Bonds Flashcards
What is a bond?
A bond is a type of loan. When a company wishes to borrow money from the public (not from banks) on a long-term basis, it does so by selling (issuing) debt securities called bonds.
What is the structure of a bond?
The investor loans a company some money
The company pays you interest every period
The company repays the amount it borrowed at end of loan
Usually bonds have an active secondary market
Define Face Value
The principal amount of a bond that is repaid at the end of the term.
Define Annual Coupon
The stated interest payment made on a bond per year.
Define Maturity
the specified date on which the principal amount of a bond is paid
Define Yield to Maturity YTM
the rate required in the market on a bond
Define security
Bonds are normally unsecured…
Define Call provision
allows the company to repurchase part or all of the bond issue at stated prices over a specific time.
Define sinking fund
an account managed by the bond trustee for early bond redemption
what is the indenture?
the written agreement between the corporation and the lender detailing the terms of the debt issue.
Includes: The basic terms of the bonds; the total amount of bonds issued; a description of property used as security; the repayment arrangements; the call provisions; details of the protective covenants.
what is a par bond?
a bond that is selling at face value
what is interest rate risk?
the sensitivity of the bond value to interest rates. If you invested in a bond and interest rates rise, your bond will fall in value and you will lose value.
why do bonds with a greater time to maturity have greater interest rate risk?
because the further away the cash flows, the greater the impact on the PV calculations of a change in interest rates because the current market interest rate is used as the discount rate.
why is it that the lower the coupon rate, the greater the interest rate risk?
because the bond with the higher coupon has a larger cash flow early in its life, so its value is less sensitive to changes in the discount rate.
what is accrued interest?
when a bond is sold between coupon payment dates, part of the next coupon payment belongs to the seller. this is the accrued interest.
What is the nominal rate?
The interest rate that has not been adjusted for inflation
What does the term structure of interest rates represent?
The combined effect of the:
- real rate of interest: the compensation that investors demand for forgoing the use of their money
- inflation premium: the portion of a nominal interest rate that represents compensation for expected future inflation
- interest rate risk premium: the compensation that investors demand for bearing interest rate risk
What do bond yields and interest rates represent the combined effect of? (6 things)
- real rate of interest
- expected future inflation
- interest rate risk premium: the compensation investors demand for bearing interest rate risk
- default risk premium: the portion of a nominal interest rate or bond yield that represents compensation for the possibility of default
- taxability premium: the portion of a nominal interest rate or bond yield that represents compensation for unfavourable tax status
- liquidity premium: the portion of a nominal interest rate or bond yield that represents compensation for lack of liquidity ( so bonds with longer period to maturity carry greater liquidity premium)
What is a zero coupon bond?
A bond that makes no coupon payments and is priced at a deep discount. also PURE DISCOUNT BONDS
What is a floating rate bond?
a bond where the coupon payment is adjustable. The adjustments are tied to an interest rate index such as the Treasury Bill
what is the link between interest rates and bond value?
as interest rates rise, prices fall:
if YTM = coupon rate then Bond Price = Face Value
YTM > coupon rate then Bond Price < face value
YTM < coupon rate then Bond Price > face value
