
percentage change in price for a unit change in yield. It really makes sense only
for an instrument with fixed cash flows.
• The modified duration is a derivative (rate of change) or price sensitivity and
measures the percentage rate of change of price with respect to yield. The
Macaulay duration
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concept of modified duration can be applied to interest-rate sensitive instruments
with non-fixed cash flows.
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Bond Valuation > Understanding Bonds
Indenture
• Terms of indentures include the interest rate, maturity date, repayment dates,
convertibility, pledge, promises, representations, covenants, and other terms of
the bond offering.
• A bond indenture is held by a trustee. If the company fails to live up to the terms
of the bond indenture, the trustee may bring legal action against the company on
behalf of the bondholders.
• The offering memorandum, also known as a prospectus, is a document that
describes a financial security for potential buyers.
Indenture
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Bond Valuation > Understanding Bonds
Ratings
• Ratings play a critical role in determining how much companies and other entities
that issue debt, including sovereign governments, have to pay to access credit
markets; for example, the amount of interest they pay on their issued debt.
• The ratings are assigned by credit rating agencies such as Moody's, Standard &
Poor's, and Fitch. Ratings to have letter designations (such as AAA, B, CC),
which represent the quality of a bond.
• A bond is considered investment-grade (IG) if its credit rating is BBB- or higher by
Standard & Poor's, or Baa3 or higher by Moody's, or BBB(low) or higher by
DBRS. Bond ratings below BBB/Baa are not considered to be investment grade;
such bonds are called junk bonds.
Credit Rating Equivalents
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Appendix
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Bond Valuation
Key terms
• convertibility Quality of a bond that allows the holder to convert into shares of common stock in the issuing company or cash of
equal value, at an agreed-upon price.
• Convexity As interest rates change, the price does not change linearly, but rather is a convex function of interest rates.
Convexity is a measure of the curvature of how the price of a bond changes as the interest rate changes. Specifically, duration
can be formulated as the first derivative of the price function of the bond with respect to the interest rate in question, and the
convexity as the second derivative.
• corporate bonds A corporate bond is a bond issue by a corporation. It is a bond that a corporation issues to raise money
effectively in order to expand its business.
• credit rating agencies A credit rating agency (CRA) is a company that assigns credit ratings to issuers of certain types of debt
obligations, as well as to the debt instruments themselves.
• indenture a document, written as duplicates separated by indentations, specifying such a contract
• municipal bonds A municipal bond is a bond issued by an American city or other local government, or their agencies.
• public debt offerings A public debt offering is the offering of debt securities of a government, a company or a similar corporation
to the public.
• Treasury bonds A United States Treasury bond is a government debt issued by the United States Department of the Treasury
through the Bureau of the Public Debt, with a maturity of 20 years to 30 years.
• Yield to maturity The yield to maturity (YTM) of a bond or other fixed-interest security, such as gilts, is the internal rate of return
(IRR, overall interest rate) earned by an investor who buys the bond today at the market price, assuming that the bond will be
held until maturity and that all coupon and principal payments will be made on schedule.
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Bond Valuation
A bond from the Dutch East India Company
A bond is a financial security that represents a promise by a company or government to repay a certain amount, with interest, to the bondholder.
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Bond Valuation
Indenture
Bond indenture (also trust indenture or deed of trust) is a legal contract issued to lenders.
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Bond Valuation
Modified duration
The modified duration is the name given to the price sensitivity and is the percentage change in price for a unit change in yield.
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Bond Valuation
Macaulay duration
The Macaulay duration is the name given to the weighted average time until cash flows are received and is measured in years.
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Bond Valuation
Credit Rating Equivalents
Credit ratings are used to report on the credit worthiness of a bond issuing company or government
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Bond Valuation
Which of the following is NOT a type of bond?
A) Treasuries
B) Corporate Bonds
C) Certificate of deposits (CDs)
D) Municipal Bonds
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Bond Valuation
Which of the following is NOT a type of bond?
A) Treasuries
B) Corporate Bonds
C) Certificate of deposits (CDs)
D) Municipal Bonds
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Bond Valuation
Which of the following describes a difference between stocks and
bonds?
