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Q: Bonds and yield to maturity ( Answered ,   0 Comments )
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 Subject: Bonds and yield to maturity Category: Business and Money > Finance Asked by: mammabear-ga List Price: \$20.00 Posted: 03 Dec 2005 07:00 PST Expires: 02 Jan 2006 07:00 PST Question ID: 600872
 ```I am in the midst of taking an online Finance class. Although I have read the text in Finance book I cannot find the answer to this question. I do not just want the answer. I need to know where I can find the information to this answer. Other things equal, will the following provisions increase or decrease the yield to maturity at which a firm can issue a bond? a.) Call provision b.) A restriction on further borrowing? c.) A provision of specific collateral for the bond? d.) An option to convert the bonds into shares? Thank you for your help!```
 ```Hi!! The first thing you need to know is what are you talking about, that is a key definition is needed to answer this question: Yield to Maturity: "A rate of return measuring the total performance of a bond (coupon payments as well as capital gain or loss) from the time of purchase until maturity." "Yield to Maturity (YTM) - Definition": http://www.moneychimp.com/glossary/ytm.htm The calculation of YTM takes into account the current market price, par value, coupon rate and time to maturity, and it is also assumed that all coupons are reinvested at the same rate. See also "Bond Yield to Maturity (YTM) Formula": http://www.moneychimp.com/articles/finworks/fmbondytm.htm So, at the moment in which a bond is issued all of its future payouts are determined. The issuer defines the variables and with that it is determining the YTM, which results being the rate of return offered to the investors. As in all investments lower rates are accepted for low risk investment and viceversa high rates are needed to make attractive a high risk investment. So what do you need to find is how the different provisions affect the possibility to get more return on investment to the bond holders, and with this you can determine if a higher or lower YTM is needed in the offer. a.) Call provision: Call provision is a clause in the written agreement between the bond issuer and the bondholder granting the issuer the right to buy back all or part of an issue prior to the maturity date. Buying a callable bond the buyer of the bond is giving up something: under certain conditions, the right to hold the bond until its maturity is not exclusive of the bond holder, the issuer have the right to redeeem the bonds if the market rate or other variables make this option advantageous for its interests. With this action wealth will transferred from the bondholders to the shareholders. Thus, the buyer is only willing to pay less for the callable bonds. "A bond call will typically occur when market rates have fallen to a level where refunding the bond issue will be profitable to the issuer. Because call provisions subject investors to reinvestment risk, callable bonds will carry higher yields than non-callable bonds, all else being equal." From "BOND CALL - Definition": http://bwnt.businessweek.com/Glossary/definition.asp?DEFCode=B30 See also: "callable bond Definition": "...A company will often call a bond if it is paying a higher coupon than the current market interest rates. Basically, the company can reissue the same bonds at a lower interest rate, saving them some amount on all the coupon payments..." http://www.investorwords.com/671/callable_bond.html As you can see call provision gives the bond issuer a valuable option to save money, but this money is taken from the bond holders' future gains. The investors will require a compensation to buy this kind of bonds. -------------------- b.) A restriction on further borrowing: A bond issued with this provision is a Bond Covenant: "COVENANT or BOND COVENANT": "... A covenant whereby the issuer is affirmatively obligated to undertake a duty in order to protect the interests of bondholders (e.g., to maintain insurance) is called a ?protective covenant.? ..." http://www.msrb.org/msrb1/glossary/view_def.asp?param=COVENANT Covenants are designed to protect the interests of the bondholders, and in this particular case, this provision is clearly a protective one that gives more security to the holders and restrict the issuer's actions. The issuer is giving a plus with the bond: it restrict its actions in order to give the investors more security lowering the risk of the bonds, then this bonds will require lower YTM. See also: "Bond Covenants": http://www.finpipe.com/bcoven.htm "FINANCIAL CONTRACTING - Chapter 9": See the section '9.6 Working in Contractual Relationships' http://www.washburn.edu/sobu/rhull/cf9.html "Session 6: Bond and Other Long Term Finance": See the section 'Trust Deeds and Covenants'. http://cbdd.wsu.edu/kewlcontent/cdoutput/TOM505/page38.htm ------------------- c.) A provision of