Chapter 5: bonds, bond valuation, and interest rates Flashcards
Bond
A promissory note issued by a business or governmental unit
a contract under which a borrower agrees to make payments of interest and principal, on specific dates, to the holders of the bond
Main types of bonds
Treasury
corporate
municipal
foreign
Treasury Bonds and Treasury bills
T-bonds and T-bills
issued by federal government
almost no default risk
prices decline when interest rates rise
Agency debt
debt issued by federal agencies that is not backed by the full faith and credit of the U.S. Government but investors assume that the government implicitly guarantees this debt, so these bonds carry interest rates only slightly higher than treasury bonds
Government-sponsored enterprise debt also in this category
Corporate bonds
issued by corporations. Default risk depends on the issuing company and bond terms
higher risk = higher interest rates needed to incentivize investors to purchase
Municipal Bonds
bonds issued by state and local government
some default risk
interest exempt from federal taxes (and state taxes of the issuing state)
lower interest rates due to tax incentives
Foreign bonds
issued by foreign governments or foreign corporations
denominated in the currency of the country in which the issue is sold
some default risk even for foreign government bonds
additional risk based on value of currency
Basis point
1/100 of a percentage point
Credit default swap
a derivative product which serves as a form of insurance against the default against an underlying borrower or debt instrument
par value
stated (face) value of the bond
generally represents the amount promised to pay on the maturity date
Coupon payment
dollar amount of interest paid to each bondholder on the interest payment dates
fixed at the time a bond is issued, typically tries to be at a level that will enable bond to be issued at or near par value (coupon rate near market rate)
coupon interest rate
stated rate of interest on a bond (coupon payment / par value)
Floating-rate bonds
a bond whose coupon payment may vary over time. Coupon rate is generally linked to the rate of some other security (treasury bond rate) or other rate (prime rate or LIBOR)
may be convertible to fixed-rate debt or have upper and lower limits (caps and floors) on the rate
means interest probably moves with the market
LIBOR
London interbank offered rate
Zero coupon bonds
bonds with no coupons (no annuities) but are offered at a substantial discount below par value and thus provide capital appreciation (rather than interest income)
generally treasury bonds but some issued by banks
Original issue discount bond
OID bond
generally any bond originally offered at a price that is significantly below its par value
Payment-in-kind bonds
PIK bonds
don’t pay cash coupons but rather coupons consisting of additional bonds or a percentage of an additional bond.
generally issued by companies with cash flow problems. risky
Step-up provisions
if the company’s bond rating is downgraded then it must increase the bond’s coupon rate
can cause trouble for companies who are already having problems servicing their debt
Maturity date
date when the bond’s par value is repaid to the bondholder
original maturity
maturity at the time the bond is issued
effective maturity
years till a bond matures (from present date)
Consol
a type of perpetuity (payments every period without a stated maturity date)
originally issued in UK to consolidate past debt
Call provision
provision on a bond contract that gives the corporation the right to call the bonds for redemption - generally at a amount greater than par value (premium)
call premium
the extra amount above par value that a company must pay if it calls a bond that has a call provision. generally declines over time (as maturity gets closer)
Deferred call
when a callable bond may not be called until a specified number of years after issue has passed
also known as call protection
refunding operation
when a company issues debt at a current low rate and uses the proceeds to repurchase on of its existing high-coupon rate debt issues (if high-coupon rate debt has call provision may be able to buy back debt at a call price lower than market price)
Who do call provisions favor and why?
Issuer
issuer can leave bond paying given rate if market rates go up. if market rates go down issuer can call bond and issue new debt at current lower rates and investors will only get lower rates
means that callable bonds generally have a higher coupon rate than similar noncallable bonds
Bonds redeemable at par
gives the investors the right to sell the bonds back to the corporation at a price that is usually close to the par value
allows investors to reinvest their money with a higher return if interest rates rise
Event risk
the chance that some sudden event will occur and increase the credit risk of a company, lowering the firm’s bond rating and the value of its outstanding bonds
firms deemed likely to face these events must pay higher interest rates
super poison put
a covenant on a bond that enables the bondholder to turn in (put) a bond back to the issuer at par in the event of a takeover, merger, or major recapitalization
Make-whole provision
issuing company may call the bond but it must pay a call price that is essentially equal to the market value of a similar noncallable bond
Sinking fund provision
facilitates the ordered retirement of a bond issue by:
- firm may be required to deposit money with a trustee who invests the funds and then uses that money to retire bonds when they mature (less likely)
- company call call in for redemption (at par value) a certain (small) percentage of bonds each year (best option if interest rates have fallen)
- company may buy the required amount of bonds on the open market (best option if interest rates have risen and bond prices fallen)
(first rare, second two more usual)
reduces overall risk to the investors
results of failure to meet a sinking fund requirement
puts bond into default
affect of sinking fund provision on bond coupon rates
since sinking fund is regarded as risk mitigation, rates usually lower than bonds without sinking fund provisions
Convertible bond
bond that can be converted into a given number of shares of common stock, at a fixed price, at the option of the bond holder
generally offer lower coupon rates as this increases the value to the investors
aka delayed equity
Warrants
Options that permit the holder to buy stock at a fixed price (some bonds may have warrants attached)
Income bond
required to pay interest only if earnings are sufficient to cover interest expense
riskier than regular bonds
Indexed bonds
aka purchasing power bonds
interest payments and maturity payments rise when inflation rate rises (rate linked to something like the consumer price index)
TIPS
treasury inflation protected securities
US indexed bonds
who owns and trades most bonds?
large financial institutions (banks, investment banks, insurance companies, mutual funds, and pension funds)
Bond markets
electronic markets with relatively few players
information not widely published
Cash flows of a bond
interest payments through the life of the bond
par value paid on maturity
Discount rate for figuring out bond’s present value
required rate of return on debt
generally market interest rate (going interest rate, yield)
same as coupon rate ONLY if bond is selling at par
Present value of a bond
PV of all interest payments + present value of payment at maturity discounted at the required rate/ market rate (where N= years or periods to maturity)
Excel Price function
finds bond value as of a given date
Change in bond price as market rate changes
bond price moves in opposite direct from rate (if interest rate rises, bond price falls, if interest rate decreases, bond price rise)
Discount bond
Bond with a coupon rate that is below the market rate. (not worth as much as bonds with higher rates so sells lower)
Premium bond
bond with a coupon rate above the market rate (worth more than bonds with lower rates, so sells higher)
new issue bond
bond that has just been issued - generally classified that way for about a month
after that becomes outstanding or seasoned bonds
Bond Yield
Total rate of return on the sale of a bond
= Interest (current) yield
+ capital gains yield (- loss)
Interest yield
= interest received / price paid
Capital gains yield
capital gain on sale / price paid (if negative is capital loss)
rate of return due to change in price (present value) of a bond
why would a company exercise a call provision
essentially to refinance. if rates have gone down or company risk has decreased they can now borrow money at a lower rate
Leveraged buyout
buyout financed by company debt
when a company issues more bonds and uses the money to buy back all the shares so only a small group of investors hold all the shares
massive increase of company debt causes company risk to rise and price of bonds to drop
Put feature
Bond holders have the right to sell the bond back to the company at a predetermined amount (in case of bond price falling precipitiously)
Financial asset valuation using financial calculator
!/Y = market rate return required given company risk
PMT = annual (or other regular) cash flows
FV = maturity value (capital returned)
N = number of years receiving payments
calculate present value to get current valuation
