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Financial Managment > Chapter 5: bonds, bond valuation, and interest rates > Flashcards

Chapter 5: bonds, bond valuation, and interest rates Flashcards

1
Q

Bond

A

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

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2
Q

Main types of bonds

A

Treasury
corporate
municipal
foreign

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3
Q

Treasury Bonds and Treasury bills

A

T-bonds and T-bills

issued by federal government

almost no default risk

prices decline when interest rates rise

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4
Q

Agency debt

A

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

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5
Q

Corporate bonds

A

issued by corporations. Default risk depends on the issuing company and bond terms

higher risk = higher interest rates needed to incentivize investors to purchase

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6
Q

Municipal Bonds

A

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

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7
Q

Foreign bonds

A

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

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8
Q

Basis point

A

1/100 of a percentage point

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9
Q

Credit default swap

A

a derivative product which serves as a form of insurance against the default against an underlying borrower or debt instrument

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10
Q

par value

A

stated (face) value of the bond

generally represents the amount promised to pay on the maturity date

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11
Q

Coupon payment

A

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)

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12
Q

coupon interest rate

A

stated rate of interest on a bond (coupon payment / par value)

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13
Q

Floating-rate bonds

A

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

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14
Q

LIBOR

A

London interbank offered rate

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15
Q

Zero coupon bonds

A

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

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16
Q

Original issue discount bond

A

OID bond

generally any bond originally offered at a price that is significantly below its par value

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17
Q

Payment-in-kind bonds

A

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

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18
Q

Step-up provisions

A

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

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19
Q

Maturity date

A

date when the bond’s par value is repaid to the bondholder

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20
Q

original maturity

A

maturity at the time the bond is issued

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21
Q

effective maturity

A

years till a bond matures (from present date)

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22
Q

Consol

A

a type of perpetuity (payments every period without a stated maturity date)

originally issued in UK to consolidate past debt

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23
Q

Call provision

A

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)

24
Q

call premium

A

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)

25
Q

Deferred call

A

when a callable bond may not be called until a specified number of years after issue has passed

also known as call protection

26
Q

refunding operation

A

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)

27
Q

Who do call provisions favor and why?

A

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

28
Q

Bonds redeemable at par

A

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

29
Q

Event risk

A

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

30
Q

super poison put

A

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

31
Q

Make-whole provision

A

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

32
Q

Sinking fund provision

A

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

33
Q

results of failure to meet a sinking fund requirement

A

puts bond into default

34
Q

affect of sinking fund provision on bond coupon rates

A

since sinking fund is regarded as risk mitigation, rates usually lower than bonds without sinking fund provisions

35
Q

Convertible bond

A

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

36
Q

Warrants

A

Options that permit the holder to buy stock at a fixed price (some bonds may have warrants attached)

37
Q

Income bond

A

required to pay interest only if earnings are sufficient to cover interest expense

riskier than regular bonds

38
Q

Indexed bonds

A

aka purchasing power bonds

interest payments and maturity payments rise when inflation rate rises (rate linked to something like the consumer price index)

39
Q

TIPS

A

treasury inflation protected securities

US indexed bonds

40
Q

who owns and trades most bonds?

A

large financial institutions (banks, investment banks, insurance companies, mutual funds, and pension funds)

41
Q

Bond markets

A

electronic markets with relatively few players

information not widely published

42
Q

Cash flows of a bond

A

interest payments through the life of the bond

par value paid on maturity

43
Q

Discount rate for figuring out bond’s present value

A

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

44
Q

Present value of a bond

A

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)

45
Q

Excel Price function

A

finds bond value as of a given date

46
Q

Change in bond price as market rate changes

A

bond price moves in opposite direct from rate (if interest rate rises, bond price falls, if interest rate decreases, bond price rise)

47
Q

Discount bond

A

Bond with a coupon rate that is below the market rate. (not worth as much as bonds with higher rates so sells lower)

48
Q

Premium bond

A

bond with a coupon rate above the market rate (worth more than bonds with lower rates, so sells higher)

49
Q

new issue bond

A

bond that has just been issued - generally classified that way for about a month

after that becomes outstanding or seasoned bonds

50
Q

Bond Yield

A

Total rate of return on the sale of a bond

= Interest (current) yield
+ capital gains yield (- loss)

51
Q

Interest yield

A

= interest received / price paid

52
Q

Capital gains yield

A

capital gain on sale / price paid (if negative is capital loss)

rate of return due to change in price (present value) of a bond

53
Q

why would a company exercise a call provision

A

essentially to refinance. if rates have gone down or company risk has decreased they can now borrow money at a lower rate

54
Q

Leveraged buyout

A

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

55
Q

Put feature

A

Bond holders have the right to sell the bond back to the company at a predetermined amount (in case of bond price falling precipitiously)

56
Q

Financial asset valuation using financial calculator

A

!/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

Financial Managment (11 decks)

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