Chapter 4 Bond Valuation Flashcards
Call Provision
Issuer can refund if rates decline. That helps the issuer but hurts the investor. Therefore, borrowers are willing to pay more, and lenders require more, on callable bonds. Most bonds have a deferred call and a declining call premium.
Sinking Fund
Provision to pay off a loan over its life rather than all at maturity. Similar to amortization on a term loan. Reduces risk to investor, shortens average maturity. Not good for investors if rates decline after issuance.
Coupon rate < r_d
Bond sells at a discount.
Coupon rate = r_d
Bond sells at its par value.
Coupon rate > r_d
Bond sells at a premium.
Cap Gains Yield =
YTM - Current yield
YTM =
Current Yield + Cap gains yield
What is the real risk-free rate?
The rate that a hypothetical riskless security pays each moment if zero inflation were expected. This can be approximated by the rate on TIPS.
What is the nominal risk-free rate?
The rate on a U.S. Treasury security.
Estimating IP
The IP for a particular length maturity can be approximated as the difference between the yield on a non-indexed Treasury security of that maturity minus the yield on a TIPS of that maturity.
Spread =
DRP + LP
What ratios affect default risk and bond ratings?
Financial ratios, such as Debt ratio, Coverage ratios, Profitability ratios, Current ratios.
Other factors that affect bond ratings
Secured vs. unsecured debt, senior versus subordinated debt, guarantee provisions, sinking fund provisions, debt maturity, earnings stability, regulatory environment, potential product liability, accounting policies.
What is reinvestment rate risk?
The risk that CFs will have to be reinvested in the future at lower rates, reducing income.
Term Structure
The relationship between interest rates and maturities.
