CORPORATE

BONDS
CORPORATE BONDS
• A long-term debt instrument indicating that a corporation has
borrowed a certain amount of money and promises to repay it in
the future under clearly defined terms.
• Coupon Interest Rate - The percentage of a bond’s par value that
will be paid annually, typically in two equal semiannual payments, as
interest; the bondholders, who are the lenders, are promised the
semiannual interest payments and, at maturity, repayment of the
principal amount.
LEGAL ASPECTS OF CORPORATE BONDS
• The legal arrangements required to protect purchasers of
bonds.
 Bond Indenture
 Trustee
BOND INDENTURE
• A legal document that specifies both the rights of the bondholders and the
duties of the issuing corporation.
• Included in the indenture are:
descriptions of the amount and timing of all interest and principal payments
Various standard and restrictive provisions
sinking-fund requirements and security interest provisions
• Standard Provisions
- specifying certain record-keeping and general business
practices that the bond issuer must follow; normally, they do not
place a burden on a financially sound business.
• Restrictive Provisions - restrictive covenants, which place operating and
financial constraints on the borrower. These provisions help protect the
bondholder against increases in borrower risk. Without them, the borrower
could increase the firm’s risk but not have to pay increased interest to
compensate for the increased risk.
 Most Common Restrictive Covenants:
1. Require a minimum level of liquidity, to ensure against loan default.
2. Prohibit the sale of accounts receivable to generate cash. Selling
receivables could cause a long-run cash shortage if proceeds were used to
meet current obligations.
3. Impose fixed-asset restrictions. The borrower must maintain a specified
level of fixed assets to guarantee its ability to repay the bonds.
4. Constrain subsequent borrowing. Additional long-term debt may be
prohibited, or additional borrowing may be subordinated to the original loan.
*Subordination means that subsequent creditors agree to wait until all
claims of the senior debt are satisfied.
5. Limit the firm’s annual cash dividend payments to a specified percentage or
amount.
• The violation of any standard or restrictive provision by the
borrower gives the bondholders the right to demand immediate
repayment of the debt. Generally, bondholders evaluate any
violation to determine whether it jeopardizes the loan. They may
then decide to demand immediate repayment, continue the loan, or
alter the terms of the bond indenture.
• Sinking-Fund Requirements - objective is to provide for the systematic
retirement of bonds prior to their maturity. To carry out this requirement, the
corporation makes semiannual or annual payments that are used to retire
bonds by purchasing them in the marketplace.

• Security Interest - the bond indenture identifies any collateral pledged

against the bond and specifies how it is to be maintained. The protection of
bond collateral is crucial to guarantee the safety of a bond issue
TRUSTEE
– A paid individual, corporation, or (most often) commercial bank trust
department that acts as the third party or a “watchdog” to a bond
indenture and can take specified actions on behalf of the bondholders
if the terms of the indenture are violated
COST OF BONDS TO THE ISSUER
• cost of bond financing (rate of interest paid by the bond issuer) is
generally greater than the issuer would have to pay for short-term
borrowing
 Major Factors that affect the cost:
 Bond Maturity
- longer the maturity of a bond = less accuracy in predicting future interest rates =
greater the bondholders’ risk of giving up an opportunity to lend money at a higher
rate
- longer the term = greater the chance that the issuer might default
 Size of the offering
- Increase in offering size = decrease in bond flotation and administration costs per
peso borrowed
- Increase in offering size = increase in risk of default = increase in risk of bondholders
Issuer’s Risk
- greater the issuer’s default risk = the higher the interest rate.
* Some of this risk can be reduced through inclusion of
appropriate restrictive provisions in the bond indenture.

Basic Cost of money

- cost of money in the capital market is the basis for determining a
bond’s coupon interest rate.
GENERAL FEATURES OF A BOND ISSUE
• Conversion Feature
- A feature of convertible bonds that allows bondholders to change each
bond into a stated number of shares of common stock.
- its inclusion by the issuer lowers the interest cost and provides for
automatic conversion of the bonds to stock if future stock prices
appreciate noticeably.
• Call Feature
- A feature included in nearly all corporate bond issues that gives the issuer the
opportunity to repurchase bonds at a stated call price prior to maturity.
- enables an issuer to call an outstanding bond when interest rates fall and issue a new
bond at a lower interest rate
- has a higher interest rate than that on a noncallable bond
- As a rule, the call price exceeds the par value of a bond by an amount equal to 1 year’s
interest.
Example : A ₱1,000 bond with a 10 percent coupon interest rate would be callable for
around ₱ 1,100 [₱ 1,000 + (10% x ₱1,000)].
*The amount by which the call price exceeds the bond’s par value (₱100) is
commonly referred to as the call premium which compensates bondholders
for having the bond called away from them and serves as cost of calling the
bonds for the issuer.
• Stock Purchase Warrants
- acts as “sweeteners” to make bonds more attractive to prospective
buyers
- Instruments that give their holders the right to purchase a certain
number of shares of the issuer’s common stock at a specified
price over a certain period of time.
- inclusion typically enables the issuer to pay a slightly lower coupon
interest rate than would otherwise be required.
BOND YIELDS
• yield, or rate of return, on a bond is frequently used to assess a bond’s performance over a
given period of time, typically 1 year
– Current Yield
= annual interest payment
current price
Example : What is the current yield of a ₱1,000 par value bond with an 8%
coupon interest rate that currently sells for ₱970?
(₱1,000) (.08)
Current yield = = .08247 𝑜𝑟 𝟖. 𝟐𝟓%
₱970
BOND PRICES

- All bonds are quoted as a percentage of par. So the Company C’s ₱1,000 – par – value bond
quoted at 103.143 is priced at ₱1,031.43 (₱1,000 x 103.143%).
BOND RATINGS
• Normally an inverse relationship exists between the quality of a bond and the rate of return
that it must provide bondholders: High-quality (high-rated) bonds provide lower returns than
lower-quality (low-rated) bonds. This reflects the lender’s risk–return trade-off. When
considering bond financing, the financial manager must be concerned with the expected ratings
of the bond issue, because these ratings affect salability and cost.

