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Bonds and Their Valuation: rounds of Federal Reserve rate cuts, Treasury

Sizing Up Risk in the Bond Market rates may not have much room to fall. Also,
there is concern that recent Fed easing is
Many people view Treasury securities as a sowing the seeds for higher inflation down the
lackluster but ultra-safe investment. From a road, which would lead to higher rates and
default standpoint, Treasuries are indeed our lower bond prices. In the face of similar risks in
safest investments; but their prices can still 2001, a BusinessWeek Online article gave
decline in any given year if interest rates investors the following advice, which is still
increase. This is especially true for long-term applicable today:
bonds, which lost nearly 9% in 1999. However, Take the same diversified approach to
bonds can perform well—in fact, they bonds as you do with stocks. Blend in
outgained stocks in 5 of the 8 years between U.S. government, corporate—both high-
2000 and 2007. All bonds aren’t alike, and they quality and high-yield—and perhaps
don’t necessarily all move in the same even some foreign government debt. If
direction. For example, corporate bonds are you’re investing taxable dollars,
callable and they can default, whereas Treasury consider tax-exempt municipal bonds.
bonds are not exposed to these risks. This And it doesn’t hurt to layer in some
results in higher nominal yields on corporates, inflation-indexed bonds.
(Sources: Scott Patterson, “Ahead of the Tape: Junk Yields
but the spread between corporate and
Flashing Back to ’01 Slump,” The Wall Street Journal, January
Treasury yields differs widely depending on the 30, 2008, p. C1; Stocks, Bonds, Bills, and Inflation: (Valuation
risk of the particular corporate bond. Edition) 2008 Yearbook (Chicago: orningstar, Inc., 2008); and
Susan Scherreik, “Getting the Most Bang Out of Your Bonds,”
Moreover, yield spreads vary substantially over
BusinessWeek Online, November 12, 2001.)
time, especially for lower-rated securities. For
example, as information about WorldCom’s WHO ISSUES BONDS?
deteriorating condition began coming out in A bond is a long-term contract under which a
2002, the spread on its 5-year bonds jumped borrower agrees to make payments of interest
from 1.67% to over 20% in mid-2002. These and principal on specific dates to the holders of
bonds subsequently defaulted, so greedy the bond. Bonds are issued by corporations and
people who bought them expecting a high government agencies that are looking for long-
return ended up with a large loss. When the term debt capital. For example, on January 3,
economy is strong, corporate bonds generally 2009, Allied Food Products borrowed $50
produce higher returns than Treasuries— their million by issuing $50 million of bonds. For
promised returns are higher, and most make convenience, we assume that Allied sold 50,000
their promised payments because few go into individual bonds for $1,000 each. Actually, it
default. However, when the economy weakens, could have sold one $50 million bond, 10 bonds
concerns about defaults rise, which leads to each with a $5 million face value, or any other
declines in corporate bond prices. For example, combination that totaled $50 million. In any
from the beginning of 2000 to the end of 2002, event, Allied received the $50 million; and in
a sluggish economy and a string of accounting exchange, it promised to make annual interest
scandals led to some major corporate defaults, payments and to repay the $50 million on a
which worried investors. All corporate bond specified maturity date.
prices then declined relative to Treasuries, and
the result was an increase in yield spreads. As Until the 1970s, most bonds were beautifully
the economy rebounded in 2003, yield spreads engraved pieces of paper and their key terms,
declined to their former levels, which resulted including their face values, were spelled out on
in good gains in corporate bond prices. The the bonds. Today, though, virtually all bonds
situation is once again worrisome in 2008. The are represented by electronic data stored in
subprime mortgage crisis has led to fears of secure computers, much like the “money” in a
recession; and this has caused spreads to rise bank checking account. Bonds are grouped in
dramatically, especially for lower-rated bonds. several ways. One grouping is based on the
For example, the spread on junk bonds over issuer: the U.S. Treasury, corporations, state
Treasuries rose from 2.4% to 7.5% in the 6 and local governments, and foreigners. Each
months from mid-2007 to January 2008. Bond bond differs with respect to risk and
investors are rightly worried today. If a consequently its expected return.
recession does occur, this will lead to increased Treasury bonds, generally called Treasuries and
defaults on corporate bonds. A recession might sometimes referred to as government bonds,
benefit investors in Treasury bonds. However, are issued by the federal government.1 It is
because there have already been several reasonable to assume that the U.S. government
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will make good on its promised payments, so prices, and expected returns. To understand
Treasuries have no default risk. However, these bonds, it is essential that you understand the
bonds’ prices do decline when interest rates following terms.
