Examples of premium bond in the following topics:
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- When a bond is sold at a premium, the difference between the sales price and face value of the bond must be amortized over the bond's term.
- When a bond is issued at a premium, that means that the bond is sold for an amount greater than the bond's face value.
- The difference between the cash from the bond sale and the face value of the bond must be credited to a bond premium account.
- To calculate the amortization rate of the bond premium, a company generally divides the bond premium amount by the number of interest payments that will be made during the term of the bond.
- The company must debit the bond premium account by the amortization rate.
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- The bond yield plus risk premium (BYPRP) approach is another method we can use to determine the value of an asset, specifically, a company's publicly traded equity.
- In the BYPRP approach, we use a bond's yield to maturity, which is the discount rate at which the sum of all future cash flows from the bond (coupon payments and principal payments) are equal to the price of the bond.
- Treasury Bond yield)
- Estimating the value of an equity using the bond yield plus risk premium approach has its drawbacks.
- Describe the process for the bond yield plus risk premium approach
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- To find the amortized acquisition cost the securities are amortized like a mortgage or a bond.
- Z company purchases 40,000 of the 8%, 5-year bonds of Tee Company for $43,412.
- The bonds provide a 6% return, with interested paid semiannually.
- The accounting records show the debt at the amortized cost (face amount plus premium/less discount) and the difference between the maturity value and the cost of the bonds is amortized to the income statement over the life of the bonds.
- The first interest payment is $1,600, but since the company paid a premium, the effective interest earned is $1,302 (net the amortization of the premium).
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- A bond's value is measured by its sale price, but a business can estimate a bond's price before issuance by calculating its present value.
- The bond's contract rate is another term for the bond's coupon rate.
- If the market rate is greater than the coupon rate, the bonds will probably be sold for an amount less than the bonds' face value and the business will have to report a "bond discount. " The value of the bond discount will be the difference between what the bonds' face value and what the business received when it sold the bonds.
- If the market rate is less than the coupon rate, the bonds will probably be sold for an amount greater than the bonds' value.
- The business will then need to record a "bond premium" for the difference between the amount of cash the business received and the bonds' face value.
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- Economists call the difference between the interest rate on the U.S. government bonds and corporate bonds the default risk premium.Investors add default risk premium to a risk-free investment, so they can invest in "risky" bonds because they earn a greater return.
- Risk premium is always positive.
- Taking the difference between the government bond and corporate bond interest rates, we can calculate the risk premium.
- As the default risk increases, then the risk premium increases too.
- Impact of a risk premium on the bond markets
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- For bond issuers, they can repurchase a bond at or before maturity.
- Redemption is made at the face value of the bond unless it occurs before maturity, in which case the bond is bought back at a premium to compensate for lost interest.
- The issuer has the right to redeem the bond at any time, although the earlier the redemption takes place, the higher the premium usually is.
- These bonds are referred to as callable bonds.
- With some bonds, the issuer has to pay a premium, the so-called call premium.
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- This bears the owner's name on the bond certificate and in the register of bond owners kept by the bond issuer or its agent, the registrar.
- A term bond matures on the same date as all other bonds in a given bond issue.
- Serial bonds in a given bond issue have maturities spread over several dates.
- The exercise of the call provision normally requires the company to pay the bondholder a call premium of about USD 30 to USD 70 per USD 1,000 bond.
- A call premium is the price paid in excess of face value that the issuer of bonds must pay to redeem (call) bonds before their maturity date.
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- A callable bond (also called redeemable bond) is a type of bond that allows the issuer of the bond to retain the privilege of redeeming the bond at some point before the bond reaches its date of maturity.
- Most callable bonds allow the issuer to repay the bond at par.
- With some bonds, the issuer has to pay a premium, known as the call premium.
- The price behavior of a callable bond is the opposite of that of puttable bond.
- Price of callable bond = Price of straight bond – Price of call option
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- On issuance, the journal entry to record the bond is a debit to cash and a credit to bonds payable.
- Also, the bondholders may sell their bonds to other investors any time prior to the bonds maturity.
- Bonds can sell for less than their face value, for example a bond price of 75 means that the bond is selling for 75% of its par (face value).
- If a bond has a coupon interest rate that is higher than the market interest rate it is considered a premium.
- The premium (higher interest rate) is to offset the assumed higher than average risk associated with investing in the company.
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- We start the analysis with the same liquidity in both the government bond and corporate bond markets in Figure 2.
- Thus, both bond markets have the identical equilibrium bond price, P*, and hence, the exact liquidity.
- Thus, the government bond prices rise, which reduces the interest rate for government bonds.
- On the other hand, the corporate bond prices decrease, raising the market interest rate for corporate bond.
- Nevertheless, economists refer the difference in interest rates as a risk premium.