A) Stockholders generally have an equity stake in the business while
bondholders have a creditor stake.
B) Bonds always have a defined term while stocks may be outstanding
indefinitely.
C) Stocks can be resold on a secondary market, while bonds cannot.
D) All of these answers.
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Bond Valuation
Which of the following describes a difference between stocks and
bonds?
A) Stockholders generally have an equity stake in the business while
bondholders have a creditor stake.
B) Bonds always have a defined term while stocks may be outstanding
indefinitely.
C) Stocks can be resold on a secondary market, while bonds cannot.
D) All of these answers.
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Bond Valuation
Which of the following are debt instruments that companies use
as investments? Choose one answer.
A) Stocks
B) Bank Loans
C) Bonds
D) Unpaid Accounts
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Bond Valuation
Which of the following are debt instruments that companies use
as investments? Choose one answer.
A) Stocks
B) Bank Loans
C) Bonds
D) Unpaid Accounts
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Bond Valuation
Which of the following is the definition of the Macaulay duration?
A) The percentage change in price for a unit change in yield.
B) The weighted average time, measured in years, until cash flows are
received.
C) The price sensitivity of a bond.
D) All of these answers.
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Bond Valuation
Which of the following is the definition of the Macaulay duration?
A) The percentage change in price for a unit change in yield.
B) The weighted average time, measured in years, until cash flows are
received.
C) The price sensitivity of a bond.
D) All of these answers.
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Bond Valuation
Which of the following specifications regarding a bond is
contained in the bond's indenture?
A) All of these answers.
B) The maturity date.
C) The interest rate.
D) The bond's pledge.
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Bond Valuation
Which of the following specifications regarding a bond is
contained in the bond's indenture?
A) All of these answers.
B) The maturity date.
C) The interest rate.
D) The bond's pledge.
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Bond Valuation
Which of the following entities "holds" the indenture and is
responsible for enforcing the contract?
A) The bondholders.
B) A trustee.
C) The shareholders.
D) All of these answers.
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Bond Valuation
Which of the following entities "holds" the indenture and is
responsible for enforcing the contract?
A) The bondholders.
B) A trustee.
C) The shareholders.
D) All of these answers.
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Bond Valuation
Which of the following ratings would indicate a "junk bond?"
A) A Baa3 rating by Moody's.
B) A BBB- rating from Standard & Poors.
C) A Ba rating by Moody's.
D) BBB(low) by DBRS.
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Bond Valuation
Which of the following ratings would indicate a "junk bond?"
A) A Baa3 rating by Moody's.
B) A BBB- rating from Standard & Poors.
C) A Ba rating by Moody's.
D) BBB(low) by DBRS.
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Bond Valuation
Attribution
• Wikipedia. "Duration (finance)." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Duration_(finance)
• Wikipedia. "Yield to maturity." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Yield%20to%20maturity
• Wikipedia. "Convexity." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Convexity
• Wikipedia. "Bond indenture." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Bond_indenture
• Wikipedia. "Prospectus (finance)." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Prospectus_(finance)
• Wiktionary. "indenture." CC BY-SA 3.0 http://en.wiktionary.org/wiki/indenture
• Wikipedia. "convertibility." CC BY-SA 3.0 http://en.wikipedia.org/wiki/convertibility
• Wikipedia. "public debt offerings." CC BY-SA 3.0 http://en.wikipedia.org/wiki/public%20debt%20offerings
• Wikipedia. "municipal bonds." CC BY-SA 3.0 http://en.wikipedia.org/wiki/municipal%2520bonds
• Wikipedia. "Bond (finance)." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Bond_(finance)
• Wikipedia. "Treasury bonds." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Treasury%2520bonds
• Wikipedia. "corporate bonds." CC BY-SA 3.0 http://en.wikipedia.org/wiki/corporate%2520bonds
• Wikipedia. "Bond rating." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Bond_rating
• Wikipedia. "Bond (finance)." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Bond_(finance)
• Wikipedia. "credit rating agencies." CC BY-SA 3.0 http://en.wikipedia.org/wiki/credit%20rating%20agencies
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