Bonds Flashcards
Principles applied in bond valuation
- Money has time value.
- Risk requires reward.
- Market prices are generally right.
Definition bonds
Type of debt or long-term promissory note, issued by a borrower, promising to its holder a predetermined and fixed amount of interest per year and repayment of principal at maturity.
Types of bonds (5)
- Debentures
- Subordinated bonds
- Mortgage bonds
- Eurobonds
- Convertible Bonds
Definition debenture
- unsecured long-term debt
- for issueing firms, debetures provide the benefit of not tying up property as collateral
- for bondholders, debentures are more risky than secured bonds and provide a higher yield
Definition subordinated debenture
- hierarchy of payout in case of insolvency
- claims of subordinated debentures are honored only after the claims of secured debt and unsubordinated debentures have been satisfied
Definition mortgage bond
- secured by a lien on real property
- value of the real property is usually greater than that of the bond itself
Definition eurobonds
- securites (bonds) issued in a country different from the one whose in whose currency the bond is denominated
- e.g. a bond issued by an American corporation in Japan that pays interest and principal in dollars
Definition convertible bonds
debt securities that can be convertey int o a firm’s stock at a pre-specified price
Bond terminology: claims on assets an income
seniority in claims: in case of insolvency, claims of debt, including bonds are honored before those of common or preferred stock
Bond terminology: par value
- face value of the bond, returned to the bondholder at maturity
- bonds will return the par value at maturity, regardless of the price paid at the time of purchase
Bond terminology: coupon interest rate
- percentage of the par value of the bond that will be paid periodically in the form of interest
- some bonds are zero-coupon bonds
Bond terminology: maturity
length of time until the bond issuer returns the par value to the bondholder and terminates or redeems the bond
Bond terminology: call provision
- Call provision (if it exists on a bond) gives corporation the option to redeem the bonds before the maturity date.
- For example, if the prevailing interest rate declines, the firm may want to pay off the bonds early and reissue at a more favorable interest rate.
- Issuer must pay the bondholders a premium.
- There is also a call protection period where the firm cannot call the bond for a specified period of time.
Bond terminology: indenture
- An indenture is the legal agreement between the firm issuing the bond and the trustee who represents the bondholders.
- It provides for specific terms of the loan agreement -(such as rights of bondholders and issuing firm).
- Many of the terms seek to protect the status of bonds from being weakened by managerial actions or by other security holders.
Bond terminology: bond ratings
- bond rating reflect the future risk potential of a bond
- lower bond ratings indicate higher probability of default
Favorable factors affecting bond rating
- greater reliance on equity a opposed to debt in financing the firm
- profitable operations
- low variability in past earnings
- large firm size
- minimal use of subordinated debt
Bond terminology: junk bonds
- high risk bonds with ratings of BB or below
- also referred to as high-yield bonds as they pay high interest rates
Definition book value
value of an asset as shown on a firm’ s balance sheet
Definition: liquidation value
Dollar sum that cozuld be realized if an asset were sold individually and not as part of a going concern
Definition: market value
the observed value for the asset in the marketplace
Definition: intrinsic or economic value
- also called fair value
- the present value of the asset’s expected future cash flows
What affects value? (3)
- amount and timing of the asset’s expected future cash flows
- riskiness of the cash flows
- investor’s required rate of return for undertaking the investment
Value of a bond (V) =
( C1/(1+r)^1 ) + ( C2/(1+r)^2) … + ( Cn/(1+r)^n )
C: future expected cash flows in the form of interest and repayment of principal
n: time to maturity
r: the investor’s required rate of return
Definition: yield to maturity (YTM)
- rate of return the investor will earn if the bond is held to maturity
to find YTM, we need:
- current price
- time left to maturity
- par value
- annual interest payment
Definition: current yield
- ratio of the interest payment to the bond’s current market price
- annual interest payment/ current market price
three important relationships: #1
the value of a vond is inversely related to changes in the investor’s present required rate of return
- a interest rate increases, the value of the bond decreases and vice versa
three important relationships: #2
the market value of a bond will be less than the par value if the investor’s required rate of return is above the coupon interest rate (discount) and vice versa (premium)
three important relationships: #3
- long-term bonds have greater interest rate risk than short-term bonds
- a change in interest rate will have a relatively greater impact on long-term bonds
main risks for bond holders
- changes in current interest rates
- default risk (no or partial payment in case of bankruptcy)
- call risk (if bonds are called before maturity date
