Bonds and their valuation
A bond is a long term contract under
which a borrower agrees to make
payments of interest and principal on
specific dates, to the holders of the bond
Types of bonds
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Treasury bonds: gilt edged bonds or government
bonds have no default risk but prices will rise and fall
depending on the interest rates
Corporate bonds: exposed to default risk and price
varies according to company’s characteristics and
terms of the specific bonds
Municipal bonds: have default risk but are tax exempt
Foreign bonds: default risk and exchange rate risk
Corporate bonds
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Mortgage bonds are backed by fixed assets
Debentures
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Subordinated debentures have a claim on assets
only after the senior debt has been paid off in
the event of liquidation
Bond ratings
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Safe bonds AAA, AA
Investment grade bonds A, BBB
Junk bonds
Bond rating criteria
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Ratios (debt ratio and times interest earned ratio) –
the better the ratio, higher the rating
Mortgage – higher the value of the asset in relation to
the debt, better the rating
Guarantee granted by a strong firm is favorable
Sinking fund is a plus point
Shorter Maturity, less risky
Stability in sales and profitability, higher rating
Antitrust actions pending against the firm will erode its
position
Bond rating criteria
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If involved in overseas operations, percentage
of profits from and political climate in host
countries
Possibility of labor unrest will weaken its
position
Safety of its products on consumers a plus
Conservative accounting policies is a plus
Key characteristics of bonds
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Par value – face value of bond
Coupon interest rate – the stated interest rate on the bond
 Fixed rate remains in force during the life of a bond
 Floating rate depends on treasury bond rate, market rate may be
convertible to fixed rate or may have caps
 Zero coupon bond – no interest bond, sold below its par value, to
provide capital appreciation
Call provisions – provision in a bond that provides the issuer the right
to redeem the bond under specific terms prior to maturity date
 Generally redeemed at a call premium which varies with each year
 Call provision can be detrimental to investor if the bonds were
issued during a high interest period, refunding operation enables
the firm to reduce interest expense
Key characteristics of bonds
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Sinking Fund provision facilitates the orderly retirement of
the bond issue
company chooses least cost method from the following:
 call for redemption of certain number of bonds every
year
 buy the required number of bonds in the open market
 If interest rates fall - call the bonds
 If interest rates rise - buy from open market
Bonds with sinking fund tends to have a lower interest
rate because of safety factor
Other features
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Convertible bonds are exchangeable at the option
of the holder for common stock of the issuing firm
Warrant is a long term option to buy a stated
number of shares of common stock at a specified
price
Callable bonds give the issuer the option to
redeem the bonds prior to maturity
Putable bonds allow the investors to sell the bonds
back to the company prior to maturity at a
prearranged price
Indexed or purchasing power bonds have interest
rates tied to consumer price index