High-quality bond = Lower risks = Lower returns

Lower-quality bond = Higher risks = Higher returns

COMMON TYPES OF BONDS
• Traditional
COMMON TYPES OF BONDS
• Traditional
• Contemporary
 VALUATION
FUNDAMENTALS
VALUATION
• The process that links risk and return to determine the worth of an asset.
• 3 Key Inputs
1. Cash Flows (Returns)
2. Timing
3. Risk and Required Return
BASIC VALUATION MODEL
• The value of any asset is the present value of all future cash flows it is expected to provide
over the relevant time period.
• Formula :
 BOND
VALUATION
BASIC BOND VALUATION
• Simply,

PV of Bonds = PV of principal + PV of interest payments

*PV of principal = Principal x PV of 1 at effective interest rate

or required return rate
*PV of interest payments
=(Nominal rate or Coupon Interest rate x Principal)
x PV of ordinary annuity of 1 at effective
interest rate
HOW TO GET PV OF 1 AND PV OF
ORDINARY ANNUITY OF 1?
• Using Basic Calculator
PV of
1 + r = ÷ ÷ = = = PV of 1 - 1 +/- ÷ r = ordinary
annuity of
1
Required return or Total number of periods
effective rate to maturity

• Using formula
1 1
- 𝑃𝑉 𝑜𝑓 1 = 1 − - 𝑃𝑉 𝑜𝑓 𝑜𝑟𝑑𝑖𝑛𝑎𝑟𝑦 𝑎𝑛𝑛𝑢𝑖𝑡𝑦 𝑜𝑓 1 =
(1+𝑖)𝑛 (1+𝑖)𝑛
Example :
Tim Sanchez wishes to determine the current value of the Mills Company’s ₱1,000,
10 % interest bond, maturing on 10 years. Assuming that interest on the Mills Company bond
issue is paid annually and that the required return is equal to the bond’s coupon interest rate, and
years.
Solution:
PV of 1 at 10% for 10 periods .38554
PV of ordinary annuity of 1 at 10% for 10 periods 6.14457

PV of principal (₱1,000 x .38554) ₱ 385.54

PV of principal [(₱1,000 x .10)(6.14457) 614.457
Total Present Value ₱ 1000
BOND VALUES BEHAVIOR
• If the required return rate = coupon interest rate, the bond sells at a value
equal to its par value, hence, no discount or premium.

• If the required return rate > coupon interest rate, the bond sells at a value that
is less than its par value or is said to sell at a discount.

• If the required return rate < coupon interest rate, the bond sells at a value
greater than its par value or is said to sell at a premium.
Example :
Tim Sanchez wishes to determine the current value of the Mills Company’s ₱1,000,
10 % interest bond, maturing on 10 years.

• If the required return rate is 12%

PV of 1 at 12% for 10 periods .32197
PV of ordinary annuity of 1 at 12% for 10 periods 5.65022

PV of principal (₱1,000 x .32197) ₱ 321.97

PV of principal [(₱1,000 x .10)(5.65022) 565.022
Total Present Value ₱ 886.992
Principal Amount (1,000)
Discount ₱ 113.008
Example :
Tim Sanchez wishes to determine the current value of the Mills Company’s ₱1,000,
10 % interest bond, maturing on 10 years.

• If the required return rate is 8%

PV of 1 at 8% for 10 periods .46319
PV of ordinary annuity of 1 at 8% for 10 periods 6.71008

PV of principal (₱1,000 x .46319) ₱ 463.19

PV of principal [(₱1,000 x .10)(6.71008) 671.008
Total Present Value ₱ 1134.198
Principal Amount (1,000)
Premium ₱ 134.198
YIELD TO MATURITY
• Also known as the required return rate or the effective rate
• The rate that exactly discounts estimated future cash payments through the expected life of
the bonds payable or when appropriate, a shorter period to the net carrying amount of the
bonds payable
• compound annual rate of return earned on a debt security purchased on a given day and
held to maturity
Example : Earl Washington wishes to find the YTM on Mills Company’s bond. The bond currently
sells for ₱ 1,080, has a 10% coupon interest rate and ₱1,000 par value, pays interest
annually, and has 10 years to maturity.
Step 1: Determine if the bond sells at a premium or discount. In this example, the bond sell at a
premium, meaning the YTM should be less than the coupon interest rate of 10%.
Step 2 : Trial and Error
 at 8%; PV of 1 for 10 periods = .46319
PV of ordinary annuity of 1 for 10 periods = 6.71008
PV of principal (₱1,000 x .46319) ₱ 463.19
PV of interest [(₱1,000 x .10) x 6.71008] 671.008
Total Present Value ₱ 1134.98
 Step 3: Interpolate

8% 1,135
x 55
2% ? 1,080 135
10% 1,000

𝑥 .02
=
55 135

135x = 1.10
135 135
x = .00815
YTM = .08 + .00815
= .08815 or 8.81%
PERIODS OTHER THAN ANNUALLY
• Example : Mills Company’s ₱1,000, 10% interest bond pays interest semiannually and that the
required stated annual return is 12% for similar-risk bonds that also pay semiannual interest.
Solution:
PV of 1 at 6% for 20 periods 0.31180
PV of ordinary annuity of 1 at 6% for 20 periods 11.46992

PV of principal (1,000 x .31180) ₱ 311.80

PV of interest payments [(1000x.05)(11.46992) 573.496
Total Present Value ₱ 885.296