BKM 14: Bonds Flashcards
Par value
Face value of bond
Coupon rate
Interest payment on bond
Bond indenture
Contract between issuer and bondholder
Accrued interest on bonds
If bond purchased between coupon payments, buyer must pay seller for accrued interest
Callable bonds
Issued with call provisions allowing issuer to repurchase bond at specified call price; issued wiht higher coupons and promised YTMs than noncallables
Convertible bonds
Gives bondholder option to exchange each bond for a specified number of common stock shares; lower coupons and stated or promised YTMs
Conversion ratio
Ratio of shares for which each convertible bond can be exchanged
Market conversion value
Current value of shares for which a convertible bond may be exchanged; conversion premium is excess of bond value over conversion value
Puttable bond
Gives option to bondholder to extend or retire bond at the put date
Floating-rate bonds
Make interest payments tied to some measure of current market rates; not adjusted for changes in financial condition of the firm
Preferred stock
Receive dividends before common stockholders
Foreign bond
Issued by a borrower from a country other than the one in which it is sold; denominated in marketed country’s currency
Examples of foreign bonds
Yankee (foreign sold in US)
Samurai (foreign sold in Japan)
Bulldog (sold in UK)
Eurobonds
Denominated in one currency but sold in other national markets
Examples of Eurobonds
Eurodollar ($-denominated sold outside US)
Euroyen (yen-denominated selling outside of Japan)
Eurosterling (UK)
Inverse floaters
Coupon rate falls when general level of interest rates rise
Indexed bonds
Make payments tied to a general price index (ex: inflation)
Nominal rate of return
(Interest + appreciation)/price
Real return
(1 + Nominal) / (1 + Inflation) - 1
Bond value in financial calculator
Convexity
Progressive increases in interest rate result in progressively smaller reductions in bond price
Yield to Maturity
Interest rate that makes PV of bond’s payments equal to price
Current yield
Annual coupon payment divided by bond price
Rule for bonds: coupon rate, current yield, and YTM
For premium bonds, coupon rate > current yield > YTM
Yield to call
Just like YTM, except time to first call replaces time until maturity
Realized compound return
Return realized at maturity date (not forecast)
Offsetting risk of bonds as interest rates change
- When rates rise, bond prices fall
- When rates rise, coupons reinvested at higher rate
Imputed interest
IRS method to determine tax; uses constant yield method (implied return vs. actual return)
Credit risk
Risk of bond default
Junk bonds
“Fallen angels” - originally investment grade
“Original-issue junk”
Key ratios to evaluate bond safety
- Earnings to fixed costs (coverage)
- Leverage ratio, debt-to-equity ratio
- Liquidity ratios (current, quick)
- Profitability ratios
- Cash flow to debt ratio
Altman ratio (bonds)
1.23 (bad) - 2.9 (safe)
Sinking fund
Spreads payment of debt over several years
Subordination of further debt
Restricts amount of additional borrowing
Bond indenture examples
Sinking funds
Subordination of further debt
Dividend restrictions
Collateral
Default premium
Difference between promised yield and yield of an otherwise-identical government bond
Credit default swap
An insurance policy on the default risk of a bond or loan; can effectively raise the quality of debt from lower to AAA
Premium on swap should approximate yield spread
Now used to speculate on issuer’s financial health
Collateralized debt obligation
Tool to reallocate credit risk by pooling and then tranching; used to create high-rated bonds from junk bonds
