Distinguish between the types of bonds. What factors determine their value? Explain three important relationships that exist in bond valuation.
There are many kinds of bonds, but five stick out.
Debentures are essentially long-term debt that’s sold as a bond. These are extremely risky, and are usually only worth it if they have a high return or interest rate.
Subordinated debentures have even higher interest rates, but aren’t paid out until secured debt and unsubordinated debentures are paid out, making them even riskier should the issuing company become insolvent (Debentures, n.d.).
Mortgage bonds are based on liens on property, with the property offered as collateral should the bonds not pay out. These are valued less than the property, to protect against a fluctuating market.
A fourth type of bond are Eurobonds, which are just bonds issued in some country in a denomination from another country. These can’t be bought in the US, and aren’t subject to US regulation, which makes them easy to issue and get, but can also make them risky.
Lastly are the convertible bonds, which can be converted into company stock at a certain point in the future at a certain price which is determined at the point of purchase. So, if the stock is worth more at the time of conversion, the bond holder gets a good deal, where as if the stock is worth less, the bond holder can just opt to get the cash back.
There are numerous relationships in valuing bonds. Following are just three of them.
If an investor’s required rate of return is greater than the bond’s coupon rate, then the bond’s market value is less than its par value, and vice versa. As I understand it, to get a market value that is worth your investment, you want the bond to have a coupon rate greater than your required rate of return.
As the maturity rate of a bond approaches, its market value approaches its par value. Whether the market value is less or more than the par value, it will approach par value the closer the bond comes to maturing and paying out at the par value. It either becomes more valuable if the market value is under par, or less valuable if the market value is over par.
Long-term bonds are always a higher interest rate risk than short-term bonds. Interest rates affect something based on time invested, so a drop in interest rate will affect a short-term bond far less than a long-term. The same can also be said to the reverse – a rise in interest rate would produce a greater return from a long-term bond than a short-term.