Bonds And Their Evaluation
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Bonds and their Valuations
A bond is a long term contract under which a borrower agrees to make payments of principal and interest, on specific dates to the holders of the bond. For ex. When a company borrows $50mn by issuing $50mn of bonds, the company agrees to make the annual monthly payments and repay the $50mn on a specified maturity date.
Bonds may be:
Treasury Bonds: These are issued by the Federal Government and are also called Government bonds. It does not have any default risk as it is assumed that the Government will repay the amount on due date. Interest on Treasury bonds is exempt from state and local taxes, though not from federal taxes. The Bond prices may however decline when the interest rate rises.
Corporate Bonds: they are issued by corporations and carry default risk. When a company is in trouble, it may be unable to pay the promised interest and the principal payments. Default risk is also called “credit risk” and the larger the default risk, the higher the interest rate the issuer must pay.
Municipal Bonds: “Munis” are issued by the state and local government and have default risk. However the interest earned on munis is exempt from federal taxes and from state taxes when the holder is a resident of the state. Consequently, the interest paid on munis is much less than that of the corporate bonds.
Foreign Bonds: These are issued by foreign corporations and foreign governments. They are exposed to default risk and an additional risk exists when the investor buys bond in currency other than that of his home currency. For ex. If a US investor buys bonds in yen and the yen falls relative to dollar, he loses even if the company does not default on its bonds.
Key Characteristics of Bonds:
Par Value: is the stated face value of bonds (assumed to be $1000). It is the amount of money the firm borrows and promises to pay on the maturity date.
Coupon Interest Rate: This the coupon payments (the annual/semi-annual) to be made on the bonds divided by the par value of the bonds ($1000. In US, $1000 has been used as the par value since a very long time).
For some bonds called “Floating-rate bonds” the coupon rate is set for initial 6 months after which it is changed every 6 month based on market fluctuations. Such bonds may carry additional provisions such as the upper and lower limits (caps and floors) OR may be converted to fixed rate debt. These bonds are popular with investors as they fluctuate with rising interest rates which in turn keeps the market value of bonds stabilized. These are also popular with corporations as they