COMM 309 — Business Finance
CHAPTER 6: Bond Valuation and Interest
Rates
Comprehensive Exam Preparation Notes
6.1 The Basic Structure of Bonds
A bond is a long-term debt instrument in which the issuer agrees to pay the bondholder a
regular series of cash payments (coupons) and to repay the full principal amount by the stated
maturity date. These promises are specified in the bond contract and represent a fixed
contractual commitment — meaning the issuer is legally obligated to make every payment
regardless of its financial performance. Bonds are also called fixed income securities because
both the interest payments and the principal repayment are fixed at the time of issuance.
Bond Maturity Terminology (by term):
• Bills / Paper: Maturity less than 1 year
• Notes: Maturity between 1 and 10 years
• Bonds: Maturity greater than 10 years
All three are valued using the same discounting methods. The distinction is purely based on
maturity length.
Structure of a Traditional Coupon Bond: A bond can be decomposed into two cash flow
streams:
• Annuity component: Equal, regular interest (coupon) payments made throughout the life
of the bond (typically semi-annually in Canada)
• Lump-sum component: The face value (principal) repaid in a single bullet/balloon
payment at maturity
This two-component structure means valuing a bond is a direct application of the TVM tools
from Chapter 5: PV of annuity (coupons) + PV of single sum (face value).
📌 Bond vs. Mortgage — Key Structural Difference
Mortgage: 'Blended' payments — each payment includes BOTH interest AND principal repayment.
→ Principal declines gradually over the life of the loan.
Bond: Interest-only payments (coupons) throughout the life, then a SINGLE large principal
repayment (bullet/balloon payment) at maturity.
→ Principal outstanding remains constant at face value until maturity.
In Canada, bonds are registered and payments are made directly to bank accounts.
Originally, bonds had literal coupons that investors had to clip and mail in — hence the name.
,Main Bond Issuers in Canada:
• Federal, provincial, and municipal governments
• Government agencies (e.g., CMHC, Hydro-Québec)
• Corporations (corporate bonds)
• Non-resident issuers (e.g., Maple bond market)
Main purchasers: institutional investors — insurance companies, pension funds, and bond
mutual funds.
Basic Bond Terminology
Bond Indenture: A legal document that specifies ALL payment requirements and salient
matters relating to a bond issue (collateral, covenants, features). It is held and administered by
a trust company (fiduciary), whose job is to ensure the issuer complies with all terms. Any
change to the indenture normally requires approval of bondholders representing 50% to 66.7%
of outstanding bonds. Changes to the indenture are uncommon, which is why investors must
review each bond contract individually.
Term Definition / Explanation
Par Value / Face Value / The amount paid to the bondholder at maturity. Standard par value is
Maturity Value $1,000. Bond prices are quoted per $100 of par value, so a quote of
$99.583 means a $1,000 bond sells for $995.83.
Term to Maturity The time remaining until the bond's maturity date. As this decreases, the
bond's interest rate sensitivity decreases.
Coupon Rate The stated annual interest rate on the bond. Applied to par value to
determine the coupon payment. Always stated on an annual basis.
Coupon / Interest The regular interest payment. I = Coupon Rate × Par Value. If paid semi-
Payment (I) annually: I_semi = (Coupon Rate / 2) × Par Value. Example: 6% coupon on
$1,000 → $60/yr annually, or $30 every 6 months.
Bullet / Balloon Payment The single lump-sum repayment of the full principal (par value) made at the
maturity date.
Security and Protective Provisions
Bond Security Types: Not all bonds are secured equally. The type of security affects the
priority of repayment in default.
Bond Security Type Description
Mortgage Bonds Secured by specific real assets (land, buildings). In default, bondholder
has claim on those specific assets.
Debentures Unsecured, or secured by a general floating charge over the company's
unencumbered assets. Government bonds are technically debentures
(no specific asset pledged), but are considered highest quality because
the government can tax or print money.
, Collateral Trust Bonds Secured by a pledge of other financial assets (stocks, bonds, T-bills)
held in trust.
Equipment Trust Certificates Secured by specific equipment (e.g., railway rolling stock). Investors
own the assets through a lease; serial maturities repay investors
progressively.
