Describe the essential characteristics of a bond and how these characteristics interact to determine bond value, inclusive of how both the interest rate and coupon rate influence bond value and pricing.
It is probable to identify bonds as the investment option of primary importance, and the proper usage of bonds becomes one of the most significant issues. Bonds are to be bought with a set interest rate (Ku & Yoo, 2015). To receive cash, it is possible to sell them early. If one wants to sell their bonds early, it is necessary to consider the present-day interest rates. The bond may be sold for a premium price as long as the existing rates are lower in comparison with the interest of the bond (Ku & Yoo, 2015). On the other hand, the converse proposition may also be stated: should the present-day rates be higher than the interest rate of a certain bond, it will be possible to sell it only at a lower price.
Summarize call provisions and sinking fund provisions. Explain how these types of provisions individually make bonds more or less risky for a) an investor, and b) the issuer.
By means of the call provisions, the issuing company has the opportunity to repurchase the bonds before the maturity at a certain price which is termed as the call price. While investors demand the higher yield to repay for the provision, other issues are level, and it makes one sure that the bond will remain payable at any moment to some extent. It is necessary to say that the advantage of the sinking fund provision is that the money may be utilized to pay off the active debts on particular bonds. However, there is also the disadvantage of the sinking fund provision: the issuer can pay the bond early, and the agreement with the bond owner is not necessary (Burton, Nesiba, & Brown, 2015).
The value of an asset whose value is based on expected future cash flows is determined by the present value of all future cash flows the assets will generate. Given the case scenario and target audience provided, select and discuss a simple asset situation that could apply to exemplify this concept.
In case of a simplified financial scenario, the task of paramount importance is to understand how a person should spend their money at the moment. Having $500 for the next year purchase, an individual should not just keep this money: the mere saving results in the loss of value on it. It would be wiser to try and earn the interest.
For example, a person has $1000 at the moment. They understand that the value of money will grow up to $1060 provided they are investing this money in some investment yielding 6% per year. In this context, the cash flow adds up to $6.
One more illustration is the purchase of the machinery. Until it gets broken, it can make products that will be sold for $200 000 per annum for five years. To identify the value of the machinery, it is necessary to remember that it will depend on the future cash inflow generated. When the cost of the machinery is lesser than the current value of the future benefits, it is probable to make a purchase. Otherwise, it will be unfavorable to buy this machinery.
Define what it means when a bond is callable. Provide two measures you can review to understand what type of returns to expect if the bond is called or if it is not called.
It is possible to identify some bonds as callable. When the bond is issued, the issuer has a chance to reserve their right to call the bond early providing it is a favorable option, and the present rates indicate it (Azar, 2015). In other words, a callable bond enables the issuer to return the investor’s principal and stop interest payments prior to the maturity date of this bond (Burton et al., 2015). One should take into account whether the bond that is being bought is callable. It is essential because, as the bond owner, a person can, first of all, closely monitor a certain market and then track if the situation when the bond might need to be sold early is likely to occur. If these conditions are observed, one can ensure it is not called when the rates become high.
Describe the type of returns one could one expect with a callable bond trading at a premium price and provide your rationale. Explain the significance of the designation “premium price.” Discuss why or why not a callable bond trading at a premium price would be an appropriate investment for the target audience’s organizations.
It is estimated that the bonds trading at a “premium price” may be sold for a substantial return on the investment (Dickinson, 2015). For instance, a certain bond is sold at its face value, $10 000, with a 5-year term and 5% interest: it means that a person will receive not only their $10 000 but also the annul $500 at its maturity (Investopedia, n.d.). However, it does not guarantee the future success since the prices are determined by a wide range of factors, such as the supply and demand. It is not recommended to sell the callable bond at the premium price: the issuer might call the bond and then reissue it at the less profitable for the bond owner interest rate – consequently, a person risks their own money or, under relatively favorable conditions, the opportunity to earn the interest on this investment.
Select an example scenario appropriate to the seminar’s target audience. Write a general expression for the yield on a probable debt security (rd) and define these terms in regards to that hypothetical security: real risk-free rate of interest (r*), inflation premium (IP), default risk premium (DRP), liquidity premium (LP), and maturity risk premium (MRP).
