# Important bond conceptuals

map1 Wrote: ------------------------------------------------------- > Lets take yours: > > lets say you have a 5% bond that pays annually, > 4%YTM when issued, and its a 5-yr > > FV=100 pmt=5 YTM=4 5=n CPT PV=104.4518 > > IE= 4%*104.4518=4.17 which is less than the coupon > (the difference ammortizes the gain, the premium > from face) > > lets say you have a 3% bond that pays annually, > 4%YTM when issued, and its a 5-yr > > FV=100 pmt=3 YTM=4 5=n CPT PV=95.5482 > > IE= 4%*95.5482=3.82 which is higher than the > coupon, the difference ammortizes the loss (the > discount from face) Then why is CFO under a discount bond overstated

CFAI FSA book pg 467 look at the interest expense

Ok here is an example that is easy to see answer to #1: FV:\$1,000 Coupon: 8% n=3 ytm=4% PV=\$1,111 With annual interest, this premium bond has a first year interest expense of \$44.44 (\$1,111*.04) -For a discount bond, change coupon to 0%, PV = \$889 The interest expense on this is \$889*.04 = \$35.56. Since int expense is lower for the discount bond, net income is higher. 2. A bond with warrants is issued at a discount because a portion of the bond is allocated to debt and a portion to equity (the warrants) 3. Floating rate bond price will stay the same when interest rates change unless there is a cap or floor, or if there is a change in some type of margin that is added to the bond to determine price.

Check on 470, effects of bonds at discount, or premium. And I was wrong when I replied to saurya_s, it is the coupon payment that gets registered, not the IE!

that example doesnt use the same interest rates (i’m referring to the one on page 467)

That is an example to compare CFO and CFF effects, not IE.

I know it doesnt, the effect of IE is supposed to be for the SAME bond, if you change one of the fundamental characteristics of the bond (coupon) you change the entire game. the point they are trying to make is that if you issue the same bond at different YTM’s

the one on 467 does not talk about cfo or cff

Ok, if the coupon goes into income statement as interest expense, then we calculate the difference between interest expense and coupon just to amortise the discount/premium on the balance sheet? My fragile foundations are stirred! S

Check on 470, there you have the described effects.

saurya_s Wrote: ------------------------------------------------------- > Ok, if the coupon goes into income statement as > interest expense, then we calculate the difference > between interest expense and coupon just to > amortise the discount/premium on the balance > sheet? > My fragile foundations are stirred! > S Yes, that’s why we calculate it.

if you really want to see exactly how the interest expense should actually be, you should just recreate one of the bond amortization charts on 467, but use the same ytm for both bonds. that would also be useful for the test if you know how to set one of those up.

Check a few posts above, I just did an example keeping the YTM and changing the coupon.

doesnt the table on 467 use the same YTM’s? (was talking to someone on the phone who had the books and I don’t have the CFAI books in front of me) I dont think you can hold YTM constant and change the coupon, that would be comparin 2 bonds with completely different fundamentals. I was under the impression (through schweser’s books) that to compare the IE on bonds you compare the SAME bond issued @ 2 different YTM’s

if a company wants to issue a bond right now, they have a choice to use a 0% coupon, a 10% coupon, or whatever. but they can’t change the ytm, which is the prevailing market interest rate. the example on 467 has YTM = 8% for the premium bond and 12% for the discount.

Ok, when you say the CFO is over/under stated what are you comparing- difference between interest expense and cash coupon or the cash coupon of bond issued at par? S

dsbreber, what if a company forecasts that interests rates will fall from 5% to 4%, if you compare the same bond @ these times then you hold everything constant instead of YTM. I think we should just agree to disagree, we are both right but we are comapring two diffrenent situations.

If you fix the YTM and vary the coupon rate, which is the correct way, then clearly CFO under a premium bond is overstated, since you are deducting the full coupon payment, while in reality you should only deduct the interest, which is less than coupon. Correct?

we are comparing two different situations. but if you are calculating the interest expense on a bond or what the issue price is, you have to use what the ytm is right now.

Dreary Wrote: ------------------------------------------------------- > If you fix the YTM and vary the coupon rate, which > is the correct way, then clearly CFO under a > premium bond is overstated, since you are > deducting the full coupon payment, while in > reality you should only deduct the interest, which > is less than coupon. Correct? Under schweser is says that CFO is understated and CFF is overstated for premiums, thats what I am going with