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Determining a Bond's Issuance Price

Determining a Bond's Issuance Price
Coming up next: Issuing Bonds at a Discount or a Premium

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  • 0:01 What Are Bonds?
  • 1:03 Demand
  • 3:30 Risk
  • 4:37 Market Conditions
  • 5:13 Lesson Summary
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Lesson Transcript
Instructor: Tammy Galloway

Tammy teaches business courses at the post-secondary and secondary level and has a master's of business administration in finance.

In this lesson, we'll discuss factors that affect a bond's issue price: demand, risk, and market conditions. You'll also discover whether these factors increase or decrease bond prices.

What Are Bonds?

Bob has owned a technology firm for ten years. The business has done very well, and now he wants to expand and invest in more research and development to offer more product lines.

When a company wants to expand and grow, they have three options to finance the expansion: sell stock, seek a loan from a financial institution, and sell bonds. Bob's firm has several outstanding loans, and he's already spoken with an investment banker about selling stock. Now, he's interested in issuing bonds. He makes another appointment with the investment banker to discuss selling bonds.

The investment banker explains to him that a bond is similar to an IOU, where investors loan the technology firm money with the expectation of annual interest payments and repayment at maturity. He also says that the initial price of the bond issue would be determined by three factors: demand, risk, and market conditions. For the rest of this lesson, we'll examine how these factors affect the initial price of the bond.

Demand

Demand represents how interested investors are in the company. If Bob's firm is on the cutting edge of technology and in the process of developing the most technologically-advanced widgets, then investors may be interested. However, if Bob's firm has an idea to bring back the analog TV era, then there may be little interest in his company.

Let's say Bob's firm is in the process of developing the world's most advanced widget, and investors are lining up to purchase the bonds. With the help of the investment banker, Bob decides he will issue $100,000 bonds with $9,000 as the annual payment payable to the investor for five years. At the end of the fifth year, Bob's firm will pay the $100,000 back.

In this instance, $100,000 represents the principal, $9,000 are the annual coupon payments, and five years are considered the maturity date. Based on demand and other factors which we'll discuss later, the bonds can sell at discount or a premium.

If the bonds sell at a discount, the investors will purchase the bonds at a price less than the principal. For example, they may purchase the bonds at $98,000. In year one through five, they'll receive $9,000 each year, and at the end of the fifth year, they'll receive the profit of $2,000 ($100,000 - $98,000). For purchasing the bond, they receive $47,000 ($2,000 in profit + (5 years * $9,000)) in total.

Now, what if the bonds are in great demand, and investors are willing to pay $125,000 for the bonds? Keep in mind that they'll only receive $100,000 of principal at maturity. These bonds are being sold at a premium, which means bonds are sold at a price greater than the principal. Why would an investor lose money on the principal? Good question; remember the interest payments? Typically, the coupon payments will be higher when bonds are sold at a premium.

For example, let's say the firm will issue $100,000 bonds with $15,000 annual coupon payments and five years to maturity. While we know the investor will lose $25,000 from the principal ($100,000 - $125,000), they will make $75,000 ($15,000 * 5) in coupon payments for a net profit of $50,000 ($75,000 - $25,000). Now, let's look at another factor of the price, which is risk.

Risk

Risk is the chance of financial loss. Investors know there's a possibility of losing money when they invest. However, investors have different risk tolerances. Some are willing to lose a lot of money, we call these investors 'risk tolerant.' While others are considered 'risk averse,' meaning they do not want to lose very much money, if any.

In order to assess a bond's risk level, bond ratings are assigned based on the company's financial health. Bond ratings are similar to school grades, an A is excellent, B is good, C represents average and a D needs improvement. An A-rated bond would be considered a good, low risk investment, and a D-rated bond would be considered high risk. D bonds are extremely speculative, and they are called junk bonds.

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