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Po
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= Asset's price today (at time 0)
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CFn
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= Cash flow expected at time t
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t
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= time
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r
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= required return. Discount rate that reflects the asset's risk.
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n
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= Assets life / period it distributes cash flows
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$C
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= Coupon payment amount
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$M
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= par value maturity amount
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The rate of return that investors expect or require an investment to earn given its risk.
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Riskier = higher the return required by investors in the marketplace
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Purchase of investment means investor loses the opportunity to invest their money in another asset. Opportunity cost.
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In a market economy, ownership of an asset confers rights to stream of benefits generated by asset.
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Benefits may be tangible, such as interest payments on bonds, or intangible, e.g. viewing a beautiful ring
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Asset value = present value of all its future benefits
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Finance theory focuses on tangible benefits, usually cash flows an asset pays over time
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e.g. landlord. Incoming = Rental payments from tenants. Outgoing = Liabilities for maintaining premises, paying taxes, etc.
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When selling an asset the market price should equal present value of all future net cash flows
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Step 1:
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Estimate $$ an investment distributes over time
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Step 2:
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Discount expected cash payments using time value of money maths
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Therefore pricing an asset requires knowledge of
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its future benefits
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the appropriate discount rate to convert future benefits into a present value
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Certainty
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If an assets future benefits are uncertain then investors will apply a larger rate when discounting those benefits to present value
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An inverse relationship exists between risk and value
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Investors will pay a higher price for investment with more credible promise.
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Riskier investments must offer higher returns
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Marginal benefit of owning an asset = right to receive cash flows it pays
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Marginal cost = opportunity cost of committing funds to this asset rather than to an equally risky alternative
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Floating-rate bonds
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Bonds that make coupon payments that vary through time. The coupon payments are usually tied to a benchmark market interest rate
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also called variable-rate bonds
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provide some protection against interest rate risk
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If market interest rates increase, then eventually, so do the bond’s coupon payments
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Makes borrowers future cash obligations unpredictable
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Risk is transferred from buyer to issuer
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London Interbank Offered Rate (LIBOR)
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The interest rate that banks in London charge each other for overnight loans. Widely used as a benchmark interest rate for short-term fl oatingrate debt.
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Cash rate
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Rate Aus banks charge each other for overnight loans
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Spread
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The difference between the rate that a lender charges for a loan and the underlying benchmark interest rate
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Also called the credit spread
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to the benchmark interest rate, according to the risk of the borrower
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Lenders charge higher spreads for less creditworthy borrowers
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Capital indexed bonds / inflation linked bonds
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Issued by Aus govt, face value changes each year with inflation
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Unsecured debt
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Debt instruments issued by an entity backed only by faith and credit score of borrowing company
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Subordinated unsecured debt
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Debt instruments issued by an entity which is backed only by the credit of the borrowing entity which is paid only after senior debt is paid
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Collateral
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The specifi c assets pledged to secure a loan.
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Mortgage bonds
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A bond secured by real estate or buildings
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Collateral trust bonds
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A bond secured by financial assets held by a trustee
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Debentures
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Usually backed by property
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Equipment trust certificates
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A bond often secured by various types of transportation equipment
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Pure discount bonds
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Bonds that pay no interest and sell below par value. Also called zero-coupon bonds.
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Convertible bond
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A bond that gives investors the option to convert their bonds into the issuer’s common stock.
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Exchangeable bonds
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Bonds issued by corporations which may be converted into shares of a company other than the company that issued the bonds.
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Callable
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Bonds that the issuer can repurchase from investors at a predetermined price known as the call price
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Call price
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The price at which a bond issuer may call or repurchase an outstanding bond from investors
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Putable bonds
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Bonds that investors can sell back to the issuer at a predetermined price under certain conditions
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Sinking fund
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A provision in a bond indenture that requires the borrower to make regular payments to a third-party trustee for use in repurchasing outstanding bonds, gradually over time
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Protective covenants
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Specify requirements that the borrower must meet as long as bonds remain outstanding
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Fundamentally, a bond is just a loan
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Bonds make interest-only payments until they mature
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Principal
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The amount of money on which interest is paid
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Maturity date
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The date when a bond’s life ends and the borrower must make the fi nal interest payment and repay the principal.
