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Investment Banking > Bonds, Loans And Interest Rates > Flashcards

Bonds, Loans And Interest Rates Flashcards

1
Q

What is the default premium?

A

Default premium is the difference in yield between a government bond and a corporate bond with the same maturity, to compensate the investor for the default risk of the corporation compared with the “risk free” government bond

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2
Q

What is the default risk?

A

Default risk is the risk that the company will not be able to pay its interest payments or pay back the principal amount of their debt. The bigger the company’s default risk, the higher the interest the lender will ask to pay

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3
Q

What is face value?

A

Face value is the amount you need to pay in the mature date. Bonds usually have a 1000 face value or par value

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4
Q

What is the coupon payment?

A

Coupon payment is the amount a company pays its loan or bondholders on an annual, semi-annual or quarterly basis. The coupon payment is the coupon rate times the face value of the bond.
For instance, the coupon payment on an annual 10% bond with a $1000 face value would be $100

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5
Q

What is the difference between an investment grade bond and a “junk bon”

A

An investment grade bond is a bond issued by a company that has a good credit rating (AAA to BBB), a low risk of default and steady stream of cash flows. Investment grade bonds because its considered a safe, low-risk investment pays a low interest rate

A “junk bond” is a bond issued by a company with a poor credit rating (BB to D), high risk of bankruptcy so the company has to pay investors a higher interest rate because of the riskiness associated with this bond.

‘Junk bonds’ are normally issued by companies with less consistent cash flows or in volatile industries

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6
Q

Credit ratings of S&P

A 
AAA
AA
A
BBB
BB
B
CCC
CC
C
D
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7
Q

What is the difference between a corporate bond and a consumer loan?

A

The main difference between a corporate bond and a consumer loan is the market it is trading on. A corporate bond because involves borrowing a larger amount of capital, it is sold in the public market and it can be traded. A consumer loan is normally borrowing less amount of capital, it is issued by a bank and is not traded in the public market.

Ex: K getting a loan from the bank to buy a house, borrowing X dollars and paying coupon payment every year for 30 years based on the agreed interest rate
Company Z issuing bonds in NYSE for Y term with an interest rate, and coupon payment will be paid each year

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8
Q

Similarities between a corporate bond and a consumer loan

A

They are both forms of debt
Bond : issuer, holder, interest rate
Loan: borrower, creditor, interest rate

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9
Q

What is the discount rate of a bond?

A

Bond discount is the when the bond’s market price is lower than its face value. It’s the difference between the face value and market price
Ex: bond with par value 1000 that is trading at 800 has a bond discount of 20

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10
Q

How do you determine the discount rate on a bond?

A

It’s determined by the company’s default risk
Factors that affect discount rate
1. Company’s credit rating
2. Volatility of their cash flows
3. The interest rate on comparable U.S. bonds
4. Amount of current debt outstanding,leverage and interest coverage

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11
Q

What is floating interest rate?

A
  • used to protect against fluctuations in interest rates
  • normally seen in bank loans as LIBOR + a certain number of basis points
  • LIBOR is the London interbank offer rate and the basis point is the spread which is based on the default risk of the borrower
  • For example, if the term loan is at L + 600 bps (6%) and if LIBOR is at 1% interest payments will be at 7% per year
  • If LIBOR increases to 4%, company will be required to pay 10% annually
  • the higher the borrower’s default risk the higher the spread
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12
Q

What are covenants?

A
  • requirements included in the legal documents of a bond or loan
  • company must comply with these requirements during the life of the bond or loan in order to avoid default
  • For example, covenants may include maintaining a certain leverage ratio, limiting expenditures on capes, paying dividends, etc
  • lender may waive a covenant normally for a fee and not force the company into bankruptcy
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13
Q

What is amortization?

A
  • lowers the cost of a loan by paying in regular installments the face value of the loan instead of paying the face value at maturity
  • each payment period, the company pay its lenders the interest payment and a portion of the loan;s face value
  • since the pay down of the face value of the loan makes the outstanding balance smaller, the interest payments get smaller each period
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14
Q

How are convertible bonds accounted for in calculating enterprise value?

A
  • if the convertible bond are in the money, conversion price is below the current market price, then you include the bonds as additional dilution to the Equity Value
  • if they are out of the money, then account for them as debt at their face value
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15
Q

How do you price a bond?

A
  • take the present value of its future cash flows. PV of interest payments and face value.
  • to get the present value of FCF you take the interest payment of each period and divided it by the rate of return you would get if you invested in the bonds of comparable companies, to the power of the period of the interest payment
  • then you add that to the FCF of the face value
  • If the interest rate of a bond is higher than the interest rate of comparable companies, then you will have to pay a higher price for that higher return hence the price of the bond will be higher because of the required premium. Since you have to pay a premium, the yield on the bond goes down to levels in line with comparable
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16
Q

If the price of a bond goes up, what happens to yield?

A

Bonds and yield move in opposite directions, higher bond lower yield

17
Q

If you believe interest rates will fall, and are looking to make money due to the capital appreciation on bonds, should you buy them or short sell them?

A

You should buy bonds if you think interest rates will fall, because price of bonds and interest rates move in opposite directions. So you should buy them now because once interest rates fall their prices will increase

18
Q

If the price of the 10-year treasury note rises, what happens to the note’s yield?

A

Price rises, yield decreases

19
Q

What would cause the price of a treasury note to rise?

