Week 5 - Valuing Shares and Bonds

Bonds are an investment ‘asset’ and their price (or value or worth) is the present value of their future cash flows. The bond contract is a special kind of business agreement. The deed of trust (bond indenture) states the explicit terms of the agreement such as the (fixed) coupon rate and the face value to be paid on the bond. The legal effect of having the agreement enshrined in a deed of trust rather than a contract of sale, means that the bond carries a stronger security of claim and lower probability of default risk. The economic effect of the trust deed means that the bond purchaser gains greater certainty over the cash flows the bond will generate. The bond must be held to maturity for it to generate the quoted yield.  The bond price remains subject to interest rate changes in the market.

The inverse relationship between interest rates and values is particularly relevant to bond markets.  If interest rates surge because of unexpected rises in inflation for example, bond prices fall analogously.  Bondholders then face the double stress of a lower bond value and lower interest income on their fixed-rate investment. Conversely, if there is a surge in demand for bonds, their yields may fall. This phenomenon has been recently reported in the US Junk bond market (BBB credit rating and below). Investors who were reportedly unhappy with the low returns being paid on secure bonds, increased their demand for riskier securities. They reportedly spent $US4.6 billion in the first six weeks of 2011 in the BBB-rated and below bond markets. This sent the high-risk class of bond yields down to extremely low levels.

(http://www.theaustralian.com.au/business/markets/junk-bond-yields-fall-to-all-time-lows/).

Essentially, the market pricing mechanism ensures that everyone gets the same deal no matter what coupon interest rate the issuer is paying. If the bond coupon rate is above the market average, you have to pay more for the bond; if the bond coupon rate is below the market average, you pay less for the bond; and if the bond coupon rate is equal to the market average, you pay the same as the face value of the bond.

Here are some slides and notes for bonds.

Ross7e_PPT_Ch06

Week 5a

Week 5 (Ch 6) Tutorial Questions

 

So another alternative for a company to raise funds is issuing stocks (shares). Take alook at this video...

 

Try to understand that first and we shall discuss later when we meet. Next, maybe I will touch a bit regarding the type of bonds...

Later...