Chapter 5: Bonds, Bond Valuation, and Interest Rates Flashcards
bond
long-term contract under which a borrower agrees to make payments of interest and principal, on specific dates to the holders of the bond. 4 types: treasury, corporate, municipal and foreign
treasury bond ( T bonds) and Treasury bills (T bills)
issued by the federal government. gov is good on its promised payments so these bonds have almost no default risk.
-treasury bond prices decline when interest rates rise, so they aren’t free of all risks.
Agency debt
GSE debt
- debt issued by federal agencies like the tennessee value authority. it’s not officially backed by the government, but investors assume gov guarentees this debt so the bonds carry interest rates slightly higher than treasury bonds.
- gov sponsored enterprise debt. an agency debt that isn’t backed by the government
corporate bonds
issued by corps.
default risk- if the issuing company gets into trouble, it may not be able to make the promised interest and principal payments.
default risk aka credit risk –> the larger the credit risk, the higher the interest rate the issuer must pay
municipal bonds
issued by state and local governments
- default risk
- interest earned on most of these bonds is exempt from federal taxes and state if they are a resident of the issuing state.
- lower interest rates than corporate bonds but with same default risk.
foreign bonds
- issued by foreign gov/corps
- default risk
- more risk if the bonds are denominated in a currency other than that of the investor’s home currency.
refunding operation
when a company issues debt at current low rates and uses the proceeds to repurchase one of its existing high coupon rate debt issues
super poison put
enables a bondholder to turn in or “put” a bond back to the issuer at par in the event of a takeover, merger, or major recapitalization
make whole provision
allows a company to call the bond but it has to pay a call price that’s essentially equal to the market value of a similar noncallable bond.
-lets companies have an easy way to repurchase bonds as part of a financial restructuring (merger)
floating rate bond
bond’s coupon payment varies over time.
popular with investors worried about the risk of rising interest rates bc the interest paid on these bonds increase when the market rates rise.
zero coupon bonds
original issue discount (OID) bond
payment in kind (PIK) bonds
- bonds that pay no coupons at all but are offered at a substantial discount below their pay values so they provide capital appreciation
- any bond originally offered at a price significantly lower than its par value
- bonds don’t pay cash coupons but pay with additional bonds (issued by companies with cash flow problems)
consol
any bond that pays interest perpetually
redeemable at par
protect investors against a rise in interest rates
key characteristics of bonds
o Par value- face value of the bond. Represents the amount of money the firm borrows and promises to repay on the maturity date.
o Coupon rate- stated rate of interest on a bond. interest/par value
o Maturity date- specified date when the bond must be repaid. Effective maturity of a bond declines each year after it has been issued.
o Call provision: states that if the bonds are called then the company must pay the bondholders an amount greater than the par value/call premium. Most bonds have a call provision. Allows bond issuers to redeem the debt before its maturity date.
- Sinking funds- an account containing money set aside to pay off a debt/bond. May help pay off the debt at maturity or assist in buying back bonds on the open market. Paying off debt early via a sinking fund saves a company interest expense and prevents the company from being put in financial difficulties in the future. Can administer in 2 ways:
o Company can call in for a redemption a certain % of the bonds each year
o Company may buy the required number of bonds on the open market
o Firm chooses cheapest method
Understand what convertible, callable, and putable bonds are. Explain how sinking funds work, and why investors might prefer them. Understand the definition of warrant, income bond, and indexed bond.
- convertible - owners of these can convert the bonds into a fixed number of shares of common stock
- warrant - permit the holder to buy stock at a fixed price, thereby providing a gain if the price of the stock rises.
- investors prefer sinking because they are safer. they have lower coupon rates.
- income bond - required to pay interest only if earnings are high enough to cover the interest expense
- indexed bond- aka purchasing power bonds. interest rate is based on inflation index like consumer price index. so the interest paid rises automatically when the inflation rate rises, thus protecting bondholders from inflation
