Chap 10 Flashcards
Refunding provision:
prohibits the premature retirement of an issue from proceeds of a lower-coupon bond.
PIK bond
an unusual type of junk bond
PIK stands for “payment in kind”
Rather than paying the bond’s coupon in cash, the issuer can make annual interest payments in the form of additional debt, usually for five or six years, before making interest payments in real money.
Junior bonds:
Unsecured debt, backed only by the promise of the issuer to pay interest and principal on a timely basis.
Conversion privilege
key element of a convertible that stipulates the conditions and specific nature of the conversion feature.
Forced conversion:
while the bondholder has the right to convert the bond at any time, more often than not, the issuing firm initiates the conversion by calling the bonds.
Call price
the bond’s par value plus the call premium.
Purchasing Power Risk
the chance that bond yields will lag behind inflation rates. Inflation erodes the purchasing power of money.
–Corporate and government bond rates tend to move :
together, but corporate bond rates are higher.
Corporate bonds are more risky and thus require a higher rate to compensate for this risk.
Difference between the corporate and government bond rates is called the yield spread, or credit spread.
Treasury bonds: (time)
maturity of 30-years
Coupon rate
the interest payment that the bond issuer makes as a percentage of the bond’s par value
Agency bonds:
debt securities issued by various agencies and organizations of the government
High quality securities with almost no risk of default.
Usually provide yields that are slightly above the market rates for Treasuries
Business/Financial Risk
the risk that the issuer of the bond will default on interest or principal payments
Mortgage bonds
are secured by real estate.
Debenture
a bond that is totally unsecured, meaning there is no collateral backing up the obligation.
What Ratings Mean
Ratings are tied to bond yields: the higher the rating the lower the yield.
A bond’s rating has an impact on how sensitive its price is to interest rate movements as well as to changes in the company’s financial performance.
Bond ratings serve to relieve individual investors of the time and cost of a thorough credit analysis of their own, but keep in mind:
Bond ratings only measure an issue’s default risk, which is not related at all to an issue’s exposure to interest rate risk.
Ratings agencies do make mistakes.
Eurodollar bonds
issued and traded outside of the U.S. and are not registered with the SEC.
Denominated in U.S. dollars
Eurodollar market primarily aimed at institutional investors and dominated by foreign-based investors.
Call Risk
risk that a bond will be “called” (retired) before its scheduled maturity date.
equity kicker
the right to convert these bonds into shares of the company’s common stock
Liquidity Risk
the risk that a bond will be difficult to sell at a reasonable price.
Bond Interest and Principal
Coupon
Principal (par value; face value)
Coupon rate
Current Yield
Conversion period
the time period during which a convertible issue can be converted.
Bond rating agencies:
institutions that perform extensive financial analysis on companies issuing bonds to assess the credit risk associated with a particular bond issue.
Examples: Moody’s, Standard & Poor’s, Fitch
Treasury Inflation-Protected Securities (TIPS)
first issued in 1997, these securities offer investors the opportunity to stay ahead of inflation by periodically adjusting their returns for any inflation that has occurred.
Payback period(conversion)
a measure of the length of time it will take to recover the conversion premium from the extra interest income earned on the convertible.
Investment-grade bonds
bonds receiving one of the top four ratings, indicating financially strong, well-run companies.
Mortgage-backed bond:
a debt issue that is secured by a pool of residential mortgages.
Global View of the Bond Market
Foreign bonds have caught on with investors because of their high yields and attractive returns.
Big risk with foreign bonds has to do with the impact that currency fluctuations can have on returns in U.S. dollars.
The U.S. has the world’s biggest bond market, followed by Japan, China, and several EU countries (Germany, Italy, France), together accounting for greater than 90% of the world bond market.
Non-callable
issuer is prohibited from retiring the bond prior to maturity.
types of risk (bonds)
Interest Rate Risk
Purchasing Power Risk
Business/Financial Risk
Liquidity Risk
Call Risk
Convertible bonds:
securities originally issued as bonds (or even preferred stock) by a corporation and containing a provision that gives investors the option to convert their bonds into shares of the issuing firm’s stock.
Convertibles are hybrid securities because they contain attributes of both debt and equity.
They should be viewed primarily as a form of equity.
