Summary (2)
by Maestri- The value of a bond is found as the present value of an annuity (the interest payments) plus the present value of a lump sum (the principal). The bond is evaluated at the appropriate periodic interest rate over the number of periods for which interest payments are made.
- The equation used to find the value of an annual coupon bond is:
- The return earned on a bond held to maturity is defined as the bond’s yield to maturity (YTM). If the bond can be redeemed before maturity, it is callable, and the return investors receive if it is called is defined as the yield to call (YTC). The YTC is found as the present value of the interest payments received while the bond is outstanding plus the present value of the call price (the par value plus a call premium).
- The longer the maturity of a bond, the more its price will change in response to a given change in interest rates; this is called interest rate risk. However, bonds with short maturities expose investors to high reinvestment rate risk, which is the risk that income from a bond portfolio will decline because cash flows received from bonds will be rolled over at lower interest rates.
- Corporate and municipal bonds have default risk. If an issuer defaults, investors receive less than the promised return on the bond. Therefore, investors should evaluate a bond’s default risk before making a purchase.
- There are many different types of bonds with different sets of features. These include convertible bonds, bonds with warrants, income bonds, purchasing power (indexed) bonds, mortgage bonds, debentures, subordinated debentures, junk bonds, development bonds, and insured municipal bonds. The return required on each type of bond is determined by the bond’s riskiness.
- Bonds are assigned ratings that reflect the probability of their going into default. The highest rating is AAA, and they go down to D. The higher a bond’s rating, the lower its risk and therefore its interest rate.
Taken From : Five-Minute MBA – Corporate Finance
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