rise; so they are not completely riskless. Par Value
Corporate bonds are issued by business firms. The par value is the stated face value of the
Unlike Treasuries, corporate are exposed to bond; for illustrative purposes, we generally
default risk—if the issuing company gets into assume a par value of $1,000, although any
trouble, it may be unable to make the promised multiple of $1,000 (e.g., $5,000 or $5 million)
interest and principal payments and can be used. The par value generally represents
bondholders may suffer losses. Different the amount of money the firm borrows and
corporate bonds have different levels of default promises to repay on the maturity date.
risk depending on the issuing company’s Coupon Interest Rate
characteristics and the terms of the specific Allied Food Products’ bonds require the
bond. Default risk is often referred to as “credit company to pay a fixed number of dollars of
risk”; the larger this risk, the higher the interest interest each year. This payment, generally
rate investors demand. referred to as the coupon payment, is set at the
Municipal bonds, or munis, is the term given to time the bond is issued and remains in force
bonds issued by state and local governments. during the bond’s life. Typically, at the time a
Like corporates, munis are exposed to some bond is issued, its coupon payment is set at a
default risk; but they have one major level that will induce investors to buy the bond
advantage over all other bonds: The interest at or near its par value. Most of the examples
earned on most munis is exempt from federal and problems throughout this text will focus on
taxes and from state taxes if the holder is a bonds with fixed coupon rates. When this
resident of the issuing state. Consequently, the annual coupon payment is divided by the par
market interest rate on a muni is considerably value, the result is the coupon interest rate. For
lower than on a corporate of equivalent risk. example, Allied’s bonds have a $1,000 par
Foreign bonds are issued by a foreign value, and they pay $100 in interest each year.
government or a foreign corporation. The bond’s coupon payment is $100, so its
All foreign corporate bonds are exposed to coupon interest rate is $100/$1,000 ¼ 10%. In
default risk, as are some foreign government this regard, the $100 is the annual income that
bonds. An additional risk exists when the bonds an investor receives when he or she invests in
are denominated in a currency other than that the bond. Some bonds pay no coupons at all,
of the investor’s home currency. Consider, for but are offered at a discount below their par
example, a U.S. investor who purchases a values and hence provide capital appreciation
corporate bond denominated in Japanese yen. rather than interest income. These securities
At some point, the investor will want to close are called zero coupon bonds (zeros). Other
out his investment and convert the yen back to bonds pay some coupon interest, but not
U.S. dollars. If the Japanese yen unexpectedly enough to induce investors to buy them at par.
falls relative to the dollar, the investor will have In general, any bond originally offered at a price
fewer dollars than he originally expected to significantly below its par value is called an
receive. Consequently, the investor could still original issue discount (OID) bond.
lose money even if the bond does not default. Maturity Date
Bonds generally have a specified maturity date
KEY CHARACTERISTICS OF BONDS on which the par value must be repaid. Allied’s
Although all bonds have some common bonds, which were issued on January 3, 2009,
characteristics, different bonds can have will mature on January 2, 2024; thus, they had
different contractual features. For example, a 15-year maturity at the time they were
most corporate bonds have provisions that issued. Most bonds have original maturities
allow the issuer to pay them off early (“call” (the maturity at the time the bond is issued)
features), but the specific callprovisions vary ranging from 10 to 40 years, but any maturity is
widely among different bonds. Similarly, some legally permissible.3 Of course, the effective
bonds are backed by specific assets that must maturity of a bond declines each year after it
be turned over to the bondholders if the issuer has been issued. Thus, Allied’s bonds had a 15-
defaults, while other bonds have no such year original maturity. But in 2010, a year later,
collateral backup. Differences in contractual they will have a 14-year maturity; a year after
provisions (and in the fundamental underlying that, they will have a 13-year maturity; and so
financial strength of the companies backing the forth.
bonds) lead to differences in bonds’ risks,
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Call Provisions cases, the issuer can handle the sinking fund
Most corporate and municipal bonds, but not requirement in either of two ways:
Treasuries, contain a call provision that gives 1. It can call in for redemption, at par value, the
the issuer the right to call the bonds for required $5 million of bonds. The bonds are
redemption.4 The call provision generally states numbered serially, and those called for
that the issuer must pay the bondholders an redemption would be determined by a lottery
amount greater than the par value if they are administered by the trustee.
