Bonds Flashcards
What is the concept of terms structure of interest rates?
The term structure of interest rates is the relationship between yield to maturity and time to maturity
It is important to corporate treasures who must decide whether to issue short or long-term debt and to investors who must decide whether to buy short or long-term debt
The graph has 4 yield curves:
- Upward sloping
- Flat
- Downward sloping
- Humped
Note: In recent years, long-term rates have been higher than short-term rates, so the yield curve is usually upward sloping
When plotting a yield curve, what factors are held constant?
When plotting a yield curve, several factors are held constant:
- Default risk of instruments
- Taxability of the instruments
- Callability of the instruments
- Sinking fund provisions
What are the advantages of bonds to an issuer?
The following are advantages of issuing bonds:
- Interest paid on debt it tax deductible. This is by far the most significant advantage of debt. For a corporation facing a 40% - 50% marginal tax rate, the tax savings produced by the deduction of interest can be substantial
- Basic control of the firm is NOT shared with debt holders
What are the disadvantages of bonds to an issuer?
The following are disadvantages of issuing bonds:
- Unlike returns on equity investments, the payment of interest and principal on debt is a legal obligation. If cash flow is insufficient to service debt, the firm could become insolvent
- The legal requirement to pay debt service raises a firm’s risk level. Shareholders will consequently demand higher capitalization rates on retained earnings, which may result in a decline in the market price of the stock
- The long-term nature of bond debt also affects risk profiles. Debt originally appearing to be profitable may become a burden if interest rates fall and the firm is unable to refinance
- Certain managerial prerogatives are usually given up in the contractual relationship outlined in the bond’s indenture contract (i.e. specific ratios must be kept above a certain level during the term of the loan)
- The amount of debt financing available to the individual firm is limited. Generally accepted standards of the investment community will usually dictate a certain debt-equity ratio for an individual firm. Beyond this limit, the cost of debt may rise rapidly or debt may not be available
What is a Term bond?
A term bond has a single maturity date at the end of its term
What is a Serial bond?
A serial bond matures in stated amounts at regular intervals
What are Variable rate bonds?
Variable rate bonds pay interest that is dependent on market conditions
What are Zero-coupon (Deep-discount bonds)?
Zero-coupon or deep-discounted bonds bear no stated rate of interest and thus involve no periodic cash payments; the interest component consists entirely of the bond’s discount
What are Commodity-backed bonds?
Commodity-backed bonds are payable at prices related to a commodity such as gold
What are Callable bonds?
Callable bonds may be repurchased by the issuer at a specified price before maturity
What are Convertible bonds?
Convertible bonds may be converted into equity securities of the issuer at the option of the holder under certain conditions
What are Mortgage bonds?
Mortgage bonds are backed by specific assets (usually real estate)
What are Debentures?
Debentures are backed by the borrower’s general credit but not by specific collateral. Thus, debentures are risker to investors than secured bonds
What are Registered bonds?
Registered bonds are issued in the name of the holder. Only the registered holder may receive interest and principal payments
What are Bearer bonds?
Bearer bonds are not individually registered. Interest and principal are paid to whomever present the bond
