Bonds Flashcards
Which are the 3 principles applied in bond valuation?
- Money has time value
- Risk requires reward
- Market prices are generally right
What are bonds?
Type of debt or long term promissory note.
Issued by a borrower.
Promising to its holder a fixed amount of interest per year and repayment of principal at maturity
What are Issuers of bonds?
Corporations, Govs., State and local municipalities
What types of bonds exist?
- Debentures
- subordinated Debentures
- Mortgage Bonds
- Eurobonds
- Convertible Bonds
What are Debentures?
Are unsecured long term debt
For issuing firm: Debentures provide the benefit of not typing up property as collateral
For bondholders: More risky than secured bonds -> also higher yield
What are Subordinated Debentures?
There is a hierarchy of payout in case of insolvency
The claims of subordinated debentures are honored only after the claims of secured debt and unsubordinated debentures have been satisfied
What are Mortgage Bonds?
Secured by a lien on a property
Typically the value of the real property is greater than that of the bond issued
What are Eurobonds?
Securities issued in a country different from the one in whose currency the bond is denominated
E.g. A bond issued in Japan by an american compnay that pays interest and principal in dollar
What are convertible Bonds?
Debt securities that can be converted into stocks at a pre specific price
What means Seniority in Claims?
In the case of insolvency, claims of debts including bonds are honored before those of common or preferred stock
What is the par value?
Also known as face value. Returned to the bondholder at maturity
Usually corporate bonds have a par value of $1000
What is the Coupon interest rate?
Percentage of the par value that will be paid in form of interest.
What is Maturity?
Length of time until the bond issuer returns the par value to the bondholder and terminates the bond
What is Call Provision?
Gives company the option to redeem the bonds before maturity date.
-> have to pay bondholders a premium
What is an Indenture?
legal agreement between the firm issuing the bond and the trustee who represents the bondholder
Protects the status of bonds from being weakened by managerial actions or by other security holders
What are bond ratings?
Reflect the future risk potential of a bond.
lower rating -> higher reward
Which factors affect bond rating?
Greater reliance on equity as opposed to debt in financing the firm
Profitable operations
Low variability in past earnings
Large firm size
Minimal use of subordinated debt
What are junk bonds?
High risk bonds with ratings of BB or below by moody’s and Standard & Poor’s
-> High yield bonds
What is the book value?
Value of an asset as shown on a firms balance sheet
What is the liquidation value?
Dollar sum that could be realized if an asset would be sold individually.
What is the market value?
The observed value for the asset in the marketplace
What is the intrinsic value?
Also called fair value - the present value of the asset’s expected future cash flows
What are efficient markets?
In an efficient market, the values of all securities fully reflect the public information
if the markets are efficient, the market value and the intrinsic value will be the equal
What determines value?
Present value of its expected cashflow using the required rate of return as the discount rate
Affected by:
Amount and timing of the expected cash flows
Riskiness of the cash flows
Investors required rate of return for undertaking the investment
What is the bond value combination?
C: Future expected cash flow (coupon, principal)
n: The time to maturity
r: Required rate of return
What is Yield to Maturity?
Rate of return the investor will earn if the bond is held to maturity. Also known as expected rate of return
YTM = Discount rate that equates the present value of the futures cash flows with the current market price of the bond.
How do we find YTM?
We need to know:
current price
time left to maturity
par Value
annual interest payment
What is Current Yield?
The ratio of the interest payment to the bonds current market price.
Current Yield = Annual Interest payment / current market price of the bond
What is Total Yield?
Current Yield + Capital gain or loss from bond sale
Example: Bond bought for 700$, sold for 725$
TY = 80 + (725-700)
= 105$ or 105/700
= 15%
What is the first bond relationship?
Value of a bond is related to changes in the investors present required rate of return (current interest rate)
As interest increases (decreases), the value of the bond deacreases (increases)
What is the second bond relationship?
Market value of a bond will be less than the par value if the investors required rate of return is above the coupons interest rate.
Bond will be valued above par value if the investors required rate of return is below the coupon interest rate
What are discount bonds?
Market value of a bond will be below the par when the investors required rate is greater than the coiupon interest rate -> discount bonds
What are premium bonds?
The market value of a bond will be above the par or face value when the investor’s required rate is lower than the coupon interest rate. These bonds are known as premium bonds.
If investor’s required rate of return is equal to the coupon interest rate, the bonds will trade at par.
What is the third bond relationship?
long term bonds have greater interest rate than do short term bonds
A change in interest rate will have bigger impact on long term bonds
What are the main risks for bondholders?
Changes in current interest rates
Default risks (bankruptcy etc.)
Call risk (if bonds are called before maturity) Bonds are usually called when the interest rate decreases,
