CH 7_IR and Bonds valuation Flashcards

Question

How to find the yield to maturity (r) **********CHECK THIS!!!

Answer 1

use a financial calculator N= # OF PERIODS PV= -CURRENT PRICE OF BOND FV= +1000 USUALLY PMT= +COUPON RATE * FV

Answer 2

equity secrurity debt security

Answer 3

ownership interest in the firm paying dividends to shareholders iS not a cost of doing business and is therefore NOT TAX DEDUCTIBLE residual claim: you have only rights to whats left over after laibilties paid bankruptcy beenfit= cant cause bankruptyc by issues equity

Answer 4

debt must be repaid creditors dont have voting power paying interest on debt is A COST OF DOING BUSINESS, AND IS TAX DEDUCTIBLE UNPAID DEBT=LIABILITY, creidots can take legal action (Can cause liqudiation or reorg) possibility of financial failure

Answer 5

cuz of tax benefits of debt and possibility of having no bankruptcy from equity

Answer 6

1 yr + vs 1 yr or less

Answer 7

notes, debenture, bond

Answer 8

public issue and privately placed

Answer 9

written aggreement b/w corp and creditor has: - basic terms of bonds - amounts of the bonds issued - description of property used as security - repayment agreement - call provision - detail of protective covenant

Answer 10

pricipal value

Answer 11

- collateral: whats pledged to protect creditors - mortgage securitues: secure loaonds on mortgage of propertty - debenture: unsecured debt with og maturity >10 years - Notes: unsecured debt with og maturity <10 years

Answer 12

unsecrued bond (no specfific pledge is made)

Answer 13

if maturity of unsecured bond (the eebenture) is less than 10 years when it is orginally issued

Answer 14

sometimes some bonds are senior and some are junior senior bonds are paid off frist if bankruptcy SINKING FUNDS ARE AN EXAMPLE

Answer 15

bonds can be repaid at maturity or they may be repaid in part or in entirety priior to maturity ex of early repayment: :sinking fund

Answer 16

A sinking fund is an account managed by the bond trustee for the purpose of repaying the bonds. The company makes annual payments to the trustee, who then uses the funds to retire a portion of the debt. The trustee does this by either buying up some of the bonds in the market or calling in a fraction of the outstanding bonds. We discuss this second option in the next section. There are many different kinds of sinking fund arrangements. The fund may start immediately or be delayed for ten years after the bond is issued. The provision may require the company to redeem all or only a portion of the outstanding issue before maturity. From an investor’s viewpoint, a sinking fund reduces the risk that the company will be unable to repay the principal at maturity, so it’s credit positive. Some bonds simply have a defined amortization schedule of blended principal and interest payments directly to the investor. The disadvantage of this “amortizing bond” structure is that it significantly complicates secondary trading and, therefore, comes with a liquidity premium

Answer 17

some bonds lalow companies to repurchase or call part/all of the bond call price - stated value= call premium (Call premium gets smaller over time) not as important in early years bc bonds arent called early, they get caleld in later years

Answer 18

part of a loan agreement that limits certain actions a company might otherwise take during the term of the loan REDUCE AGENCY COSTS to BOND HOLDERS (limit things ocmpany can do!) negative covenant: limits actionso f company positive covenant: specifies actions/conditions company must abide by!!

Answer 19

!credit risk! not interest rate risk!!!! - so the price of a highly rated bond can still be quite volatile AAA= best A= worst of the best BBB= average B= not sure CCC= ew D= terrible, bankruptcy type shit

Answer 20

high yield high risk, usually below BBB

Answer 21

STRIPPED BONDS FLAOTING RATE BONDS ETC

Answer 22

financial engineering

Answer 23

creates exotic, hybrid securitiess that have features of equity but are treated as debt

Answer 24

bond paying NO coupons, therefore these bonds are sold at much lower than stated value!! (coupon rate =0%). * The entire yield-to-maturity comes from the difference between the purchase price and the par value. * Cannot sell for more than par value. * Sometimes called zeroes, or deep discount bonds. * Bondholder must pay taxes (ouch!) on accrued interest every year, even though no interest is received.

