The two common metrics for describing bond return are yield to maturity (YTM) and yield to call (YTC).Yield to maturity is the yield of the bond if it is held until maturity that is for the duration of the bond. Yield to maturity is an example of time value of money and investment risk-based returns. A yield to maturity is the effective interest rate earned on an investment for a particular price, assuming that the investor holds the investment to maturity. Yield to maturity in essence is the effective compounding interest rate that accumulates investment earnings over the remaining years to an investment’s maturity. You can think of yield of maturity as (the interest earned + (principal value – purchase price) divided by the principal price of the bond divided by the number of years the bond is held.
Yield to call measures what the yield on a bond will be if it is called at the earliest possible call date. Mainly, you can think of the yield to call as (the interest earned + (sale price – purchase price) divided by the purchase price of the bond divided by the number of years the bond is held.
When an issuer calls a bond it pays investors the call price (usually the face value of the bonds) together with the accrued interest to date and at that point stops making interest payments. An issuer may choose to call a bond when current interest rate drop below the interest rate on the bond. This way the issuer can save money by paying off the bond and issuing another bond at a lower interest rate. When an investor whose bond has been called, they are often faced with reinvesting the money at a lower, less attractive rate. Because of this callable bonds often have a higher annual return to compensate for the risk that the bonds might be called early.
2. What are bond ratings and how do they affect the ability of the firm to raise funds? Are these ratings similar to the ratings for a country or a company?
A company’s bond rating presents awareness into the company’s financial strength. If the bond rating is good the company is strong enough to pay its obligations. A lower rating indicates the company’s financial health is failing and may mean that a company is having problems paying its debts. The highest rating that is issued by S&P is AAA. The grades AAA, AA, and A are considered “investment grade” or of high quality. The grades B’s and C’s indicate poor grades and anything lower than that is considered to be very risky (they are referred to as junk bonds). When companies need to raise money, issuing bonds is one way to do it. A bond functions like a loan between an investor and a corporation. The investor agrees to give the corporation a specific amount of money for a specific period of time in exchange for periodic interest payments at designated intervals.
A credit rating can be useful not only for an investor but also for individuals looking for investors. An investment grade rating can be put a security, company or country on the global radar, which can attract foreign money and boost a country’s economy.
3. What are the differences between common stock and preferred stock? Explain your answers.
Stocks are not all created equal. There are two main types of stock common and preferred stock. Both common and preferred stock represent some degree of ownership of a company. Someone with common stock gives them the opportunity to vote in the election of the board of directors. Which is usually is equivalent to one vote per share that a person owns. Having preferred stock usually guarantees the payment of dividends but does not come with voting rights. Having either type of stock entitles you to a piece of the company’s profits. Common stockholders never know the value of their dividends in advance, whereas preferred stockholders receive dividends at a fixed rate. While dividends on preferred stocks tend to be higher than those on common stock, they will not appreciate with company growth.
In the case of bankruptcy preferred stock owners rank above common stock owners but below ordinary bondholders. Common stock tends to respond to general market instability and its level of risk also varies greatly by company. However, when viewed over long investment holding periods, common stocks have historically offered higher returns than preferred stocks or bonds,
Brigham, E. F., & Houston, D. J. F. (2014). Fundamentals of Financial Management, Concise Edition (with Thomson ONE – Business School Edition 6-Month Printed Access Card), 8th Edition. [VitalSource Bookshelf version]. Retrieved from http://digitalbookshelf.southuniversity.edu/books/9781305217218/