called. The additional sum, which is termed a 2. The company can buy the required number
call premium, is often equal to one year’s of bonds on the open market. The firm will
interest. For example, the call premium on a choose the least-cost method. If interest rates
10-year bond with a 10% annual coupon and a have fallen since the bond was issued, the bond
par value of $1,000 might be $100, which will sell for more than its par value. In this case,
means that the issuer would have to pay the firm will use the call option. However, if
investors $1,100 (the par value plus the call interest rates have risen, the bonds will sell at a
premium) if it wanted to call the bonds. In most price below par; so the firm can and will buy $5
cases, the provisions in the bond contract are million par value of bonds in the open market
set so that the call premium declines over time for less than $5 million. Note that a call for
as the bonds approach maturity. Also, while sinking fund purposes is generally different
some bonds are immediately callable, in most from a refunding call because most sinking fund
cases, bonds are often not callable until several calls require no call premium. However, only a
years after issue, generally 5 to 10 years. This is small percentage of the issue is normally
known as a deferred call, and such bonds are callable in a given year. Although sinking funds
said to have call protection. Companies are not are designed to protect investors by ensuring
likely to call bonds unless interest rates have that the bonds are retired in an orderly fashion,
declined significantly since the bonds were these funds work to the detriment of
issued. Suppose a company sold bonds when bondholders if the bond’s coupon rate is higher
interest rates were relatively high. Provided the than the current market rate. For example,
issue is callable, the company could sell a new suppose the bond has a 10% coupon but similar
issue of low-yielding securities if and when bonds now yield only 7.5%. A sinking fund call
interest rates drop, use the proceeds of the at par would require a long-term investor to
new issue to retire the high-rate issue, and thus give up a bond that pays $100 of interest and
reduce its interest expense. This process is then to reinvest in a bond that pays only $75
called a refunding operation. Thus, the call per year. This is an obvious disadvantage to
privilege is valuable to the firm but detrimental those bondholders whose bonds are called. On
to long-term investors, who will need to balance, however, bonds that have a sinking
reinvest the funds they receive at the new and fund are regarded as being safer than those
lower rates. Accordingly, the interest rate on a without such a provision; so at the time they
new issue of callable bonds will exceed that on are issued, sinking fund bonds have lower
the company’s new noncallable bonds. coupon rates than otherwise similar bonds
without sinking funds.
Sinking Funds
Some bonds include a sinking fund provision Other Features
that facilitates the orderly retirement of the Several other types of bonds are used
bond issue. Years ago firms were required to sufficiently often to warrant mention. First,
deposit money with a trustee, which invested convertible bonds are bonds that are
the funds and then used the accumulated sum exchangeable into shares of common stock at a
to retire the bonds when they matured. Today, fixed price at the option of the bondholder.
though, sinking fund provisions require the Convertibles offer investors the chance for
issuer to buy back a specified percentage of the capital gains if the stock increases, but that
issue each year. A failure to meet the sinking feature enables the issuing company to set a
fund requirement constitutes a default, which lower coupon rate than on nonconvertible debt
may throw the company into bankruptcy. with similar credit risk. Bonds issued with
Therefore, a sinking fund is a mandatory warrants are similar to convertibles; but instead
payment. of giving the investor an option to exchange the
Suppose a company issued $100 million of 20- bonds for stock, warrants give the holder an
year bonds and it is required to call 5% of the option to buy stock for a stated price, thereby
issue, or $5 million of bonds, each year. In most providing a capital gain if the stock’s price rises.
Because of this factor, bonds issued with
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warrants, like convertibles, carry lower coupon exchanges. The Wall Street Journal routinely
rates than otherwise similar nonconvertible reports key developments.
bonds. Whereas callable bonds give the issuer
the right to retire the debt prior to maturity, Reference:
putable bonds allow investors to require the
company to pay in advance. If interest rates Brigham, Eugene, Fundamentals of Financial
rise, investors will put the bonds back to the Management, 12th edition
company and reinvest in higher coupon bonds.
Yet another type of bond is the income bond,
which pays interest only if the issuer has
earned enough money to pay the interest.
Thus, income bonds cannot bankrupt a
company; but from an investor’s standpoint,
they are riskier than “regular” bonds. Yet
another bond is the indexed, or purchasing
power, bond. The interest rate is based on an
inflation index such as the consumer price
index; so the interest paid rises automatically
when the inflation rate rises, thus protecting
bondholders against inflation.

BOND VALUATION
The value of any financial asset—a stock, a
bond, a lease, or even a physical asset such as
an apartment building or a piece of machinery
—is the present value of the cash flows the
asset is expected to produce.

BOND YIELDS
Unlike the coupon interest rate, which is fixed,
the bond’s yield varies from day to day
depending on current market conditions. To be
most useful, the bond’s yield should give us an
estimate of the rate of return we would earn if
we bought the bond today and held it over its
remaining life. If the bond is not callable, its
remaining life is its years to maturity. If it is
callable, its remaining life is the years to
maturity if it is not called or the years to the call
if it is called. In the following sections, we
explain how to calculate those two possible
yields and which one is likely to occur.

BOND MARKETS
Corporate bonds are traded primarily in the
over-the-counter market. Most bonds are
owned by and traded among large financial
institutions (for example, life insurance
companies, mutual funds, hedge funds, and
pension funds, all of which deal in very large
blocks of securities), and it is relatively easy for
over-the-counter bond dealers to arrange the
transfer of large blocks of bonds among the
relatively few holders of the bonds. It would be
more difficult to conduct similar operations in
the stock market among the literally millions of
large and small stockholders, so a higher
percentage of stock trades occur on the
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