Answer 25

For tax purposes, the owner must pay taxes on interest accrued every year, even though no interest is actually received. This tax feature makes taxable stripped bonds less attractive to taxable investors because the tax bill must be funded from other sources. However, they are still a very attractive investment for taxexempt investors with long-term dollar-denominated liabilities, such as pension funds, because the future dollar value is known with relative certainty. Stripped coupons can be attractive to individual investors for tax-sheltered registered retirement savings plans (RRSPs) because they don’t have to worry about paying taxes each year that are not funded by cashflows (taxes are paid instead when the money is withdrawn from the RRSP). It turns out that stripped bonds can also be attractive in a taxable account because taxes are only assessed on the interest rate rather than on the coupon rate. In our low interest environment, most bonds have coupons bigger than their interest rate, so taxable investors in coupon bonds end up getting overtaxed. On stripped bonds they pay a fair tax, not an unfairly low one

Answer 26

* Coupon rate floats depending on some index value. * There is less price risk with floating rate bonds − The coupon floats, so it is less likely to differ substantially from the yield-to-maturity. * Coupons may have a “collar” - the rate cannot go above a specified “ceiling” or below a specified “floor” The conventional bonds we have talked about in this chapter have fixed-dollar obligations because the coupon rate is set as a fixed percentage of the par value. Similarly, the principal is set equal to the par value. Under these circumstances, the coupon payment and principal are fixed. With floating-rate bonds (floaters), the coupon payments are adjustable. The adjustments are tied to the Treasury bill rate or another short-term interest rate. For example, the Royal Bank has outstanding $250 million of floating-rate notes maturing in 2083. The coupon rate is set at 0.40% more than the bankers’ acceptance rate. Floating-rate bonds were introduced to control the risk of price fluctuations as interest rates change. A bond with a coupon equal to the market yield is priced at par. In practice, the value of a floating-rate bond depends on exactly how the coupon payment adjustments are defined. In most cases, the coupon adjusts with a lag to some base rate, and so the price can deviate from par within some range. For example, suppose a coupon-rate adjustment is made on June 1. The adjustment might be based on the simple average of Treasury bill yields during the previous three months. In addition, the majority of floaters have the following features: 7 8 1. The holder has the right to redeem their note at par on the coupon payment date after some specified amount of time. This is called a put provision, and it is discussed later. 2. The coupon rate has a floor and a ceiling, meaning the coupon is subject to a minimum and a maximum

