Bonds and Their Valuation
Sam Strother and Shawna Tibbs are vice-presidents of Mutual of Seattle Insurance Company and co-directors of the company's pension fund management division. A major new client, the Northwestern Municipal Alliance, has requested that Mutual of Seattle present an investment seminar to the mayors of the represented cities, and Strother and Tibbs, who will make the actual presentation, have asked you to help them by answering the following questions. Because the Boeing Company operates in one of the league's cities, you are to work Boeing into the presentation.
a. What are the key features of a bond?
1. Par or face value. We generally assume a $1,000 par value, but par can be anything, and often $5,000 or more is used. With registered bonds, which is what are issued today, if you bought $50,000 worth, that amount would appear on the certificate.
2. Coupon rate. The dollar coupon is the "rent" on the money borrowed, which is generally the par value of the bond. The coupon rate is the annual interest payment divided by the par value, and it is generally set at the value of r on the day the bond is issued.
3. Maturity. This is the number of years until the bond matures and the issuer must repay the loan (return the par value).
4. Issue date. This is the date the bonds were issued.
5. Default risk is inherent in all bonds except treasury bonds--will the issuer have the cash to make the promised payments? Bonds are rated from AAA to D, and the lower the rating the riskier the bond, the higher its default risk premium, and, consequently, the higher its required rate of return, r.
b. What are call provisions and sinking fund provisions? Do these provisions make bonds more or less risky?
Answer: A call provision is a provision in a bond contract that gives the issuing corporation the right to redeem the bonds under specified terms prior to the...