- Convertibles as Investment Outlets
- Sources of Value
- Measuring the Value of a Convertible
Types of municipal bonds
General obligation bonds
Revenue bonds
Zero-coupon bonds
do not pay interest.
Sold at a discount from their par values.
Increase in value over time at a compound rate of return; At maturity, the difference in value from their initial cost represents the bond’s return.
Subject to tremendous price volatility as interest rates fluctuate.
Interest must be reported as it is accrued for tax purposes, even though no interest is actually received.
Conversion price:
the stated value per share at which the common stock will be delivered to the investor in exchange for the convertible issue.
Subordinated debenture:
unsecured bond issues whose claim is secondary to other debenture bonds.
Quoting Bond Prices
Bonds are not widely quoted in the financial press like stocks are.
Prices of all types of bonds are usually expressed as a percent of par.
In the corporate and municipal markets, bond prices are expressed in decimals:
A quote of 87.562 translates into a price of 87.562% of par or $875.62 for a bond with a $1,000 par value.
In U.S. Treasury and agency bond quotes are stated in thirty-seconds of a point (1 point equals $10):
A quote for a T-bond of 94.16 translates to 94 16/32 or 94.5% of par, assuming $1,000 par value (i.e., $945.00).
The price of bond depends on its coupon and maturity, so these are usually included in a price quote.
Deferred call
the issue cannot be called until after a certain length of time has passed from the date of issue.
Split rating
occurs when a bond issue is given different ratings by major rating agencies.
Treasury strips:
zero-coupon bonds created from U.S. Treasury securities and sold by government securities dealers.
Conversion ratio:
denotes the number of common shares into which the convertible issue can be converted.
Types of “Call feature”
Freely callable
Noncallable
Deferred call
Interest Rate Risk
the chance that changes in interest rates will negatively affect the bond’s value.
First and refunding bonds
are a combination of first mortgage and junior lien bonds.
bonds secured in part by a first mortgage on some of the issuer’s property and in part by second or third mortgages on other properties.
Less secure than straight first-mortgage bonds.
Junk bonds (high-yield bonds):(grading)
bonds with below-investment-grade ratings, reflecting issuers lacking financial strength.
Treasury notes
issued with maturities of 2,3,5,7, and 10 years.
Securitization:
various lending vehicles are transformed into marketable securities.
Collateral trust bonds
are secured by financial assets owned by the issuer but held in trust by a third party.
Bonds versus Stocks
Compared to stocks, bonds generally offer lower returns.
Main benefits of bonds in a portfolio:
–Lower risk
–High levels of current income
–Diversification
Bonds add an element of stability to a portfolio
Yankee bonds
issued by foreign governments or corporations or by supernational agencies, like the World Bank and the InterAmerican Bank.
Issued and traded in the U.S.
Registered with SEC
All transactions are in U.S. dollars
No currency exchange rate risk
Corporate Bonds
Issued by corporations from four major segments:
- Industrial
- Public Utilities
- Transportation
- Financial services
Wide variety of bond quality and bond types available
Popular with individuals because of the steady, predictable income they provide.
Revenue bonds (municipal bonds)
are serviced by the income generated from specific income-producing projects (e.g. toll road).
Municipal bonds
issued by states, counties, cities, and other political subdivisions (school districts, water and sewer districts)
Some are backed by municipal bond guarantees, which are an additional source of collateral in the form of insurance, which improves the quality of the bond (higher ratings and improved liquidity).
The bond market is:
Mainly over-the-counter in nature.
Far more stable than the stock market.
Growing rapidly
Current Yield
measures the interest component of a bond’s return relative to the bond’s market price (calculated as the bond’s annual coupon divided by the bond’s current market price).
Income bonds
most junior of all bonds; unsecured debts requiring that interest be paid only after a certain amount of income is earned.
LYON (liquid yield option note):
zero-coupon convertible bond that is convertible, at a fixed conversion ratio, for the life of the issue
No current income, but no limit on potential capital appreciation.
Put option allows security to be sold back to issuer at prespecified prices, providing downside protection
Bond ratings
letter grades that rating agencies give to new bond issues, corresponding to a certain level of credit risk.
Collateralized Mortgage Obligations (CMOs):
mortgage-backed bond pool that is divided into “tranches”, or classes of investors, based on whether they want a short-, intermediate-, or long-term investment.
Complex and potentially risky.
- Prepayment (call) risk.
