Bonds, Loans And Interest Rates Flashcards
What is the default premium?
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
What is the default risk?
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
What is face value?
Face value is the amount you need to pay in the mature date. Bonds usually have a 1000 face value or par value
What is the coupon payment?
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
What is the difference between an investment grade bond and a “junk bon”
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
Credit ratings of S&P
AAA AA A BBB BB B CCC CC C D
What is the difference between a corporate bond and a consumer loan?
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
Similarities between a corporate bond and a consumer loan
They are both forms of debt
Bond : issuer, holder, interest rate
Loan: borrower, creditor, interest rate
What is the discount rate of a bond?
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
How do you determine the discount rate on a bond?
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
What is floating interest rate?
- 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
What are covenants?
- 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
What is amortization?
- 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
How are convertible bonds accounted for in calculating enterprise value?
- 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
How do you price a bond?
- 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
If the price of a bond goes up, what happens to yield?
Bonds and yield move in opposite directions, higher bond lower yield
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?
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
If the price of the 10-year treasury note rises, what happens to the note’s yield?
Price rises, yield decreases
What would cause the price of a treasury note to rise?
- 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
If you believe interest rates will fall, should you buy or sell bonds?
You should buy bonds, because if interest rates fall their prices will increase
How many basis points equal 0.5 percent?
50 basis points
What is the order of creditor preference in the event of company bankruptcy?
- Senior secured debt least risk, least return
- Mezzanine Debt
- Preferred Stock
- Common Stock most risky, more return
What is the difference between senior secured debt or bank debt and bonds?
- 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
Why would a company use bank debt instead of high-yield bonds?
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