specific collateral for the bond: Now we are talking about a Secured Bond: "Bond backed by collateral, such as a mortgage or lien, the title to which would be transferred to the bondholders in the event of default. The most common form of secured bonds are mortgage bonds. These bonds are backed by real estate or physical equipment that can be liquidated. These are thought to be high-grade, safe investments. Other bonds are secured by the revenues created by projects. If an issuer in default has both secured and unsecured bonds outstanding, secured bondholders are paid off first, then unsecured bondholders. Naturally, because unsecured bonds carry greater risk than secured bonds, they usually pay higher yields." From "secured bond Definition": http://www.investorwords.com/4435/secured_bond.html See also: "Secured Bond: A type of bond that is secured by the issuer's pledge of a specific asset, which is a form of collateral on the loan. In the event of a default, the bond issuer passes title of the asset or the money that has been set aside onto the bondholders. Secured bonds can also be secured with a revenue stream that comes from the project that the bond issue was used to finance. Because of the pledge of an asset, secured bonds are seen as less risky than unsecured bonds, and they generally provide lower returns than unsecured bonds. Securing a bond with the pledge of an asset is also a way for the bond issuer to lower its interest payments. This means that secured bonds provide investors with a lower return than unsecured bonds because even in the event of default, investors will be compensated at least somewhat for their investment. Some types of secured bonds are mortgage bonds and equipment trust certificates." From "Secured Bond": http://www.investopedia.com/terms/s/securedbond.asp Since this type of bonds have lower risk than unsecured bonds, they will require lower YTM. For further reading see: "Bonds: Secured Vs. Unsecured": http://www.ameritrade.com/educationv2/fhtml/stocksfunds/secvsunsecured.fhtml#secured ----------------- d.) An option to convert the bonds into shares: Bonds giving an option to convert the them into shares provide a substantial additional profit opportunity for investors. These bonds are Convertible Bonds: "A corporate bond, usually a junior debenture, that can be exchanged, at the option of the holder, for a specific number of shares of the company's preferred stock or common stock... ...convertible bonds tend to have lower interest rates than non-convertibles because they also accrue value as the price of the underlying stock rises. In this way, convertible bonds offer some of the benefits of both stocks and bonds..." From "convertible bond Definition": http://www.investorwords.com/1110/convertible_bond.html See also "Money Digest: Convertible bonds - Fixed Income Investing": "Convertible bonds are like other bonds except for one special feature: they give you the privilege of exchanging the bonds for a specified number of shares of the company before a certain date. Because of this attractive feature, the interest rate on convertibles is usually lower..." http://www.findarticles.com/p/articles/mi_m0JQR/is_1_18/ai_96694483 You can say that these bonds are "callable by the holders", and since the bonds callable by the issuer gives them a valuable option to save money, these ones gives this option to the holders lowering the risk of the bonds and they will therefore require a lower YTM. More info here: "Should You Buy Convertible Bonds?": http://www.kiplinger.com/personalfinance/basics/investing/bonds/convertibles.html ------------------------------------------------------------------- For further reading I suggest you the following articles and documents: "Bonds and their valuation" (PowerPoint presentation): http://uwacadweb.uwyo.edu/sanning/Chapter07_overheads.ppt "An Investor's Guide to Corporate Bonds" (PDF file): http://www.bondmarkets.com/assets/files/An_Investors_Guide_to_Corporate-Bonds(2).pdf "What Are Bonds?": Continue the reading with the links at the left frame menu. http://www.ameritrade.com/educationv2/fhtml/stocksfunds/whatrbonds.fhtml "Financial Pipeline Bond Page": http://www.finpipe.com/fixed.htm "Introduction To Bonds - InvestorGuide University": Continue the reading with the links at the right frame menu. http://www.investorguide.com/igup1-introduction-to-bonds.htm ---------------------------------------------------------- -Search strategy- At Google.com I used to search the following keywords: calculation "yield to maturity" bond definition "yield to maturity" callable bonds callable bonds risk covenant bond covenant risk bond secured bonds risk convertible bonds convertible bonds "yield to maturity" I hope that this heps you. Feel free to use the clarification feature if you need it before rate this anser. Regards, livioflores-ga```
 mammabear-ga rated this answer: and gave an additional tip of: \$5.00 `Thank you so much. The links are so much more helpful.`