Chapter 10 - bond prices and yields Flashcards
bond
A security that obligates the issuer to make specified payments to the holder over a period of time
par/face value
The payment to the bondholder at the maturity of the bond
coupon rate
A bond’s annual interest payment per dollar of par value
annual bond payment =
= coupon rate x par value
indenture
the contract between the issuer and the bondholder
zero coupon bond
A bond paying no coupons that sells at a discount and provides only a payment of par value at maturity
asked yield
a bond’s YTM based on the asking price
yield to maturity (YTM)
- the average rate of return to an investor who purchases the bond for the asked price and holds it until maturity
- The discount rate that makes the present value of a bond’s payments equal to its price
sale/invoice price
the amount the buyer actually pays, equals the stated price plus the accrued interest
accrued interest
= (annual payment / 2) x (days since last payment/days separating payments)
bill
maturity of less than a year
notes
maturities from 1-10 years
bond
maturities from 10-30 years
call provision
allow the issuer to repurchase the bond at a specified call price before the maturity date
refunding
using proceeds from the new bond issue to pay for the repurchase of the existing higher-coupon bond at the call price
callable bond
- Bond that may be repurchased by the issuer at a specified call price during the call period
- Issued with higher coupons and promised YTM
deferred callable bond
a callable bond that has a period of call protection, an initial time during which the bonds are not callable
convertible bond
- A bond with an option allowing the bondholder to exchange the bond for a specified number of shares of common stock in the firm
- Offer lower coupon rates and stated/promised YTM
conversion ratio
number of shares for each bond that is exchanged
conversion premium
the excess of the bond price over its conversion value
put bond
gives the holder the right to demand the issuer pay back the principal before the bond matures, for whatever reason
floating rate bonds
Bonds with coupon rates that periodically reset according to a specified market rate
risk of a floating rate bond
if the health of the firm decreases, investors will demand a greater yield premium, and the price of the bond will fall
preferred stock
Promises to pay a specified cash flow stream to perpetuity
how is preferred stock different from bonds
- the failure to pay the promised dividend does not result in corporate bankruptcy
- The dividends owed simply cumulate, and the CS holders may not receive any dividends until the PS holders have been paid in full
- Dividends on PS are not considered tax-deductible expenses
what is the tax rate on preferred stock dividends
50%
where is the claim on assets of a preferred stockholder in relation to bondholders and common stockholders
below bonds but above CS
floating rate preferred stock
dividend rate is tied to a measure of current market interest rates
when do preferred stockholders get some voting power
If preferred stock dividend is skipped, holders will then be provided some voting power
municipal bonds
issued by state and local governemnts
what is the tax on municipal bonds
tax free
who are the biggest issuers of municipal bonds
FHLBB, farm credit agencies, Ginnie Mae, Fannie Mae, and Freddie Mac issue considerable amounts of muni bonds
foreign bonds
- issued by a borrower from a country other than the one in which the bonds are sold
- Denominated in the currency of the country in which it is marketed
what type of bond is “a dollar-denominated bond issued in the US by a German firm”
foreign bond
Eurobonds
are denominated in one currency, usually that of the issuer, but sold in other national markets
what kind of bonds are “dollar-denominated bonds sold outside the US”
eurobond
inverse floaters
- The coupon rate falls when the general level of interest rate rises
- PV of each dollar falls as well as the price
asset-backed bonds
The income from a specified group of assets is used to service the debt
pay-in-kind bonds
Issuers may choose to pay interest either in cash or additional bonds
catastrophe bonds
- A way to transfer “catastrophe risk” to the capital markets
- Investors receive compensation in the form of higher coupon rates for taking on risk
- But in the vent of a catastrophe, the holders will lose all or part of their investment
indexed bonds
Make payments that are tied to a general price index or the price of a particular commodity
nominal bond return =
= (interest + price appreciation) / initial price
real bond return =
= [(1 + nominal return) / (1 + inflation)] - 1
bond value =
= PV of coupons + PV of par value
pv factor
= 1 / (1 + r)^T
T-period annuity factor for IR = r:
= (1 / r) [1 - (1 / (1 + r)^T]
Financial calculator inputs
- n: number of periods till maturity
- i: interest rate per period (as a percentage), decimal on excel
- PV: present value (- number because purchase entails a cash outflow)
- FV: future value or par/face value
- PMT: amount of coupon payment
what is the relationship between bond price and yield
Inverse relationship between bond prices and yields
what is the relationship between maturity and sensitivity to changes in interest rates
the longer the maturity of the bond, the greater the sensitivity of it’s price to changes in the interest rate
flat prices
bond prices quotes net of accrued interest, appear in the financial press
invoice price
bond price quotes that include accrued interest
Invoice price =
= flat price + accrued interest
settlement date (for excel)
date you buy the bond
excel function for bond price
=PRICE(settlement date, maturity date, annual coupon rate, YTM, redemption value as % of par value, number of coupon payments per year)
yield to maturity function for excel
=YIELD(settlement date, maturity date, annual coupon rate, bond price, redemption value as % of par value, number of coupon payments per year)
bond equivalent yield
annualized yield resulting in an APR
effective annual yield
accounts for compound interest
current yield
Annual coupon divided by bond price
