OECD Capital Market Review of Croatia 2021 Capital market ...
T HE BOND MARKET. P URPOSE OF CAPITAL MARKET Firms and individuals use capital markets for long-term...
-
Upload
kaelyn-tams -
Category
Documents
-
view
220 -
download
3
Transcript of T HE BOND MARKET. P URPOSE OF CAPITAL MARKET Firms and individuals use capital markets for long-term...
THE BOND MARKET
PURPOSE OF CAPITAL MARKET
Firms and individuals use capital markets for long-term investments
CAPITAL MARKET PARTICIPANTS
Issuers of capital market securities are federal government, local government and corporations
Corporations sell both stock and bonds while governments sell only bonds
Largest buyer of capital market securities is households
Alternatively, individuals deposit funds in financial institutions that use the funds to purchase capital market instruments such as stock and bonds
CAPITAL MARKET TRADING
Primary market Secondary market
PRIMARY MARKET
New issues of stocks and bonds are introduced
Issues of the security receives the proceeds of sale
First issue of securities is Initial Public Offering
Investment funds, individuals and corporations are buyers
SECONDARY MARKETS
Sale of previously issued securities takes place
Two types of exchanges: Organized exchanges Over the counter exchanges
BONDS
A debt owed by the issuer to the investor
Bonds obligate the issuer to pay a specified amount at a given date, generally with periodic interest payments
Par, face, or maturity value of the bond is the amount that the issuer must pay at maturity
BONDS
Coupon rate is the rate of interest that the issuer must pay
Periodic interest payment is often called the coupon payment.
If the repayment terms of a bond are not met, the holder of a bond has a claim on the assets of the issuer
BONDS
Long-term bonds traded in the capital market include long-term government notes and bonds, municipal bonds, and corporate bonds
CORPORATE BONDS
Most corporate bonds have a face value of $1,000 and pay interest semi-annually
Bond indenture is a contract that states the lender’s rights and privileges and the borrower’s obligations
CHARACTERISTICS OF CORPORATE BONDS
Bearer bonds: Payments are made to whoever has physical possession of coupons
Registered bonds: Payments are made to registered owners
RESTRICTIVE COVENANTS
Rules and restrictions on managers designed to protect the bondholders’ interests
CALL PROVISION
Issuer has the right to force the holder to sell the bond back
Call provision usually requires a waiting period between the time the bond is initially issued and the time when it can be called
Price bondholders are paid for the bond is usually set at the bond’s par price or slightly higher (usually by one year’s interest cost)
CALL PROVISION
If interest rates fall, the price of the bond will rise
If rates fall enough, the price will rise above the call price, and the firm will call the bond
Because call provisions put a limit on the amount that bondholders can earn from the appreciation of a bond’s price, investors do not like call provisions.
CALL PROVISION
A second reason that issuers of bonds include call provisions is to make it possible for them to buy back their bonds according to the terms of the sinking fund
Sinking fund is a requirement in the bond indenture that the firm pay off a portion of the bond issue each year
CALL PROVISION
This provision is attractive to bondholders because it reduces the probability of default when the issue matures
Because a sinking fund provision makes the issue more attractive, the firm can reduce the bond’s interest rate
CALL PROVISION
A third reason firms usually issue only callable bonds is that firms may have to retire a bond issue if the covenants of the issue restrict the firm from some activity that it feels is in the best interest of stockholders
CALL PROVISION
Finally, a firm may choose to call bonds if it wishes to alter its capital structure
A maturing firm with excess cash flow may wish to reduce its debt load if few attractive investment opportunities are available.
CALL PROVISION
Because bondholders do not generally like call provisions, callable bonds must have a higher yield than comparable noncallable bonds.
Despite the higher cost, firms still typically issue callable bonds because of the flexibility this feature provides the firm.
CONVERSION
Some bonds can be converted into shares of common stock
This feature permits bondholders to share in the firm’s good fortunes if the stock price rises
Bond can be converted into a certain number of common shares at the discretion of the bondholder
TYPES OF CORPORATE BONDS
SECURED BONDS
Collateral attached
UNSECURED BONDS
Backed by only the general credit worthiness of the issuer
Carry a higher interest rate than comparable secured bonds
Subordinated debentures: carry a lower priority claim
Variable rate bonds: tied to another market interest rate
JUNK BONDS
Speculative grade bonds
FINDING THE VALUE OF COUPON BONDS
1. Identify the cash flows that result from owning the security
2. Determine the discount rate required to compensate the investor for holding the security
3. Find the present value of cash flows estimated in step 1 using the discount rate determined in step 2
YIELD TO MATURITY
The Yield to maturity (YTM) of a bond is the discount rate that equates the today’s bond price with the present value of the future cash flows of the bond
10-27
THE BOND PRICING FORMULA
The price of a bond is found by adding together the present value of the bond’s coupon payments and the present value of the bond’s face value.
The formula is:
In the formula, C represents the annual coupon payments (in $), FV is the face value of the bond (in $), and M is the maturity of the bond, measured in years.
2M2M
2YTM1
FV
2YTM1
11
YTM
CPriceBond
CURRENT YIELD
Yield to maturity on coupon bonds
Current yield = yearly coupon payment / price of the coupon bonds
10-29
PREMIUM AND DISCOUNT BONDS, I.
Bonds are given names according to the relationship between the bond’s selling price and its par value.
Premium bonds: price > par valueYTM < coupon rate
Discount bonds: price < par valueYTM > coupon rate
Par bonds: price = par valueYTM = coupon rate
10-30
RELATIONSHIPS AMONG YIELD MEASURES
for premium bonds: coupon rate > current yield > YTM
for discount bonds:coupon rate < current yield < YTM
for par value bonds:coupon rate = current yield = YTM
INVESTING IN BONDS
Bear a lower risk than stocks
Suffer from interest rate risk