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What is a Bond?

what is a bondWhat is a bondIt is a corporate or government debt instrument. It represents a loan to the company from the investing public. In this case, the company is the borrower and the investor is the lender. Companies issue bonds to raise money for business investments.

What is a Bond?

A bond has a par value, a maturity date, and a coupon rate. The maturity date is the date the company must repay the investor an amount equal to the par value. The par value is the amount the lender will receive at the maturity date. The coupon rate is the interest rate on the bond. A coupon is typically semi-annually. So if the bond has a coupon rate of 8%, the investor will receive two payments per year, each equal to 4% of the bond’s par value.

Rating agencies rate the creditworthiness of bonds. High quality bonds are considered investment grade. Low quality bonds are considered noninvestment grade, or junk bonds.

what is a bond

See Also:
Non-Investment Grade Bonds
Yield to Maturity of a Bond
Zero Coupon Bonds
Sukuk
Baby Bonds

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Zero Coupon Bonds

See Also:
What is a Bond
Non-Investment Grade Bonds
Covenant Definition of a Bond Contract
Yield to Maturity of a Bond
Financial Instruments

Zero Coupon Bonds

Zero coupon bonds are a debt security that does not have periodic interest payments. The bond, issued at a deep discount from par value, compensates for the lack of interest payments. Then they are redeemed at par value at maturity.

Stripped Bond

Banks or dealers create strip bonds, synthetic zero-coupon bonds. Therefore, separate the principal amount (the corpus) from the interest payments (the coupon payments) and sell the two parts separately to investors. Thus, this creates zero-coupon bonds. The investors then receive a lump sum at the maturity date, equal to the value of corpus or the coupon payments, depending on their contract. The contracts are known as STRIPS (Separate Trading of Registered Interest and Principal of Securities).

Imputed Interest

According to the IRS, the holder of a zero-coupon bond owes income tax on the bond’s imputed interest. Imputed interest refers to the implied periodic interest payments that the bondholder does not actually receive until maturity. Imputed interest on zero-coupon bonds issued by municipalities is tax exempt.

zero coupon bonds

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Yield to Maturity of a Bond

See Also:
What is a Bond
Non-Investment Grade Bonds
Covenant Definition of a Bond Contract
Zero Coupon Bonds
Financial Instruments

Yield to Maturity Concept

The yield to maturity (YTM) of a bond represents the annual rate of return for the full life of the bond. The YTM assumes the investor will hold the bond to maturity, and that all interest payments will (hypothetically) be reinvested at the YTM rate.

For example, a bond with a maturity of 10 years and a YTM of 5% implies that buying this bond and holding it for the full ten years would give the investor an annual return of 5% on the invested capital.

Given the bond’s price, par value, maturity date, coupon rate and coupon payment schedule, the YTM represents the time value of money – incorporating the aforementioned variables – that sets the bond price equal to the present value of the future payments of the bond, including coupon payments and principal redemption. The YTM is equal to the bond’s discount rate and internal rate of return.

Define Yield to Maturity

Yield to maturity is the implied annual rate of return on a long-term interest-bearing investment, such as a bond, if the investment is held to maturity and all interest payments are reinvested at the YTM rate.

Current Yield Calculation

The current yield of a bond differs from the yield to maturity. The current yield of a bond represents the implied return on the bond for one year, given the coupon payments and the current market price. For example, if an investor buys a bond for $95 with an annual coupon payment of $5, the current yield for that bond would be 5.26% (.0526 = 5/95). The current yield formula is:

Current Yield = Annual Payment/Current Market Price

Yield to Maturity – Bond Price

If a bond’s yield to maturity is greater than its current yield, the bond is selling at a discount, or a price less than par value. If YTM is less than current yield, the bond is selling at a premium, or a price above the par value. If YTM equals current yield, the bond is selling at par value.

Discount Price – Yield to Maturity > Current Yield

Premium Price – Yield to Maturity < Current Yield

Par Value Price – Yield to Maturity = Current Yield

Bond Yield To Maturity Formula

The formula for a bond’s yield to maturity is complicated and solving it mathematically often requires a process of trial and error. It is possible to get an approximate YTM for a bond using a bond yield table. The best way to compute the YTM for a bond is to use a financial calculator. Using a financial calculator, punching in four out of five of the relevant variables (price, par value, maturity, coupon payment, YTM) will give you the fifth variable.

To calculate the bond’s YTM, solve this formula for YTM:

Price = Coupon Payment x 1/YTM (1 – (1/((1+YTM)^Time Periods)) + Future Value/((1 + YTM)^Time Periods)

 

yield to maturity

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Par Value of Bonds

Par Value of Bonds Definition

The par value of bonds definition refers to the principal – the amount of money the bondholder receives when the bond matures. Par value is also called face value or nominal value. It is the amount stipulated in the bond contract. However, par value does not include interest payments. Bond interest rates are quoted as a percentage of the par value of the bond. While bond prices can fluctuate, the bond always matures at par value. However, if the bond issuer defaults, the bondholder may only receive a portion of the par value or nothing at all.