A
  • If the stock market is extremely volatile, and investors are scared of losing money they will prefer to invest in risk-free securities, which are government bonds. As demand for government bonds increase, price of government bonds increase and so the yield on those bonds decrease
20
Q

If you believe interest rates will fall, should you buy or sell bonds?

A

You should buy bonds, because if interest rates fall their prices will increase

21
Q

How many basis points equal 0.5 percent?

A

50 basis points

22
Q

What is the order of creditor preference in the event of company bankruptcy?

A
  1. Senior secured debt least risk, least return
  2. Mezzanine Debt
  3. Preferred Stock
  4. Common Stock most risky, more return
23
Q

What is the difference between senior secured debt or bank debt and bonds?

A
  • bank debt is secured by assets of the company, and bonds normally arent, so bank debt has lower interest rates
  • bank debt has floating interest rates based on LIBOR plus a spread, bonds normally pay a fixed interest rate
  • bank debt may carry financial maintenance covenants that require company to maintain certain leverage levels, interest coverage levels, while bonds don’t
  • bank debt is normally amortized and bonds are not
  • prepayment is allowed for bank debt, and for bonds its not
24
Q

Why would a company use bank debt instead of high-yield bonds?

A

Bank debt is secured by the assets of the company so require lower interest rates. But the downside is that they are typically amortized and may have covenants

25
Q

What are bond ratings?

A
  • scores given to bonds based on their risk of default. AAA to BBB is a good rating, BB to D is a bad rating
  • credit agencies assign scores to bonds
26
Q

What is the yield to maturity on a bond?

A
  • rate of return of a bond if its held through its maturity date based on current price, interest payments, face value and maturity date
  • if the coupon yield (coupon/fv) is lower than the current yield (coupon/price) , then it is selling at discount
  • if the coupon yield is higher than the current yield, then it is selling at a premium
27
Q

What will happen to the price of a bond if the fed raises interest rates?

A
  • price of bond will decrease
  • if interest rates rise then newly issued bonds will offer higher yields to keep pace. So existing bonds with lower interest payments become less attractive, hence their price must fall to raise the yield enough to compete with the new bonds
28
Q

What is a callable bond?

A
  • bond that allows the bond issuer to redeem the bond before its maturity at a certain date
  • a premium must be paid by the issuer to redeem the bond earlier
29
Q

What is a put bond?

A
  • opposite of callable bond

- the bondholder is able to force the bond issuer to by back the security, normally at face value before maturity

30
Q

What is a convertible bond?

A
  • bond that can be converted into common stock during the bond’s lifetime at anytime
  • if the value of shares exceed the face value of the bond, the investor normally converts the bond
31
Q

When should a company issue debt instead of equity?

A
  • issuing debt is cheaper than issuing equity
  • interest payments are tax deductible and provide a tax shield
  • but a company has to have steady cash flows in order to make interest payments, which is not necessary when you issue equity
  • a company may try to issue debt if it thinks its stock is undervalued and the stock is not raising enough capital
32
Q

If you believe interest rates will fall, which should you buy: a 10-year coupon bond or a 10 year zero-coupon bond?

A
  • zero-coupon bond price is more sensitive to fluctuations in interest rates, price moves in opposite directions of interest rates
  • So when interest rates fall, the price of the zero-coupon bond will rise more than the price of the coupon bond
  • so you should buy the zero-coupon bond
33
Q

How could inflation hurt creditors?

A
  • inflation is terrible for creditors
  • inflation cuts the real percentage return that creditors receive
  • when a bank sets its lending rate, it projects a certain rate of inflation and then assigns a level of return it wants to capture above that inflation rate, based on the riskiness of the borrower
  • For example, if a bank lends a at 7%, expecting a 2% inflation, they expect to make a 5% real gain based on the riskiness of the loan. However, if inflation rises to 4% then they are only making 3% real return on their loan
34
Q

If the stock market falls, what would you expect to happen to bond prices and yields?

A
  • if the stock market falls people will want safer investments
  • demand for bonds will increase, so price of bonds will increase and so the yield on bonds will decrease
35
Q

What are some ways to determine the extent to which a company poses a credit risk?

A
  • looking at the credit rating of the company
  • looking at some metrics: current ratio, quick ratio, interest coverage ratio and leverage ratio
    Current ratio: current assets/ current liabilities
  • ability to pay current liabilities using current assets
    Quick ratio
  • acid test
  • current assets - inventory/ current liabilities
  • assumes company can not easily liquidate inventory to pay debt coming due
    Interest coverage ratio
  • EBITDA/interest expense
  • ability to pay its annual interest expense using its annual cash flows
    Leverage ratio
  • total debt/EBITDA
  • how many years of its cash flow it would take the company to retire its debt
36
Q

What is floating interest rate?

A
  • normally using in bank loans when a bank makes a loan to a company at a rate that moves with interest rates
37
Q

What is amortization?

A
  • amortization is similar to depreciation, but it involves intangible assets
  • in a loan, when a loan is amortized the borrowing company pays off the loan over the life of the loan instead of paying the full face value amount at the maturity date
  • each payment period, the company pays its lenders the interest payments and a portion of the loan’s face value
  • since the amount outstanding decreases each paying period, the interest payments decrease each payment period
38
Q

How are convertible bonds accounted for in calculating enterprise value?

A

If the convertible bonds are in the money, meaning the conversion price if below the current market price, then you account for the bonds as additional dilution to the Equity Value. However, if the bonds are out of money, then you account for them as debt at their face value

Investment Banking (9 decks)

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