Answer 27

CAT BONDS: Other Bond Types * Catastrophe bonds (World Cup) * Income bonds * Convertible bonds (can turn them into shares – one bond can become 40 shares...but there’s no turning back!) * Put bond (retractable bond) * There are many other types of provisions that can be added to a bond and many bonds have several provisions - it is important to recognize how these provisions affect required returns Most cat bonds, however, cover natural disasters. For example, in November 2014, Kilimanjaro Re Limited issued catastrophe bonds valued at $500 million for Everest Reinsurance and it covered major losses from earthquakes in the U.S. and Canada. As these examples illustrate, bond features are really limited only by the imaginations of the parties involved. Unfortunately, there are far too many variations for us to cover in detail here. We therefore close out this discussion by mentioning only a few of the more common types. Income bonds are similar to conventional bonds, except that coupon payments depend on company income. Specifically, coupons are paid to bondholders only if the firm’s income is sufficient. In Canada, income bonds are usually issued by firms in the process of reorganizing to try to overcome financial distress. The firm can skip the interest payment on an income bond without being in default. Purchasers of income bonds receive favourable tax treatment on interest received. Real return bonds have coupons and principal indexed to inflation to provide a stated real return. In 1993, the federal government issued a stripped real return bond packaging inflation protection in the form of a zero-coupon bond. A convertible bond can be swapped for a fixed number of shares of stock at any time before maturity at the holder’s option. Convertibles are debt-equity hybrids that allow the holder to profit if the issuer’s stock price rises. Asset-backed bonds are backed by a diverse pool of illiquid assets such as accounts receivable collections, credit card debt, or mortgages. If an issuing company defaults on its bond debt repayments, bondholders become legally entitled to cash flows generated from these illiquid pools of assets. Asset backing or securitization reduces risk provided that the assets are of high quality. In the credit crisis of 2007–2008, bonds backed by sub-prime mortgages to risky borrowers lost most of their value. A retractable bond or put bond allows the holder to force the issuer to buy the bond back at a stated price. As long as the issuer remains solvent, the put feature sets a floor price for the bond. It is, therefore, just the reverse of the call provision and is a relatively new development. We discuss convertible bonds, call provisions, and put provisions in more detail in Chapter 25. A given bond may have many unusual features. An example from bank regulatory capital is CoCo bonds. CoCo is the nickname for “contingent convertible” bonds, which are also putable, callable, and subordinated. The contingent convertible clause is similar to the normal conversion feature, except the contingent feature must be met. For example, a contingent feature may require that the company stock trade at 110% of the conversion price for 20 out of the most recent 30 days. Valuing a bond of this sort can be quite complex, and the yield to maturity calculation is often meaningless. After the 2008 financial crisis and accompanying regulatory changes, banks issued CoCo bonds to strengthen their capital base and absorb 2. The coupon rate has a floor and a ceiling, meaning the coupon is subject to a minimum and a maximum. losses in times of financial distress. The important feature of CoCo is that it is convertible to equity at the discretion of the banking regulator (such as OSFI in Canada). Moody’s reported a total of $288 billion in CoCo bonds issued by banks around the globe from 2009 to 2014, mostly by European and Asian banks. In July 2014, Royal Bank of Canada issued $1.0 billion of a type of CoCo called non-viable contingent capital (NVCC) subordinated debt, a first among Canadian banks. In July 2020, Royal Bank again was first to the Canadian market with the issue of a new structure called a Limited Recourse Capital Note (LRCN). All of these structures help banks to solve the puzzle of creating loss-absorbing, extendible-maturity securities that are also tax-deductible and purchasable by the bond market. In this way CoCo, NVCC, and LRCN supplement equity capital.

Answer 28

BONDS!! Extremely large number of bond issues, but generally low daily volume in single issue

Answer 29

over the counter (no particular place where buying an dselling occurs) BC ELECTRONIC very little transparency

Answer 30

more bonds are issued than stocks! rather debt than equity

Answer 31

clean price: the quoted price -> this is net of accrued interest!! (Deduction) dirty price: clean price + accrued interest is added

Answer 32

fraction of the coupon period that has passed x multiply it by the next coupon 2/6 x $30 2 months of the semi annual payments has passed x 30 which is the next coupon

Answer 33

dirty price - accrued interest = clean price

Answer 34

a MTF that invests in bonds and other debt securities

Answer 35

As mentioned in Professor Altman’s “In Their Own Words” box earlier in this chapter, debt plays an important role in corporate restructuring activities, such as leveraged buyouts (LBOs). In an LBO, a small group of investors, usually a private equity firm, purchases all the equity shares of a public company. The purchase is usually financed with significant amount of debt—sometimes up to 90%. For example, in March 2015, Toronto-based private equity firm Onex acquired Swiss packaging firm SIG Combibloc Group for €3.75 billion. The transaction was financed with €3 billion in debt, including leveraged loans, high-yield bonds, and a revolving credit facility.

Answer 36

interest rates that have been ajusted for inflation

Answer 37

interest rates that have not been adjusted for inflation

Answer 38

makes your dollars worth less!!!

Answer 39

NOMINAL RATE!!

Answer 40

The real rate of an investment is the percentage change in how much you can buy with your dollars, in other words, the percentage change in your buying power.

