Bonds

Question 1

What are bonds?

Answer 1

They are long-term debt financing (contractual obligation to pay face amount) for corporations and government entities. Issuing bonds requires extensive legal and accounting work, so it’s rarely to see bonds with maturity of fewer than 10 years.

Question 2

What is face amount (in terms of bond)?

Answer 2

It’s also known as par value or maturity amount. This amount is received on the bond’s maturity date.

Question 3

What is annual cash interest (in terms of bond)?

Answer 3

Formula = face amount x stated rate

Question 4

What is stated rate (in terms of bond)?

Answer 4

It’s also called the coupon rate. It’s the percentage used to calculate for cash interest payments for a bond.

Question 5

What is indenture?

Answer 5

A legal contract/agreement stating the all the terms of debt.

Question 6

What are advantages for issuing a bond?

Answer 6

1. Interest paid on debt is tax deductible (most significant advantage)
2. Basic control of the firm is not shared with debt holders

Question 7

What are disadvantages for issuing a bond?

Answer 7

1. The firm can become insolvent if cash flow is insufficient to service debt
2. The legal requirement to pay debt service raises the firms’ risk level
3. The long-term nature affects the firm’s risk profile
4. Certain managerial rights are given up per the indenture (specific ratios must be kept higher)
5. Debt financing amount is limited to a firm (debt-equity ratio is usually dictated by the investment community)

Question 8

What are debt covenants?

Answer 8

The restrictions or protective clauses imposed on borrowers in a formal debt agreement or an indenture.

Question 9

List examples of debt covenants.

Answer 9

1. Limitations on issuing long or short-term debt
2. Limitations on dividend payments
3. Maintaining certain financial ratios
4. Maintaining specific collateral that backs the debt

Question 10

What happens when the debtor breaches the debt covenant?

Answer 10

The debt becomes due immediately.

Question 11

What are call provisions?

Answer 11

They allow bond issuers to exercise an option to redeem the bonds earlier than the specified maturity date.

Question 12

What is a bond sinking fund?

Answer 12

It requires the issuer to make payments into the fund to segregate and accumulate sufficient assets to pay the bond principal at maturity.

Question 13

What is a term bond?

Answer 13

It has a single maturity date at end of the term.

Question 14

What is a serial bond?

Answer 14

It matures in stated amounts at regular intervals.

Question 15

What is a variable rate bond?

Answer 15

It pays interest that is dependent on the market conditions.

Question 16

What is a zero-coupon (deep-discount) bond?

Answer 16

It bears no stated interest rate and thus involves no periodic cash payments. The interest component consists entirely of the bond’s discount.

Question 17

What is a commodity-backed bond?

Answer 17

It’s payable at prices related to a commodity (i.e. gold).

Question 18

What is a callable bond?

Answer 18

It may be repurchased by the issuer at a specified price before maturity. It is not as valuable as a straight bond to investors.

Question 19

What is a convertible bond?

Answer 19

It may be converted to equity (stock) of the issuer at the option of the holder under certain conditions.

Question 20

What is a mortgage bond?

Answer 20

It is backed by specific asset, usually real estate.

Question 21

What is a debenture?

Answer 21

It’s backed by issuer’s full faith and credit.

Question 22

What is an equipment trust bond?

Answer 22

It’s secured by a lien on a specific piece of equipment (i.e. airplane). It’s used mostly in the transportation industry.

Question 23

What is a registered bond?

Answer 23

It’s issued in the name of the holder so only the registered holder may receive interest and principal payments.

Question 24

What is a bearer bond?

Answer 24

It’s not individually registered so anyone who presents the bond can receive interest and principal payments.

Question 25

What are subordinated debenture and second mortgage bond?

Answer 25

They are junior securities with claims inferior to those of senior bonds.

Question 26

What is an income bond?

Answer 26

It pays interest only when the issuer earns interest.

Question 27

What is a revenue bond?

Answer 27

It’s issued by government entities and is payable from specific revenue source.

Question 28

What is the term structure of interest rates?

Answer 28

It’s the relationship between yield and time to maturity. It’s important to both corporate treasurer and investors for deciding whether to issue or buy short or long-term debt.

Question 29

What are the four common yield curve?

Answer 29

1. Upward (typical; longer duration of a bond means more time there is for interest rate volatility to affect a bond’s price)
2. Flat
3. Downward
4. Humped

Question 30

What is interest rate risk?

Answer 30

It’s the risk that an investment security will fluctuate in value due to changes in interest rates.

Question 31

How does inflation expectation affect interest rate?

Answer 31

The lower the expected inflation, the lower the interest rate. And vice versa.

Question 32

How to determine the cash amount an issuer will receive on the day the bond is sold?

Answer 32

It is the present value of cash flows from face amount and interest payments.

Question 33

How to determine the present value of a bond’s face amount?

Answer 33

Formula = face amount x index number (from the present value of $1 table: effective rate and period to maturity)

Question 34

How to determine the present value of a bond’s interest payments?

Answer 34

1. Interest payment = face amount x coupon rate

2. Present value of interest payment = interest payment x (index for the effective/market rate & time to maturity)

Question 35

What does it mean when stated (coupon) rate equals the market rate at time of sale?

Answer 35

Present value of a bond = face amount; the bond is sold “at par”.

Question 36

What does it mean when stated (coupon) rate is lower than the market rate?

Answer 36

Investor must be offered incentive (less cash paid to purchase) since the periodic interest payment are lower than other currently available bonds in the market. Bond is sold at a discount.

Question 37

What does it mean when stated (coupon) rate is higher than the market rate?

Answer 37

Investor is willing to pay more for the bond since the periodic interest payment is higher than other currently available bonds in the market. Bond is sold at a premium.

Question 38

What is the conversion ratio?

Answer 38

Conversion ratio = par value of convertible bond / conversion price

Question 39

How to determine cash proceeds for issuing a bond that pays more often than annually?

Answer 39

Use this rate to calculate present value for both the face amount and interest payments: interest rate on annual basis / number of times interest is paid per year
For example: 10% market rate and payment is semiannually for 5 years. 10%/2 = 5%; 2 x 5 = 10 periodic payments. Look for the index number for 5% and 10 on table.

Question 40

Why is the a firm’s cost of debt may be lower than its bond’s yield rate in the market?

Answer 40

The actual cost of debt is the net of interest payment and the offsetting tax deduction.
Cost of debt capital = interest rate x (1 - the marginal tax rate)