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Par value (bonds)
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The face value of a bond, which the borrower repays at maturity
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Typically $1,000 for corporate bonds
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Coupon
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A fixed amount of interest that a bond promises to pay investors
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Usually semiannually
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Indenture
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A legal document stating the conditions under which a bond has been issued
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Specifies dollar amount of coupon
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Specifies when the borrower must make coupon payments
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Coupon rate
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The rate derived by dividing the bond’s annual coupon payment by its par value.
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Coupon yield
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The amount obtained by dividing the bond’s coupon by its current market price (which does not always equal its par value). Also called current yield
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Might have additional features:
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Call feature allows the issuer to redeem the bond at a predetermined price prior to maturity
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Conversion feature grants bondholders right to redeem bonds for a predetermined number of shares of stock in borrowing firm
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Premium
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A bond that sells for more than its par value
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Selling at a better than market return
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As more investors buy the price goes up
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Yield to maturity
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The discount rate that equates the present value of the bond’s cash flows to its market price
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Discount
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A bond sells at a discount when its market price is less than its par value
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Might be offset with a built-in gain at maturity
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When macroeconomic factors change
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Yields may change simultaneously on a wide range of bonds
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Return on a particular bond can also change as market reassesses borrower's default risk (risk issuer could default on payments)
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Changes may be positive or negative
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Treasury bonds
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Debt instruments issued by the federal government with maturities of up to 30 years
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Corporate bonds
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Issued by corporations
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Finance new investments
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Fulfil other needs
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Range from 1 - 100 years
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Under 10 years usually called a note means the same
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Most corporate bonds have a par value of $1,000 and pay interest semiannually
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Australian government bonds
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Issued by Australian government
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Larger than the stock market
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Bond Price Quotations
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bond prices are quoted as a percentage of par values
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Yield spread
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The diff erence in yield to maturity between two bonds or two classes of bonds with similar maturities
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Basis point
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1/100 of 1 percent; 100 basis points equal 1.000 percent
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Bond ratings
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Letter ratings assigned to bonds by specialized agencies that evaluate the capacity of bond issuers to repay their debts. Lower ratings signify higher default risk.
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Junk bonds
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Bonds rated below investment grade. Also known as high-yield bonds
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Bond makes a fixed coupon payment each year
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Most bonds make 2 payments a year
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A bonds market price changes frequently as time passes
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Term to maturity
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Whether a bond sells at a discount or a premium, its price will converge to par value (+ final interest payment) as maturity date draws near.
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Economic Forces
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Most important factor is prevailing market interest rate
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Required return
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When required return on a bond changes, bonds price changes in opposite direction
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Higher bonds required return = lower its price, and vice versa
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General lessons
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Bond prices and interest rates move in opposite directions
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Prices of long-term bonds display greater sensitivity to changes in interest rates than do prices of short-term bonds
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Risk that changes in market interest rates will move bond price
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Interest rates fluctuate widely, so investors must be aware of interest rate risk
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Inherent in these instruments
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Inflation is a main factor
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Important because
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When investors buy financial assets, they expect these investments to provide a return that exceeds inflation rate.
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Investors want to achieve a better standard of living by saving and investing their money
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If asset returns do not exceed inflation investors are not better off for having invested
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Real return
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Bond yields must offer investors a positive real return
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Approximately equals difference between stated or nominal return and inflation rate
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Many types of bonds in modern financial markets
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Many bonds provide a steady, predictable stream of income
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Others have exotic features that make returns volatile and unpredictable
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Bond trading occurs in either primary or secondary market
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Primary market trading
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Initial sale of bonds by firms or government entities
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Might be through auction process
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With help of investment bankers who assist bond issuers with design, marketing, and distribution of new bond issues
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Once issued in primary market, investors trade them with each other in secondary market
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Often purchased by institutional investors who hold bonds for a long time
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Secondary market
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Because institutions hold bond for a long time, trading in bonds can be somewhat limited
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But bond market is large which means investors have a wide range of choices
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