A bond priced above par value is selling at a premium and a bond priced below par value is selling at a discount.

Par values for corporate bonds, municipal bonds, and federal government bonds are usually $1,000, $5,000, and $10,000, respectively.

Bond Face Value

The face value of a bond is the same as the par value of a bond. It is the principal amount.

Nominal Value, Bond

The nominal value of a bond is the same as the par value of a bond. It is the principal amount.

Par Value of Bonds

See Also:
Common Stock
Company Valuation
Convertible Debt Instrument
Coupon Rate Bond
Covenant Definition of a Bond Contract
Fixed Income Securities
Long Term Debt
Maturity Date
Non-Investment Grade Bonds
Owner’s Equity
Preferred Stocks

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Paid in Capital (APIC)

See Also:
Common Stock Definition
Preferred Stocks (Preferred Share)
Treasury Stock (Repurchased Shares)
Owner’s Equity
Balance Sheet

Paid in Capital Definition

The paid in capital definition is the total amount paid on equity or stock over the par value of the stock. In addition, it is a balance sheet account in the stockholder’s equity section. This account simply represents the market value over the book value of the equity. It is also called the premium stock, premium on stock, or additional paid in capital (APIC).


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Paid in Capital Equation

The following paid in capital equation is simply put as the amount paid for the stock over the par value of the stock:

Amount Paid Common Stock – Par Value Common Stock = Additional Paid in Capital

Usually the amount paid for the stock is at the market value so the following formula can also be looked at:

Market Value Stock – Book (par) Value Stock = Additional Paid in Capital

Paid in Capital Example

For example, Yazoo inc. is looking to make a public offering in the market for $2 par value common stock in the amount of 100,000 shares. Thus, the book value of the common stock is $200,000. The investment bank believes that the company will be able to receive a price based on its current market value of stock at $20 per share. Yazoo is unsure that they can receive this price. So, they opt to sell the stock at $19 per share first to the investment bank allowing them to make the offering. They can now debit cash in the amount of $1.9 million. Yazoo will also credit common stock for $200,000 or the book value, and it will also credit the additional paid in capital (APIC) account for the remainder of $1.7 million.

Note: If successful in supplying the market with the stock, then the investment bank will make a profit of $1 million dollars that Yazoo would not see. However, many companies perform this same maneuver to take the volatility of the market out of the equation allowing Yazoo to lock in a price for the financing that they will receive. This is where the term underwriting comes from when referring to investment banking.

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Paid in Capital Definition, Paid in Capital Equation, Paid in Capital
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Paid in Capital Definition, Paid in Capital Equation, Paid in Capital

 

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Commercial Paper

See Also:
Convertible Debt Instrument
NonInvestment Grade Bonds
Collateralized Debt Obligations
External Sources of Cash
Certificate of Deposit (CD)
What Your Banker Wants You To Know
Commercial Bank
Convertible Debt Instrument

Commercial Paper Definition

Commercial paper is a short-term debt instrument. Companies can borrow money by issuing it to investors.

It is unsecured, meaning collateral does not back it up. Values range from $25,000 and up. Furthermore, the typical value is $100,000. Maturities range from 2 days to 270 days, and the typical maturity is 30 days. As long as the maturity is less than 270 days, you do not have to register the debt with the SEC. It is often issued at a discount from par value, issued with interest payments, or both. Credit rating agencies rate commercial paper.

When to Issue Commercial Paper

Companies that issue commercial paper are typically large corporations with good credit. They issue it because the debt instruments have flexible maturities. They are also usually cheaper than bank loans. Finance the current assets and short-term obligations using the proceeds. Then issue it directly to investors or via a dealer.

Investors that invest in commercial paper, usually large-scale institutional investors such as mutual funds, consider it issued by a creditworthy corporation to be a safe investment. However, the returns earned on it are low.

commercial paper

 

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Capital Impairment Rule

See Also:
Dividends
Dividend Payout Ratio
Dividend Yield
Capital Structure Management
Balance Sheet

Capital Impairment Rule

The capital impairment rule is a state-level legal restriction on corporate dividend policy. The rule applies in most U.S. states. It basically limits the amount of dividends a company can pay out to shareholders. The limit is described as either a limit per capital stock or per the par value of the firm. Essentially, for a given amount of capital stock or a given firm value, there is a maximum limit to the value of dividends that a company can distribute to stockholders.

The purpose of the rule is to protect claims of creditors who have lent money to the firm in question. The idea is that a troubled firm, one that is in default or on the brink of bankruptcy, must not be able to unload cash to owners and shareholders before going out of business. Doing so would leave debt holders and creditors high and dry, or at least diminish the amount of value they could recoup from their loans. The capital impairment rule, by limiting the dividend payout, ensures that creditors will be able to reclaim a larger portion of their loans in the event of default or liquidation.

capital impairment rule

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