Chapter 6 - Bond Valuation Flashcards
Understand: - Important bond features and types of bond. - Bond values and yields, and why they fluctuate. - Bond ratings, and what they mean. - The impact of inflation on interest rates. - The term structure of interest rates, and the determinants of bond yields.
Definition: Coupon
The stated interest payment made on a bond.
Definition: Face value
The principal amount of a bond that is repaid at the end of the term. Also called the “par value”.
Definition: Coupon rate
The annual coupon divided by the face value of a bond.
Definition: Maturity
The specified date on which the principal amount of a bond is paid.
Definition: Yield to maturity (YTM)
The rate required in the market on a bond.
Definition: Discount bond
A bond that sells for less than its face value.
Definition: Premium bond
A bond that sells for more than its face value.
Check Bond Value Formula –> p. 149
Also Summary
How is the relation between bond prices and interest rates?
The move in opposite directions. When interest rates rise, a bond’s value, like any other present value, will decline. Similarly, when interest rates fall, bond values rise.
Definition: Interest rate risk
The risk that arises for bond owners from fluctuating interest rates.
You should keep the following in mind when looking at a bond:
- All other things being equal, the longer the time to maturity, the greater the interest rate risk.
- All other things being equal, the lower the coupon rate, the greater the interest rate risk.
Definition: Current yield
A bond’s annual coupon divided by its price.
Definition: Principal
The original amount borrowed
Definition: 1. Creditor/Lender & 2. Debtor/Borrower
- The person/firm making the loan.
2. The corporation borrowing the money.
Definition: Notes
Issues(/unsecured debt securities) with an original maturity of 10 years or less.
Definition: Indenture (sometimes referred to as “the deed of trust)
The written agreement between the corporation and the lender detailing the terms of the debt issue.
The bond indenture generally includes the following provisions:
- The basic terms of the bonds
- The total quantity of bonds issued
- A description of property used as security
- The repayment arrangements
- The call provisions
- Details of the protective covenants
Definition: 1. Registered form & 2. bearer form
- The form of bond issue in which the registrar of the company records ownership of each bond; payment is made directly to the owner of record
- The form of bond issue in which the bond is issued without record of the owner’s name; payment is made to whomever holds the bond.
Definition: Unsecured bond
An unsecured debt security. usually with a maturity of 10 years or more.
Definition: sinking fund
An account managed by the bond trustee for early bond redemption.
Definition: Call provision
An agreement giving the corporation the option to repurchase a bond at a specified price prior to maturity.
Definition: Call premium
The amount by which the call price exceeds the par value of a bond.
Definition: Deferred call provision
A call provision prohibiting the company from redeeming a bond prior to a certain date.
Definition: Call-protected bond
A bond that, during a certain period, cannot be redeemed by the issuer.
Definition: Protective covenant
A part of the indenture limiting certain actions that might be taken during the term of the loan, usually to protect the lender’s interest.
Definition: Zero coupon bonds
A bond that makes no coupon payments and is thus initially priced at a deep discount. Also called pure discount bonds.
What is the largest security market in the world in terms of trading volume?
The government treasury market.
Definition: Clean price
The price of a bond net of accrued interest; this is the price that is typically quoted.
Definition: Dirty price
The price of a bond including accrued interest, also known as the “full” or “invoice” price. This is the price the buyer actually pays.
Definition: Real rates
Interest rates or rates of return that have been adjusted for inflation.
- The real rat on an investment is the percentage change in how much you can buy with your cash - in other words, the percentage change in your buying power.
Definition: Nominal rates
Interest rates or rates of return that have not been adjusted for inflation.
- The nominal rate on an investment is the percentage change in the amount of cash you have.
Definition: Fisher effect
The relationship between nominal returns, real returns and inflation. –> 1+R=(1+r)x(1+h)
R=nominal rate
r=real rate
h=inflation rate
Definition: Term structure of interest rates
The relationship between nominal interest rates on default-free, pure discount securities and time to maturity: that is, the pure time value of money.
Definition: Inflation premium
The proportion of a nominal rate that represents compensation for expected future inflation.
Definition: Interest rate risk premium
The compensation investors demand for bearing interest rate risk.
Definition: Treasury yield curve
A plot of the yields on Treasury notes and bonds relative to maturity.
Definition: Default risk premium
The portion of a nominal interest rate or bond yield that represents compensation for the possibility of default.
Definition: Taxable premium
The portion of a nominal interest rate or bond yield that represents compensation for unfavorable tax status.
Definition: Liquidity premium
The portion of a nominal interest rate or bond yield that represents compensation for lack of liquidity.
On top of the real rate are five premiums representing compensation for:
- Expected future inflation
- Interest rate risk
- Default risk
- Taxability
- Lack of liquidity
