Interest Rates and Bond Valuation

Bonds are units of corporate debt issued by companies and securitized as tradeable
assets. It has different features than stocks and their prices tend to be less correlated,
making bonds a good diversifier for investment portfolios. Finding the value of a bond
can be calculated as Bond value = C × [1 − 1/(1 + r) t ]/r + F/(1 + r) t. where: C =
Coupon paid each period r = Rate per period t = Number of periods F = Bond’s face
value.

A bond will always clearly state its par value, also called face amount or face value.
Unlike market value, which changes as a stock or bond is sold on the secondary
market, par value is determined by the issuer and is fixed for the duration of a security.
Coupon rate is the interest rate that is used to calculate periodic interest, or coupon
payments, on the bond. It refers to the annual interest rate paid on a bond, paid from
issue date through maturity. The most common periods for coupon payments other than
annual are semiannual and quarterly.

Coupon payment refers to the regular interest payment on the bond. The coupon or
periodic interest payment is determined by multiplying the par value of the bond by the
coupon rate. The payment schedule can be quarterly, semiannually or annually,
depending on the agreed time. Coupon payment = face value * (annual coupon rate /
number of payments per year). Maturity date is the expiration date of the bond, or the
point in time when the term of a bond comes to an end. It is used to classify bonds into
three main categories: short-term, medium-term, and long-term. Bonds with longer
terms to maturity typically offer greater coupon rates.

Yield to maturity is essentially the discount rate used to bring the future cash flows of a
bond into present value terms. It helps quantify the overall investment value of a bond.
To calculate the approximate yield to maturity, you need to know the coupon payment,
the face value of the bond, the price paid for the bond and the number of years to
maturity. Interest rate risk is the probability of a decline in the value of an asset resulting
from unexpected fluctuations in interest rates. It is an inevitable part of the lending
business model for all financial intermediaries offering debt financing and interest-
bearing products, particularly for fixed-income securities.

Debt refers to the source of money raised from loans on which the interest is required to
be paid while equity refers to stocks, or an ownership stake, in a company. Buyers of a
company's equity become shareholders in that company. As a general rule, equity
represents an ownership interest, and it is a residual claim. Long Term Debt describes a
financial obligation with a maturity exceeding one year. The duration of a long-term debt
instrument is known as its maturity.

Debt securities can be short term (with maturities of one year or less) or long term (with
maturities of more than one year). The two major forms of long-term debt are public
issue and private issue. Public debt is obligations of governments, particularly those
evidenced by securities, to pay certain sums to the holders at some future time while
private debt includes any debt held by or extended to privately held companies. The
indenture is the written agreement between the corporation (the borrower) and its
creditors. It is sometimes referred to as the deed of trust. The bond indenture is a legal
document.
Term bonds are notes issued by companies to the public or investors with
scheduled maturity dates. Corporate bonds are usually in registered form. This means
that the company has a registrar who will record the ownership of each bond and record
any changes in ownership. Alternatively, the bond could be in bearer form. This means
that the certificate is the basic evidence of ownership, and the corporation will “pay the
bearer.” There are two drawbacks to bearer bonds. First, they are difficult to recover if
they are lost or stolen. Second, because the company does not know who owns its
bonds, it cannot notify bondholders of important events. Debt securities are issued by
governments and corporations and sold to investors as fixed-income debt assets.

Debt securities are classified according to the collateral and mortgages used to protect
the bondholder. Collateral means something provided to a lender as a guarantee of
repayment. Mortgage securities are secured by a mortgage on the real property of the
borrower. A debenture is an instrument used by a lender, such as a bank, when
providing capital to companies and individuals. Debts may be labelled as senior or
junior to denote seniority and suggest preference in position relative to other lenders.
Bonds can be repaid at maturity, early repayment in some form is more typical and
often is handled through a sinking fund.

A sinking fund is a type of fund that is created and set up purposely for repaying
debt. A call provision is a clause in the contract for a bond that allows its issuer to pay
off the bond before its maturity date. A protective covenant is that part of the indenture
or loan agreement that limits certain actions a company might otherwise wish to take
during the term of the loan. The bond market is often referred to as the debt market,
fixed-income market, or credit market. It can help investors diversify beyond stocks.
Bonds can be bought and sold in two different ways -- through the primary market and
in the secondary market.

Inflation has some effect on Interest rates because a lender must charge
more interest during high inflation periods because he needs to cover the loss of
purchasing power. Nominal rates are called “nominal” because they have not been
adjusted for inflation. Real rates are rates that have been adjusted for inflation.
The Fisher effect examines the link between the inflation rate, nominal interest rates
and real interest rates.

Jerrie May B. Jambangan

BA309