Answer 41

- investors care about real rates bc at the EOD they care about what their money can buy - R= NOMINAL, r= real, h=inflation 1 + R = (1+r) x (1+h) math it out R ~= r + h bc last component is very small You can isolate for the real rate and nominal rate

Answer 42

discount NOMINAL cf at NOMINAL rate or REAL CF at REAL rate you will get the correct answer be careful of what cf is real or nominal and what rate is real or nominal

Answer 43

relationship between short and long term interest rates

Answer 44

what nominal interest rates are on DEFAULT FREE PURE DISCOUNT bonds ANY MATURITY

Answer 45

term structure is upward sloping THIIS IS NORMAL

Answer 46

downward sloping term structure THIS IS INVERTED!!

Answer 47

when interst rates increase at first but then begin to decline

Answer 48

1) expected future inflation (inflation premium) 2) real rate of interest (compendation investors demand for giving up the use of their money) 3) interest rate risk (interest rate risk premium) real rate of interest: the underlying component that determines the nominal interest rate and the term structure!!! it doesnt really determine shape of term structure but the overall level of interest rates mostly!!

Answer 49

when inflation happens it erods the value of money, therefore the investors demand compensation for this loss by getting HIGHER NOMINAL RATES

Answer 50

As we discussed earlier in the chapter, longer-term bonds have much greater risk of loss resulting from changes in interest rates than do shorter-term bonds. Investors recognize this risk, and they demand extra compensation in the form of higher rates for bearing it. This extra compensation is called the interest rate risk premium. The longer the term to maturity, the greater the interest rate risk, so the interest rate risk premium increases with maturity. However, as we discussed earlier, interest rate risk increases at a decreasing rate, so the interest rate risk premium does as well.

Answer 51

upward sloping: interest rate risk premium middle: inflation premium flat line: real rate the line on top (slope)= nominal interest rate x acis: time to maturity y axis: interest rate

Answer 52

downward sloping: interest rate risk premium middle downard: inflation premium flat line: real rate the line on top (slope)= nominal interest rate x acis: time to maturity y axis: interest rate

Answer 53

relfection of the term structure of interest rates!!

Answer 54

the extra comp investors make in case the bond issuer defaults

Answer 55

JUNK BONDS: BB, B, CCC, CC, C, D

Answer 56

if you wanted to sell quickly, you would probably not get as good a price as you could otherwise. Investors prefer liquid assets to illiquid ones, so they demand a liquidity premium on top of all the other premiums we have discussed. As a result, all else being the same, less liquid bonds will have higher yields than more liquid bonds

Answer 57

1. real rate of interest 2. expected future inflation (inflation premium) 2. interest rate risk (interest premium) 3. default risk (premiuum) 4. tax status 5. lack of liquitdity (Liquidity premium)

Answer 58

Taxability also affects the bond yields as bondholders have to pay income tax on the interest income they receive from privately issued bonds.

Answer 59

N= # OF PERIODS (Year *2) PV= - current price PMT= +how much each coupon will pay you FV= +par value I/Y= will give you the semi annual interest rate I/Y * 2 WILL GIVE YOU THE YEARLY INTEREST RATE

Answer 60

If you know the price of one bond, you can estimate its YTM and use that to find the price of the second bond

Answer 61

Medium Grade − DBRS’s A - capacity to pay is strong, but more susceptible to changes in circumstances. − DBRS’s BBB - capacity to pay is adequate, adverse conditions will have more impact on the firm’s ability to pay

Answer 62

Very Low Grade − DBRS’s C - bonds are in immediate danger of default. − DBRS’s D - in default, with principal and/or interest in arrearS

Answer 63

the government security will have lower coupons because of its lower default risk, so it will have greater interest rate risk

Answer 64

Prices and yields move in opposite directions. Since the bid price must be lower, the bid yield must be higher.

Answer 65

All else held equal, the premium over par value for a premium bond declines as maturity approaches, and the discount from par value for a discount bond declines as maturity approaches. This is called “pull to par.” In both cases, the largest percentage price changes occur at the shortest maturity lengths

Answer 66

the longer the maturity the more sensitivity