- Different tranches have different levels of prepayment risk
Serial bond
a bond issue that has a series of bonds with different maturity dates, perhaps as many as 15 or 20, within a single bond offering.
Equipment trust certificates
are secured by specific pieces of equipment, such as boxcars and airplanes.
Call premium
the amount added to the bond’s par value and paid upon call to compensate bondholders.
Sinking fund:
stipulates how the issuer will pay off the bond over time.
Applies only to term bonds.
Not all term bonds have sinking-fund requirements.
Sinking fund requirements usually begin 1 to 5 years after the date of issue and continue annually thereafter until all or most of the issue is paid off.
Any amount not repaid would then be retired with a single “balloon” payment at maturity.
Obligates the issuer to pay off the bond systematically over time.
Bonds
are publicly traded, long-term debt securities. They are often referred to as “fixed income securities” because the payments are usually fixed
Principal (par value; face value)
the amount of capital that the borrower must repay at maturity.
How Ratings Work:
A firm’s financial strength and stability are very important in determining the appropriate rating.
Generally, higher ratings are associated with more profitable companies that:
- rely less on debt as a form of financing
- are more liquid
- have stronger cash flows
- have no trouble servicing their debt in a prompt and timely fashion
Conversion Premium
the extent to which the market price of the convertible exceeds its conversion value.
Investors are willing to pay a premium because of the added current income provided relative to the underlying stock and because of the convertible’s upside potential
Junk Bonds (general concept)
Highly speculative securities that have received low, sub-investment grade ratings.
Often take the form of subordinated debentures.
Called “junk” because of their high risk of default.
Typically offer very high yields.
Prices tend to behave more like stocks than bonds.
Conversion value
indicates what a convertible issue would trade for if it were priced to sell on the basis of its stock value.
Conversion value = conversion ratio x current market
Coupon
the amount of annual interest income the issuer pays to the bondholder.
Senior bonds
are secured obligations, meaning they are backed by a legal claim or some specific property of the issuer.
Term bond
a bond issue that has a single, fairly lengthy maturity date for all the bonds being issued; most common type.
Maturity date:
the date when a bond matures and the principal must be repaid.
Fixed
Term to maturity: amount of time remaining on a bond’s life until it matures.
Types of Senior bonds
Mortgage bonds
Collateral trust bonds
Equipment trust certificates
First and refunding bonds
Equipment trust certificate: (corporate bonds)
special corporate issue security issued by railroad, airlines and other transportation concerns; used to purchase equipment that serves as collateral for the issue.
Asset-backed securities (ABS):
securities backed by pools of auto loans, credit card bills, home equity lines of credit, as well as computer leases, hospital receivables, small business loans, truck rentals, even royalty fees.
Freely callable
issuer can prematurely retire the bond at any time.
General obligation bonds (municipal bonds)
are backed by the full faith, credit and taxing power of the issuer.
Types of Junior bonds:
Debenture
Subordinated debenture
Income bonds
Investment value
the price at which the bond would trade if it were nonconvertible and if it were priced at or near the prevailing market yields of comparable nonconvertible bonds.
Found by discounting the issue’s coupon stream and its par value back to the present, using a discount rate equal to the prevailing yield on comparable nonconvertible issues.
the most important influence on bond returns.
The behavior of interest rates is the most important influence on bond returns.
When interest rates rise, bond prices fall.
When interest rates drop, bond prices move up.
Call feature:
every bond is issued with a call feature, which stipulates whether and under what conditions a bond can be called in for retirement prior to maturity
Call features work for the benefit of the issuer, allowing issuers to take advantage of declines in market interest rates. The investor is left with a much lower rate of return than would be the case if the bond was not called
Historical Returns
As with stocks, total returns in the bond market are made up of current income from bond’s interest payments and capital gains (or losses) from changes in the bond’s value.
During a period of rising rates, total returns on bonds include capital losses that can sometimes exceed the bonds’ current interest income, resulting in a negative total return
The inverse relationship between bond prices and yields can also work in investors’ favor. Years with the highest total returns on bonds are “almost always” years in which bond yields fell during the year
What is the most common value corporate and municipal bond ? (Par value)
$1000 par values
Ex: and 12.6, 20 year bond , annual interest income
1000 x 12.6 = 126.00 $
Formula for Annual interest income
Annual interest income = coupon rate x par value ($1000)