Protective Covenants: Clauses in the trust indenture that restrict the issuer's actions to protect
bondholders.
◦ Negative Covenants: Prohibit certain actions. Examples: restricting dividend
payments above a certain amount, prohibiting pledging assets to other lenders,
preventing additional borrowing beyond a threshold.
◦ Positive Covenants: Specify actions the firm must undertake. Examples: providing
quarterly financial statements, maintaining minimum working capital levels,
maintaining specific insurance coverage.
Additional Bond Features
Beyond the standard structure, many bonds include optional features (embedded options) that
alter the timing or amount of payments. These features change the bond's risk/return profile for
both issuer and investor.
Feature Who Holds the Option / Key Condition for Exercise /
Description Investor Impact
Callable Bond ISSUER holds option to repurchase Issuer calls when market rates FALL
bonds at predetermined call prices (can refinance at lower rates). BAD for
(usually above par) at specified dates. bondholder — loses high-coupon bond
when it's most valuable. Investor
demands higher yield as compensation.
Call price > par provides partial
compensation.
Retractable / Putable BONDHOLDER holds option to sell Investor retracts when market rates
Bond bond back to issuer at predetermined RISE (bond prices fall; investor can exit
prices before maturity (shortens and reinvest at higher rates). GOOD for
maturity). bondholder. Trades at premium vs.
equivalent straight bond.
Extendible Bond BONDHOLDER holds option to extend Investor extends when rates FALL
the maturity date of the bond. (keeps attractive high-coupon bond
longer). GOOD for bondholder. Trades
at premium vs. equivalent straight
bond.
Sinking Fund Provision ISSUER must set aside funds annually Benefits issuer (avoids large balloon
to retire debt. Two methods: (1) payment at maturity). Can harm
repurchase bonds on open market; (2) investors if bonds randomly
pay into a fund that buys government repurchased at par when they trade
bonds for maturity. above par. Potential liquidity loss as
outstanding issue shrinks.
Purchase Fund Similar to sinking fund, but issuer must GOOD for investors — provides
Provision repurchase bonds ONLY if the price is liquidity and downward price support.
CHAPTER 6: Bond Valuation and Interest
Rates
Comprehensive Exam Preparation Notes
6.1 The Basic Structure of Bonds
A bond is a long-term debt instrument in which the issuer agrees to pay the bondholder a
regular series of cash payments (coupons) and to repay the full principal amount by the stated
maturity date. These promises are specified in the bond contract and represent a fixed
contractual commitment — meaning the issuer is legally obligated to make every payment
regardless of its financial performance. Bonds are also called fixed income securities because
both the interest payments and the principal repayment are fixed at the time of issuance.
Bond Maturity Terminology (by term):
• Bills / Paper: Maturity less than 1 year
• Notes: Maturity between 1 and 10 years
• Bonds: Maturity greater than 10 years
All three are valued using the same discounting methods. The distinction is purely based on
maturity length.
Structure of a Traditional Coupon Bond: A bond can be decomposed into two cash flow
streams:
• Annuity component: Equal, regular interest (coupon) payments made throughout the life
of the bond (typically semi-annually in Canada)
• Lump-sum component: The face value (principal) repaid in a single bullet/balloon
payment at maturity
This two-component structure means valuing a bond is a direct application of the TVM tools
from Chapter 5: PV of annuity (coupons) + PV of single sum (face value).
📌 Bond vs. Mortgage — Key Structural Difference
Mortgage: 'Blended' payments — each payment includes BOTH interest AND principal repayment.
→ Principal declines gradually over the life of the loan.
Bond: Interest-only payments (coupons) throughout the life, then a SINGLE large principal
repayment (bullet/balloon payment) at maturity.
→ Principal outstanding remains constant at face value until maturity.
In Canada, bonds are registered and payments are made directly to bank accounts.
Originally, bonds had literal coupons that investors had to clip and mail in — hence the name.
,Main Bond Issuers in Canada:
• Federal, provincial, and municipal governments
• Government agencies (e.g., CMHC, Hydro-Québec)
• Corporations (corporate bonds)
• Non-resident issuers (e.g., Maple bond market)
Main purchasers: institutional investors — insurance companies, pension funds, and bond
mutual funds.
