Question

The manager of a small hotel resort is considering expansion. He would like to issue bonds but do not quite understand why he may or may not receive what amount of money is stated on the face of the bond but he has to repay what is on the face of the face bond. Write a report to the manager explaining the market forces that determine how much money will be collected. Also explain how the interest payment on bonds are calculated and paid.

Answer 1

To the Manager.

Bond is a debt instrument and issued for a period of more than 1 year . The investor acquiring a bond earns interest by lending money while the borrower ( the issuer) gets needed capital (cash).

There are 3 different type of bonds pertaining to duration

- Short term bonds- 2 to 5 years.

- Medium bonds: 5 to 10 years.

- Long term bonds: 10 to 30 years.

Relationship between an interest and the time to maturity is called "yield Curve" . Investors expect increased return with increased risks. Thus the shape of a normal yield curve is upward sloping and longer term bonds normally pay returns higher than those of short term bonds.

There are many type of bonds issued by several different sources . Common ones are list are as follows

- Corporate Bonds

- Govt Bonds

- Municipal  Bonds

- Agency Bonds

- International Bonds

Bond Agreements:

Written loan agreement among all parties involved in a bond issue is called an indenture. Its an written agreement and it contains the following detail

- Terms & conditions of the bond

- Stated interest rate

- Maturity date

- Protective covenants

- Conditions defining default

- Subordination

- Sinking fund terms

- Designation and duties of the trustee.

Bond Principal :

Principal represents the dollar amount of the bond at the time it is issued. Par value is the amount the lender is repaid when the bond matures. Most bonds have a face value of $ 1,000.

Bond interest:

The interest rate stated on a bond is referred to as the coupon rate. A bonds coupon rate generally is comparable to what other bonds being issued at the time are paying. Three common forms of coupon interest on bonds are

1. Fixed Coupon rate: interest paid consistently at the same rate

2. Floating coupon rate: interest varies based on economic changes

3. Zero coupon rate: there are no ongoing interest payments ( as to bond is sold at a deep discount and redeemed at full value as compound interest accrues to the par value)

Bond Maturity:

Bonds typically have a stated maturity. This is the final date on which the bond debt becomes due for payment and the obligation is settled. Face or par value is the value of a bond maturity. A bond often is bought and sold during its lifetime . Some types of bonds may be paid back ( called) at a earlier date. At maturity, the bondholder receives the par value of the bond. A $ 1000 bond is worth $ 1,000 at maturity ( so long as the issuer does not default in payment ) .

Bond Yields:

Bonds coupon rate never changes ( except with step up bonds ) but inflation and changes in market rates affect the value of a bond.

Yields and return:

Current yield is the annual rate of return expressed as a percentage of the annual interest payment relative to the current price of the bond. Yield to maturity is the actual return on a bond from the time its purchased to maturity, assuming that all payments received are reinvested at the same rate as the original bond coupons rate. Yield to maturity considers

- interest over the life of the bond in relation to price

- purchase price in relation to par value

- any coupon or interest payments reinvested.

Bond Duration:

Bond duration considers how price of a bond changes in response to yield changes . The best interpretation of duration is the approximate price changes for a 1 % change for a 1 % changes in yield to maturity. Duration is an approximation of the price yield relation because the relation follows a curve, not straight line.

Bond Valuation:

Value of the bond is the sum of its discounted cash flows. The discount rate used is the market rate of interest. The market rate is also called the effective rate or the yield rate or the required rate of return.

Calculate the PV of the interest payments at the market rate

Calculate the PV of the face value at the market rate

Add the two PVs