Valuation of bonds
Ques1. Explain what a call provision enables bond issuers to do? Why would bond issuers exercise a call provision?
Answer: A call provision is a clause, mentioned in the bond certificate, which enables the bond issuer to repay or redeem bonds before its maturity date at a specified value (Sherman, 2011). Conditions related to time of redemption or buy back of bonds like amount to be repaid and manner in which payment is to be made are mentioned in advance. This call provision is exercised by the bond issuer at the time when the interest rates have fallen and debts are available at cheaper rate in the market. The issuer redeems the bond carrying high rate of interest and issues new bonds with low rate of interest.
Ques.2 Define a discount bond and premium bond. Provide example of each.
The bond issued by the company for the first time is a standard bond. It becomes discount bond or premium bond depending upon the price at which it is being traded in the market.
Discount bond: If the bond is being traded in the market at a price which is less than the face value, it will be termed as discount bond (Weaver & Weston, 2001). A bond becomes discount bond when it gives interest at a rate which is less than the market rate of interest. The investor will be ready to invest in bonds with lower interest rate if the purchase price of such bond is fixed in such a manner that it compensates the investor for less payment of interest in future. For example: A 5% bond is being issued at $1000. The market interest rate is 4%. The investor will be ready to invest in such bonds if the issue price is less than $1000.
Premium bond: If the bond is being traded in the market at a price which is higher than the face value, it will be termed as premium bond. A bond becomes premium bond, it its coupon rate of interest is more than the prevailing interest rate in the market. The issuer will be ready to issue such bonds if the price is fixed in such a manner that it compensates the issuer for higher payment of interest in future. For example: A 5% bond is being issued at $1000. The market interest rate is 6%. The issuer will be ready to issue such bonds if the price is more than $1000.
Ques3. What is the relationship between interest rates and bond prices?
Answer: The fundamental principle of investment in bond market is that there is inverse relationship between interest rates prevailing in the market and bond prices (SEC, 2013).
In market interest rate in bond price
In market interest rate in bond price
If the market interest rate goes up, the investor will be ready to buy bonds with low coupon rate if they are being offered at discount or low price. The investor want compensation for low interest payments to be received in future so he will be ready to buy such debentures if they are being offered at low prices. Similarly if the market interest rate goes down, the investor will be ready to buy the bonds with high coupon rate even at high prices. Thus prices of bond increase.
Ques 4: Describe the difference between coupon bond and zero coupon bond
Answer: The coupon bond is a bond which has coupon rate at which the interest is paid to the bondholder throughout the life of bonds (Sherman, 2011). The bonds are issued with interest coupons and interest is paid to the person who has the possession of coupon. The payment of interest is made at coupon rate and it may be paid quarterly, semi-annually or annually.
Zero coupon bond is a bond which does not carry any coupon of interest as no interest is payable on such bonds. These bonds are issued at deep discount and redeemed at face value on the maturity period. The difference between the issue price and the redemption value is the appreciation value and return for the investor (Weaver & Weston, 2001).
The return for the coupon bondholders is regular in nature whereas the return in case of zero coupon bonds is in the nature of capital appreciation.
References
SEC. (2013). Interest rate risk —When Interest rates Go up, Prices of Fixed-rate Bonds Fall. Retrieved February 2017, from https://www.sec.gov: https://www.sec.gov/investor/alerts/ib_interestraterisk.pdf
Sherman, E. H. (2011). Finance and accounting for nonfinancial managers (3rd ed.). New York: NY: American Management Association.
Weaver, S., & Weston, J. F. (2001). Finance and accounting for non financial managers (3rd ed.). New York: NY: Mc Graw Hill.
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