Basic Bond Terminology
Bond Indenture: A legal document that specifies ALL payment requirements and salient
matters relating to a bond issue (collateral, covenants, features). It is held and administered by
a trust company (fiduciary), whose job is to ensure the issuer complies with all terms. Any
change to the indenture normally requires approval of bondholders representing 50% to 66.7%
of outstanding bonds. Changes to the indenture are uncommon, which is why investors must
review each bond contract individually.
Term Definition / Explanation
Par Value / Face Value / The amount paid to the bondholder at maturity. Standard par value is
Maturity Value $1,000. Bond prices are quoted per $100 of par value, so a quote of
$99.583 means a $1,000 bond sells for $995.83.
Term to Maturity The time remaining until the bond's maturity date. As this decreases, the
bond's interest rate sensitivity decreases.
Coupon Rate The stated annual interest rate on the bond. Applied to par value to
determine the coupon payment. Always stated on an annual basis.
Coupon / Interest The regular interest payment. I = Coupon Rate × Par Value. If paid semi-
Payment (I) annually: I_semi = (Coupon Rate / 2) × Par Value. Example: 6% coupon on
$1,000 → $60/yr annually, or $30 every 6 months.
Bullet / Balloon Payment The single lump-sum repayment of the full principal (par value) made at the
maturity date.
Security and Protective Provisions
Bond Security Types: Not all bonds are secured equally. The type of security affects the
priority of repayment in default.
Bond Security Type Description
Mortgage Bonds Secured by specific real assets (land, buildings). In default, bondholder
has claim on those specific assets.
Debentures Unsecured, or secured by a general floating charge over the company's
unencumbered assets. Government bonds are technically debentures
(no specific asset pledged), but are considered highest quality because
the government can tax or print money.
, Collateral Trust Bonds Secured by a pledge of other financial assets (stocks, bonds, T-bills)
held in trust.
Equipment Trust Certificates Secured by specific equipment (e.g., railway rolling stock). Investors
own the assets through a lease; serial maturities repay investors
progressively.
Protective Covenants: Clauses in the trust indenture that restrict the issuer's actions to protect
bondholders.
◦ Negative Covenants: Prohibit certain actions. Examples: restricting dividend
payments above a certain amount, prohibiting pledging assets to other lenders,
preventing additional borrowing beyond a threshold.
◦ Positive Covenants: Specify actions the firm must undertake. Examples: providing
quarterly financial statements, maintaining minimum working capital levels,
maintaining specific insurance coverage.
Additional Bond Features
Beyond the standard structure, many bonds include optional features (embedded options) that
alter the timing or amount of payments. These features change the bond's risk/return profile for
both issuer and investor.
Feature Who Holds the Option / Key Condition for Exercise /
Description Investor Impact
Callable Bond ISSUER holds option to repurchase Issuer calls when market rates FALL
bonds at predetermined call prices (can refinance at lower rates). BAD for
(usually above par) at specified dates. bondholder — loses high-coupon bond
when it's most valuable. Investor
demands higher yield as compensation.
Call price > par provides partial
compensation.
Retractable / Putable BONDHOLDER holds option to sell Investor retracts when market rates
Bond bond back to issuer at predetermined RISE (bond prices fall; investor can exit
prices before maturity (shortens and reinvest at higher rates). GOOD for
maturity). bondholder. Trades at premium vs.
equivalent straight bond.
Extendible Bond BONDHOLDER holds option to extend Investor extends when rates FALL
the maturity date of the bond. (keeps attractive high-coupon bond
longer). GOOD for bondholder. Trades
at premium vs. equivalent straight
bond.
Sinking Fund Provision ISSUER must set aside funds annually Benefits issuer (avoids large balloon
to retire debt. Two methods: (1) payment at maturity). Can harm
repurchase bonds on open market; (2) investors if bonds randomly
pay into a fund that buys government repurchased at par when they trade
bonds for maturity. above par. Potential liquidity loss as
outstanding issue shrinks.
Purchase Fund Similar to sinking fund, but issuer must GOOD for investors — provides
Provision repurchase bonds ONLY if the price is liquidity and downward price support.