In terms of the real risk-free rates (r*), it is the interest rate that equates the average supply of riskless securities and demand for them in an economy with zero inflation (Dickinson, 2015). The recent data demonstrating the reduction of this rate of interest from 2 to 4% in the United States have been found in the present-day literature (Burnton et al., 2015). Further, it is necessary to emphasize that the inflation premium (IP) implies the aggregate rates of inflation predicted over the life of the security. The inflation premium is the premium supplemented to the real risk-free rates of interest in order to compensate for the expected loss of purchasing power (Cussen, n.d.). As for the default risk premium (DRP), it provides the higher risk bonds with the opportunity to have better investment yields. Later on, the liquidity premium (LP) means the value that can be considered in case a company, especially a small one, is dissolved – it is not uncommon for such businesses. In relation to the real risk-free rate of interest, LPs are added to it. Finally, maturity risk premium is also summarized with the real risk-free rate of interest to compensate for interest rate risk; its function is to examine various types of bonds and identify those that are characterized by the most profitable maturity rates at the period of maturity (Burnton et al., 2015). The example scenario may be the situation when the interest rate on a three-month U.S. Treasury bill is used as the risk-free rate for U.S.-based investors (Cussen, n.d.).
Define the nominal risk-free rate (rRF) and provide an example relevant to your target audience of a specific security that can be used as an estimate of rRF.
It is probable to define the nominal, or quoted, risk-free rate (rRF) as the “the real risk-free rate plus a premium for expected inflation,” and the formula rRF= r*+IP is relevant (Brigham & Ehrhardt, 2013, p. 210). In comparison with other indices, the nominal risk-free rate is notable for the lower risks; in spite of this fact, investing one’s money is still associated with some risk. As a rule, these rates are usually either the U.S T-bill rate for short-run risks or the U.S. T-bond rate for long-run risk-free rates (Burnton et al., 2015).
Describe interest rate risk and reinvestment rate risk and how these relate to the maturity risk premium. Based on reinvestment rate risk, provide an example on how a 1-year bond or a 10-year bond would be a better investment for a typical community as represented by those attending your seminar.
The interest rate risk can be described as the value of the bonds that a person owns at the moment. As it has been mentioned above, the bonds incur the risk of the loss in value provided the interest rates increase before they come to maturity. The reinvestment rate risk can be defined as the risk that a bond owner faces when their bond matures or if it is called, and the present-day rates are low (Brigham & Ehrhardt, 2013). The newly purchased bonds are not going to lead to the same return if the rates are lower during the purchase, and, in this respect, I can suggest that both the 1-year bond and the 10-year bond should become good options. They are connected with strengths and weaknesses, and the combination of these types is likely to reduce the potential loss of money and mitigate the total risks.
Select an example appropriate to your seminar target audience to explain the concepts of a) term structure and interest rates and b) yield curve.
The term structure can be defined as the “relationship between the interest rates (yields) on bonds and their maturities” composed of three components: interest paid on the bond, expected capital gain or loss, and liquidity services rendered (Business Dictionary, n.d.). The present-day interest rates are the fundament of these interest rates. If the relationships between the yields and the maturities of securities are presented graphically, one deals with the yield curve. Using these data, one can identify where the most profitable investments are. Following the example of the U.S. Treasury, one can state its yield curve includes the three-month, two-year, five-year and 30-year issued U.S. Treasury debt (Cussen, n.d.).
Review corporate bankruptcy law. If a firm were to default on its bonds, describe how the company assets could be/would be liquidated. What is a likely outcome for bondholders? Select and describe an example scenario that applies to your seminar attendees’ organizations.
If a firm is ordered to liquidate their assets because of the bankruptcy, one should be aware of where their investments stand. Prior to the satisfaction of debts, the firm would have to pay the taxes (Lunny, 2014). The bond owners may fail to return their money or lose the interest. Knowing the reasons and the consequences, the attendees will learn how to avoid small organizations’ bankruptcy and manage their taxes and debts.
References
Azar, S. A. (2015). Why callable bonds are not called when the market price reaches the call price: A duration argument. International Journal of Business and Management, 11(1), 90-95.
Brigham, E. F., & Ehrhardt, M. C. (2013). Financial management: Theory & practice. New York, NY: Cengage Learning.
Burton, M., Nesiba, R., & Brown, B. (2015). An introduction to financial markets and institutions. New York, NY: Routledge.
Business Dictionary. (n.d.). The term structure of interest rates. Web.
Cussen, M.P. (n.d.). Introduction to treasury securities.
Dickinson, K. (2015). Financial market operations. New York, NY: John Wiley & Sons.
Investopedia. (n.d.). Premium bond.
Ku, J., & Yoo, J. (2015). Bond, the treaty power, and the overlooked value of non-self-executing treaties. Notre Dame Law Review, 90(4), 1607-1630.
Lunny, D. (2014). Checklist for going into business. Boca Raton, FL: Productive Publications.