In previous chapters, we noted that companies raise capital in two main forms: debt
and equity. In this chapter, we examine the characteristics of bonds and discuss the
various factors that in! uence bond prices. In Chapter 9, we will turn our attention to
stocks and their valuation.
If you skim through The Wall Street Journal, you will see references to a wide vari-
ety of bonds. This variety may seem confusing; but in actuality, only a few character-
istics distinguish the various types of bonds.
When you " nish this chapter, you should be able to:- Identify the di# erent features of corporate and government bonds.
- Discuss how bond prices are determined in the market, what the relationship is
between interest rates and bond prices, and how a bond’s price changes over time
as it approaches maturity. - Calculate a bond’s yield to maturity and its yield to call if it is callable and deter-
mine the “true” yield. - Explain the di# erent types of risk that bond investors and issuers face and the way
a bond’s terms and collateral can be changed to a# ect its interest rate.
7-1 WHO ISSUES BONDS?
A bond is a long-term contract under which a borrower agrees to make payments
of interest and principal on speci! c dates to the holders of the bond. Bonds are
issued by corporations and government agencies that are looking for long-term
debt capital. For example, on January 3, 2009, Allied Food Products borrowed
$50 million by issuing $50 million of bonds. For convenience, we assume that
Allied sold 50,000 individual bonds for $1,000 each. Actually, it could have sold
one $50 million bond, 10 bonds each with a $5 million face value, or any other
combination that totaled $50 million. In any event, Allied received the $50 million;
and in exchange, it promised to make annual interest payments and to repay the
$50 million on a speci! ed maturity date.
Bond
A long-term debt
instrument.Bond
A long-term debt
instrument.bonds over Treasuries rose from 2.4% to 7.5% the 6 months
from mid-2007 in January 2008.
Bond investors are rightly worried today. If a recession
does occur, this will lead to increased defaults on corporate
bonds. A recession might benefit investors in Treasury
bonds. However, because there have already been several
rounds of Federal Reserve rate cuts, Treasury rates may not
have much room to fall. Also, there is concern that recent
Fed easing is sewing the seeds for higher inflation down the
road, which would lead to higher rates and lower bond
prices.In the face of similar risks in 2001, a BusinessWeek Online
article gave investors the following advice, which is still
applicable today:Take the same diversified approach to bonds as you do
with stocks. Blend in U.S. government, corporate—
both high-quality and high-yield—and perhaps even
some foreign government debt. If you’re investing tax-
able dollars, consider tax-exempt municipal bonds.
And it doesn’t hurt to layer in some inflation-indexed
bonds.P U T T I N G T H I N G S I N P E R S P E C T I V E
Chapter 7 Bonds and Their Valuation 195Sources: Scott Patterson, “Ahead of the Tape: Junk Yields Flashing Back to ’01 Slump,” The Wall Street Journal, January 30, 2008, p. C1;
Stocks, Bonds, Bills, and Inflation: (Valuation Edition) 2008 Yearbook (Chicago: Morningstar, Inc., 2008); and Susan Scherreik, “Getting the
Most Bang Out of Your Bonds,” BusinessWeek Online, November 12, 2001.