Corporate Bond
Copyright 2006 by South-Western, a division of Thomson Learning. All rights reserved.
Status:
~ Bondholders are creditors (lenders)
~ They cannot vote suitable members in
boardrooms
~ Investment made is refunded once it is
called
back.
Return:
~ They receive fixed coupon payment
Your investment is
circulated in Capital
How should I
make decision?
Money has a price!!!
If you do not spend it, you can save it or
lend it to someone else for interest earned.
If you use money now, you may lose the
interest could be earned for future
consumption
A corporate bond represents a stream of future
payments
Future value = fixed coupon payment
+ principal
(Yr1 + 2)
(Yr2)
= Coupon (%) X
Principal + Principal
But present value is what we need to compute
Yr0
Yr1
Coupon (%) X Principal
Coupon (%) X Principal
+ Principal
?
?
Present value =
Future Value
(1 + Market Interest Rate) year
Yr2
C
C
C
F
n
1
2
P(1i)(1i).(1i)(1i)n
Coupon rate x Principal (Par Value)
Coupon
Principal (Par Value)
Bond holders required rate of
return or
Market interest rate
For public listed companies ~
It is Cost of debt the rate of return
necessary to compensate bondholders
For bondholders ~
It is minimum Required rate of return
Rate of return necessary to justify
undertaking an investment
,P(1.)1(.06)1$1,0
$
6
0
$
1
Suppose that Jane is about to buy
bond that will mature in 1 year
~ Principle is $1,000
~ Coupon rate is 6% per year
~ If bank depository or market interest
rate is 6%, Jane will be willing to pay
,P(1.8)1(.08)1$981.4
$
6
0
$
1
Suppose Citibank deposit rate rises to 8%
from 6%. The price of IBM bond now
becomes:
Jane would be willing to buy IBM bond for a
price below its par value. If not, She better
invests in banks deposit.
IBM should sell at discount! (lower than
par value)
Implication
As bank interest rate rises, price of
existing bonds falls
Because investors will choose deposit in
commercial bank who offers higher return
if compared to bond issue.
Bank rate = 8%
Coupon rate = 6%
Which one
you want?
,P(1.4)1(.04)1$1,09.23
$
6
0
$
1
Suppose Citibanks depository rate falls to 4%
from 6%
The price of IBM corporate bond now becomes:
Jane would be buying the bond for a price above its
face value as the return is better.
Corporation could sell at premium above par value
Implication
As bank interest rate falls, price of
existing bonds rise
Because investors will not choose deposit
in commercial bank who offers lower
return if compared to bond issue.
Bank rate = 4%
Coupon rate = 6%
Which one
you want?
General Motors bonds have 5 years to
maturity. Interest is paid annually, the
bonds have $1,000 par value, and
coupon interest rate and bank depository
rate is 8% per annum now.
1) What is the market price of these
bond?
2) If Citibank offers10%, what is the fair
price of this bond?
1) Central Bank & Commercial
Bank
In US
In UK
2) Inflation
Will you invest in bank if you have
surplus of pocket
money instead of spending it?
Because bank gives u interest rate that
higher than inflation rate to compensate
your loss in purchasing power.
Thus, bank deposit or coupon rate are
inclusive of inflation concern.
What you need to know is
Nominal Interest Rate
= Real Interest Rate +
Inflation Rate
Nominal Interest Rate
= Real Interest Rate + Inflation Rate
Implication
Nominal Interest Rate
= Real Interest Rate + Inflation Rate
Suppose bond coupon rate is 5% and the
current expected inflation rate is 3%
Expected real interest rate is 2%
It describes investors reacts to nominal
changes even though no changes in real
interest rate.
Interest Rates
(percent
per year)
Nominal interest rate
15%
10
5
0
Real interest rate
1965
1970
1975 1980 1985 1990 1995 2000 2005
Thank
You