Chapter 4 Flashcards
What is a bond
long term contract under which a borrower agrees to make payments of interest and principal on specific dates to the holder of the bond
What are the main types of bonds
treasury bonds
corporate bonds
municipal bonds
foreign bonds
what is the charactaristic of a treasury bond
no default risk
what is the characteristic of a corporate bond
default risk
what is the characteristic of a municipal bond
interest is tax expemt
what is the characteristic of a foreign bond
additional risk
what is the coupon interest rate of a bond
coupon payment/par value
rate X FV = pmt’s
What is the bonds required rate of return (rd)
the discount rate used to calculate the PV of the bonds cash flow… also called yeild
what is the difference between coupon rate and rd
rd will fluctuate but coupon is a fixed rate
How do you calculate the value of a bond
PV of all future cash flows
when Rd rises above the coupon rate what happens to the bond
the value of the bond falls below par… leads to discounted bond
a bond that has just been issued is known as a…
new issue (for about a month)
once the bond has been on the market for a while then what is it called?
outstanding/seasoned bond
As a bond (premium/discount) gets closer to maturity it gets closer to what
bond value
for semi annual bonds how do the inputs change
divide rate by 2
multiply n by 2
divide payments by 2
What are provisions to Call bond
- issuer can call the bond for redemption if rates go bad - good for issuer bad for the investors
bonds are more expensive since it is worse for the borrower
what is a call premium
if the bonds are called the company must pay the holder an amount greater than par value
what is a deferred call?
bond cannot be called until several years after the bond is issued
Provisions to Redeem Bonds
bonds that are redeemable at par at the holders option protect the holder against a rise in interest rate
if interest rates rise the holder will turn in bonds and reinvest proceeds at a higher rate
what is a sinking fund
provisions to pay off loan over time rather than all at maturity
how does. a sinking fund benefit investors
reduces their risk and shortens maturity
what are the two ways sinking funds are generally handled
- call a certain percentage at par (if interest rates are below coupon and bond sells at a premium)
- buy bond on open market (if interest rates are above coupon and bond is at a discount)
what is a convertible bond
owners can convert bond to fixed number of common stock shares
what is a warrant
option that permits the holder to buy stock at a fixed price
what is an income bond
required to pay interest only if earnings are high enough to cover interest expense
what is an indexed bond
the interest payments and maturity payments rise automatically when the inflation rises
do bond yeilds vary from day to day?
yes
what ways can a bond yield be calculated?
- yield to maturity
- current yield
- yield to call
What is YTM
the rate earned on a bond if you hold it until maturity
- equals expected return on if probability of default is zero and the bond cannot be called
what function do you use to solve YTM
RATE
What is the current yeild calculation
current yield = (annual coupon pmt/ current price)
what is the YTM basic calculation
current yield + capital gains yield
what information does the current yield provide
cash income a bond will generate in the current year
what is capital gain yields equation
Cap gain yield = YTM - current yield
what does capital gains yield represent
rate of return due to the price change
when is a callable bond likely to be called?
when the interest rates are well below an outstanding bonds coupon rate
how do you estimate a callable bonds rate
the yield to call rate (YTC)
what is N and FV in the YTC
n is the time until company is allowed to call bond
FV is the price company must pay in order to call bond
if you bought a bond would you be more likely to earn YTM or YTC
investors should except a call, therefore expected return should be YTC
what determines the markets interest rate?
Rd equation
what is r*
the interest rate that would exist on a riskless security if no inflation were expected
-rate on US treasury securities in an inflation-free world
What is an inflation premium
the average inflation rate expected over the life of the security compensates investors for the expected loss of purchasing power
what does treasury bill interest rate equal
risk free rate
what do we use in general to estimate the short term risk free rate
T-bills
what do we use in general to estimate the long term risk free rate
t-bonds
What is the Maturity Risk Premium
The net of the interest rate risk and reinvestment risk
what is interest rate risk
long term securities are more price sensitive to interest rate changes than short term securities
what affect interest rate risk
length of security as well as size of coupon pmts
what does rising rd lead to
bond prices to fall. “have to pay higher interest to holders so they get less from actual bond”
what is the reinvestment rate risk?
short term bills are exposed to reinvestment rate risk
- risk that funds will have to be reinvested in the future at lower rates, reducing income
Maturity Risk Premium characteristics of long term bonds
high interest rate risks and low reinvestment rate risk
Maturity Risk Premium characteristics of short term bonds
low interest rate risks, high reinvestment risks
is MRP more affected by interest rate risk or reinvestment rate risk
interest rate risk - long term bonds usually have greater yeilds
What is default risk premium
compensates investors for the risk that a borrower will default and hence not pay the interest or principal
the greater the default risk the…
higher the bonds yield to maturity
bond indenture
a legal document that spells out the rights of both bondholders and the issuing corporation
what is a trustee
an official who represents the bond-holders and makes
sure the terms of the indenture are carried out.
can the terms of a bond contract affect default risk
yes
what is a mortgage bond?
a corporation pledges certain assets as security
what is a debenture
unsecured bond. their holder are creditors whose claims are protected by property not otherwise pledged
subordinated debentures
in the event of bankruptcy, only have claims on assets after senior debtors has been paid off
What factors affect default risk and bond ratings?
- Financial rations
-Bond contract terms
What is a liquidity premium
a liquid asset can be converted to cash quickly and at fair market value”
(small company bonds tend to have a higher liquidity premium than large company bonds)
What is structure yield curve
the relationship between interest rates (or yields) and maturities
what does the “normal” yield curve look like
upward sloping
what does a downward sloping yield curve signify
investors expect inflation to decrease
What are Junk bonds
high risk, high-yield bonds
