As the previous examples
illustrate, bonds rarely trade at par. Attached
is an excerpt from the 07/19/02 Wall Street
Journal of bonds traded on the NYSE. Each
line is packed with information. Consider the
information about these AT&T bonds:
AT&T 6-3/4 04
AT&T 7-3/4 07
AT&T 8-1/8 22
AT&T 8-5/8 31
From this information, we learn
- the first listed AT&T bond has a coupon
rate of 6.75% and maturity date in the year
- its current yield is 6.9%
- its closing price on 07/18/02 was 97.50 (where
100 is 100% of par)
- this price is down .38 from the previous day
- 511,000 bonds were traded on 07/18/02.
This means that if you buy the 6.75% AT&T
bond at 97.50% of its face value, the investment
will yield interest payments comparable to a 6.9%
bond that matures in 2004. Consider the other
for bond price fluctuation
change in price for essentially two reasons: (1)
the issuer's riskiness changes; and (2) economic
changes cause interest rates to change - most
pronouced for long-term bonds.
Effect of changes in debt rating. What
happens if a debt rating agency (such as Moody's)
downgrades AT&T debt? The bonds now must
offer a higher yield, to compensate for the
debt's now perceived higher risk -- the bond's
price falls. For example, if the required return
(yield) on the second listed bond increased
to 8.9%, the price would fall from 97.75 to
about $95.08. (The price would rise if AT&T's
perceived riskiness fell.)
Effect of changes in interest rates.
What happens to the price of AT&T
bonds if the Federal Reserve lowers the prime
lending rate and markets perceive that long-term
interest rates will fall? The bonds now can
offer a lower yield, in line with the market's
expectation that long-term debt will pay lower
interest rates, and the bond's price rises.
That is, bond prices rise when interest rates
fall. (And bond prices fall, when interest rates
rise.) For example, if the yield on long-term
bonds fell to 7.8%, the price of the third listed
bond would rise to $103.30.
return (yield) and bond prices
have seen, when a bond's coupon rate differs from
its yield, its price will differ from par value.
Notice the relationship between a bond's coupon
rate and the required return (yield).
|Bond trades at discount
||... when its coupon rate is
less than the current yield (its price will
be below par).
|Bond trades at premium ...
||... when its coupon rate is more than the
current yield (its price will be above par).
As a bond gets closer to its maturity date, the
bond's price approaches par value. That is, the
shorter the time until a bond's maturity, the
less responsive is the bond's price to interest
rate changes. You can confirm this by looking
at the attached bond pricing spreadsheet. For
this reason, short-term debt has less "interest
rate risk" than long-term debt.
See the attached
spreadsheet to calculate prices and yields
for bonds ppaying semi-annual interest.
on junk bonds
During the 1980s, junk bonds rose in prominence
(and notoriety) as leveraged buy-outs (LBOs) became
popular. Perhaps the most storied of the LBOs
of this time was the successful bid of Kohlberg,
Kravis, and Roberts (KKR) for RJR Nabisco in late
Initially, RJR's CEO, F. Ross Johnson, attempted
a management buy out (MBO) of the company. This
triggered a bidding war eventually resulting in
the RJR's board accepting a bid by the buyout
firm KKR. Although the KKR bid was not the highest
bid, it prevailed largely because the free-spending
Johnson was not a part of it. In addition, KKR
(the leader in leveraged buyouts) had secured
junk-bond financing from the top junk financier,
Drexel, Burnham, Lambert (DBL).
Junk bonds are often viewed with disdain by members
of the public and even some in the financial community.
Their use in LBOs strapped huge debtloads onto
acquired companies. Warren Buffett even referred
to junk bonds as "bastardized fallen angels."
And it didn't help when Michael Milken, DBL's
junk bond wizard, was convicted of securities
violations conected to his junk bond financings.
Despite all of this, junk bonds remain a source
of financing for many companies today, offering
a flexible alternative to bank debt. See
Stuart C. Gilson and Jerold B. Warner, Junk
Bonds, Bank Debt, and Financing Corporate Growth
available on SSRN
. In addition, investing wisely in junk bonds
can be viewed similarly to investing wisely in
common stocks as the usual strategy is to maintain
a diversified portfolio while looking for undervalued
companies. See William A. Klein, High-Yield
("Junk") Bonds as Investments and as
Financial Tools, 19 Cardozo L. Rev. 505 (1997).
Note on poison
After the leveraged buyout of RJR Nabisco in
1989 (described more fully at 4.3.5),
bond issuers began to offer "poison puts"
to investors. Meant to protect investors in investment
grade debt securities from credit-rating downgrades,
the bonds allowed the holder to cash out under
specified circumstances -- that is, to "put"
the bond to the restructured company.
Besides protecting bondholders, the puts also had
the effect of a poison pill. (A poison pill typically
operates to dilute a company if an outsider acquires
or exercises control, without board approval.) The
bond puts were triggered whenever an outsider buys
20% of the issuer's stock, the issuer declares a
major cash dividend, or the issuer acquires more
than 30% of the stock of another comnpany. Upon
one of these triggers, the bond holder has the right
to "put" the bonds back to he issuer at
face or par value, plus a premium. The issuer is
obligated to repurhcase.
The effect of "poison puts" has been
to increase the ratings of bonds. Why? Although
issuers lost some financing flexiblity, they gained
lower interest costs. In addition, poison puts
created powerful takeover defenses. Why? An issuer
with such obligations was far less attractive
than a company whose exisitng bond holders would
bear the costs of a credit downgrade.