premium bonds
- Bonds selling above par value
- Coupon rate > current yield > YTM
discount bonds
- Bonds selling below par value
- YTM > current yield > coupon rate
Yield to call (For callable bonds)
- the same as YTM except for FV = call price
- the compound interest rate at which the present value of a bond’s future coupon payments and call price is equal to the current market price of the bond
explain how a callable bond works
- When interest rates fall, the PV of the bond’s scheduled payments rise, but the call provision allows the issuer to repurchase the bond at the call price
- If call price < PV of the scheduled payments, the issuer can call the bond at the expense of the bondholder
- Suggests that investors might be more interestedin a bond’s YTC than YTM
explain how a callable bond works
- When interest rates fall, the PV of the bond’s scheduled payments rise, but the call provision allows the issuer to repurchase the bond at the call price
- If call price < PV of the scheduled payments, the issuer can call the bond at the expense of the bondholder
- Suggests that investors might be more interested in a bond’s YTC than YTM
when does RoR = YTM
if all coupons are reinvested and earn the bond’s YTM
realized compound return
Compound rate of return on a bond with all coupons reinvested until maturity
when can realized compound return be calculated
only after the investment period ends unless there is an accurate forecast of future interest rates
horizon analysis
Analysis of bond returns over a multiyear horizon, based on forecasts of the bond’s yield to maturity and the reinvestment rate of coupons
reinvestment rate risk
Uncertainty surrounding the cumulative future value of reinvested bond coupon payments
when does a bond sell at par
coupon rate = market interest rate
when does a bond sell at a premium
when the coupon rate > market interset rate
happens when the coupon rate > market interest rate
the interest income is greater than available in the market leading investors to bid the bond price above par
when does a bond sell at a discount
coupon rate < market interest rate
what happens when coupon rate < market interest rat
the interest income is less than available in the market leading investors to bid the bond price below par
what is the relationship between YTM and HPR
inverse relationship
Original-issue discount (OID) bonds
issued at a discount to par
STRIPS
- separate trading of registered interest and principal of securities
- Zero-coupon bonds
- “Stripped” of their coupon payments and each payment is an independent security
after-tax returns
Additional gains/losses from changes in market interest rates are treated as capital gains/losses of the OID bond sold during the tax year
what are the rating agencies
Moody’s, S&P, and Fitch
investment grade bonds
bonds rated BBB and above by Standard & Poor’s or Baa and above by Moody’s
speculative grade/junk/high yield bonds
bonds rated BB or lower by Standard & Poor’s, Ba or lower by Moody’s, or unrated
what is an advantage of issuing speculative grade/junk/high yield bonds
Lower-cost financing alternative than borrowing from banks
coverage ratios
company earnings to fixed costs
Times-interest-earned ratio
EBIT
Fixed-charge coverage ratio
ratio of earnings to all fixed-cash obligations
how can coverage ratios signal possible cash flow difficulties
low/falling coverage ratios signal possible cash flow difficulties
what can leverage ratios indicate
- excessive indebtedness
- will the firm earn enough to satisfy the obligations to its bonds?
current ratio
current assets/current liabilities
quick ratio
current assets excluding inventories/current liabilities
what do liquidity ratios measure
Measures the ability to raise cash from its most liquid assets
what do profitability ratios do
measure a firm’s overall performance
ROA
EBIT/total assets
ROE
NI/equity
what does a high profitability ratio indicate
should be better able to raise money in security markets
what are some profitability ratios
- ROE
- ROA
what are some coverage ratios
- Times-interest-earned ratio
- Fixed-charge coverage ratio
what is an example of a leverage ratio
debt/equity
what are some liquidity ratios
- current ratio
- quick ratio
sinking fund
A bond indenture that calls for the issuer to periodically repurchase some proportion of the outstanding bonds prior to maturity
details of a sinking fund purchase
- repurchase a fraction of the outstanding bonds in the open market each year
- at a special call price
- Option to purchase the bonds at the MP or sinking fund price (whichever is lower)
- Call price usually set at par value
serial bond
has staggered maturity dates
subordination clause
Restrictions on additional borrowing that stipulate that senior bondholders will be paid first in the event of bankruptcy
collateral on a bond
A specific asset pledged against possible default on a bond
mortgage bond
collateral is property
debenture bond
bond not backed by specific collateral
Default premium (credit spread)
- The increment to promised yield that compensates the investor for default risk
- Difference between the promised yield on a corporate bond and the yield of an otherwise identical government bond that is riskless in terms of default
credit default swaps (CDS)
An insurance policy on the default risk of a corporate bond or loan
yield curve
A graph of yield to maturity as a function of the term to maturity
Term structure of interest rate
The relationship between yields to maturity and terms to maturity across bonds
spot rate
The yield to maturity on a zero-coupon bond of a given maturity
expectations theory
The theory that yields to maturity are determined solely by expectations of future short-term interest rates
forward rate
- The theory that yields to maturity are determined solely by expectations of future short-term interest rates
- (1 + Yn)^n = (1 + Y(n-1))^(n-1) x (1 + Fn)
liquidity theory
The theory that investors demand a risk premium on long-term bonds
liquidity premium
- The yield spread demanded by investors as compensation for the greater risk of longer-term bonds
- F = E(r) + liquidity premium
