BKM14 Flashcards
Bond
Issuer
Bondholder
Coupons
Bond: security that is used by a company to borrow money
Issuer: issues bond to the lender in return for a sum of cash
Bondholder: lender
Coupons: interest payments to the bondholder at specified dates; coupons are typically made semiannually and coupon rate is usually compounded semiannually
-bond obligates the issuer to make coupons
Par value
face value of the bond
-when bond matures, issuer pays the par value to the bondholder
Bond indenture
contract between bondholder and issuer; lists coupon rate, maturity date, par value
value of bond
Value = Par/(1+r)t +Coupon(1/r)[1-1/(1+r)t ]
Callable bonds
issued with call provision that allow the issuer to repurchase the bond at specific call price before the maturity date
Refunding
repurchase of bond by issuer if interest rate falls as they can replace them with new bonds that have lower coupon rate
Deferred callable bonds
they have initial period of call protection which is a time period in which bonds are not callable
Put bond
gives option to retire the bond to the bondholder
Convertible bond
provides bondholder option to exchange the bond for a specified number of share of the issuing firm
-holders of convertible bonds benefit from price appreciation of the stock and so convertible bonds offer lower coupon rates
Floating rate bonds
provide interest payments that are based on current market rates
- less interest rate risk: as interest rates rise, the increase in interest offsets the higher discounting rate
- interest rate risk related to change in issuer’s financial condition still exists because the yield spread is fixed; if the financial condition deteriorates, investors would demand a greater yield premium than what the security offers
Foreign bonds
issued by a borrower from a country other than the one where it is sold so it is denominated in currency of the country in which it is marketed
- a foreign firm may want to issue US denominated bonds in the US in order to acquire funds for expansion in the US
Eurobonds
denominated in one currency but sold in other markets
- due to easier regulations in another country, it may make sense to issue a bond in that country to borrow USD
Asset backed bonds, ABS
ABS: bonds where income from specified group of assets is used to service the debt; common type is mortgage backed security, MBS
Index bond
make payments that are based on general price index or price of a specific commodity
-example: treasury inflation protected securities, TIPS are bonds issued by US treasury that are linked to the rate of inflation
**coupon@t=par value@0*Π inflation*coupon rate
Nominal rate of return
based on both interest rate and price appreciation
Real return
adjusts the nominal rate of return to be net of inflation
**return volatility is reduced to 0 if the real return is constant year over year -> inflation indexed bonds reduce return volatility
investors would usually not pay exactly the quoted bond price as there is
interest that accrues between coupon dates that is not included in the bond price
-sale/invoice price includes the stated/flat price plus accrued interest
sale price of bond
Sale price = stated price + accrued interest
Premium bond
bond that is selling above the par value
Coupon > current yield > yield to maturity
Discount bond
bond selling below par value
Yield to maturity > current yield > coupon
yield to maturity
interest rate that produces a PV of bond payments equal to its price
-average return that investor would earn if he purchased the bond now and holds it until maturity
yield to call
- if bond is callable, yield to call may be more relevant than the yield to maturity especially if it is likely to be called
- can derive yield to call by using process for YTM but use time to call for time to maturity and call price for par value
current yield
annual coupon / bond price
Realized compound return
may differ from YTM in situations where the reinvestment rate differs from YTM
- issue with using YTM to measure return of bond when reinvestment rates can change: investor will actually not earn the YTM
- because the future interest rates are uncertain, future reinvestment rate is unknown
- realized return cannot therefore be calculated in advance
Horizon analysis:
realized compound return can be forecasted over specific holding periods
2 offsetting risks when interest rates change:
- Bond prices will fall (price risk/market risk)
- Reinvested coupon income would grow (reinvestment risk)
price appreciation from OID bonds is treated by the IRS as
implicit interest payment (imputed interest)
imputed interest
- imputed interest ignores changes in market interest rate; it is based on initial rate when the bond was issued
- difference between IRS price in 1yr and price if interest rate fall is treated as capital gains income and taxed at capital gains tax rate in addition to imputed interest
- if bond was not sold, difference would be treated as unrealized gains
- These are treated as an implicit interest, for tax purposes. As a result, the bondholder has to pay tax each year, rather than waiting till the bond is sold or matures. The IRS is essentially accelerating the collection of the tax
