Chapter 6: Fixed-Income Securities: Characteristics and Valuation Flashcards
Contract between issuer and lenders
Indenture
A bond that doesn’t pay interest, but is traded at a deep discount, rendering profit at maturity
Zero-Coupon Bond
Bonds issued by a national government in a foreign currency, in order to finance the issuing country’s growth
Sovereign Debt
Issued by the federal government
US Treasuries
Treasury Bills, Notes, or Bonds
Mature within one year; zero coupon
Bills
Treasury Bills, Notes, or Bonds
Mature in 1-10 years, coupon bonds
Notes
Treasury Bills, Notes, or Bonds
Maturities greater than 10 years, coupon
Bonds
What is TIPS
Treasury Inflation Protected Securities
- treasury security that is indexed to inflation in order to protect investors from the negative effects of inflation.
- Low Risk
- backed by the U.S. government and since their par value rises with inflation
- Purchasing power, in essence, stays the same
Purchasing power
The value of a currency expressed in terms of the amount of goods or services that one unit of money can buy.
Purchasing power is important because, all else being equal, inflation decreases the amount of goods or services you’d be able to purchase.
percentage of par value paid as interest annually
What is the Coupon rate
What is the lowest investment grade
Baa (medium grade)
Exchange or Over the Counter Market (OTC)
There is an exchange rate between the buyer and the seller
For example: NYSE in between the buyer and seller
Helps reduce counterparty risks
There is a standardization
Very transparent, very public
Exchange
Exchange or Over the Counter Market (OTC)
Reliant on contracts
Private – There is no “middle man” – Buyer and seller interact directly
Higher counterparty risks
Over the Counter Market (OTC)
DukeEn 6.375 19 6.8 40 93¾ –1/4
[Company] [Stated Coupon Rate (%)] [Year of Maturity] [Yield to Maturity (%)]
[Amount Traded (In Thousands)] [Closing Price (% of Par)] [Change in Price (% of Par)]
When coupon is less than yield to maturity, bond is selling at a _______
Discount
When coupon is greater than yield to maturity, bond is selling at a _______
Premium
When is coupon equal to yield?
When selling at par
Rate in order of highest required rate of return to lowest
a. Short-Term Gov Debt (Treasuy Bills)
b. Low- quality Corporate Bond
c. Common Stock
d. Long term Government Debt
e. High Quality Corporate Debt
f. High Quality Preferred Stock
c. b. f. e. d. a.
required rate of return
the interest rate that a bond issuer must offer in order to get investors interested.
Required returns are predominantly set by market forces, and is determined by the price at which issuers and investors agree.
Equation to Valuate a bond
P_o = I(PVIFA) + M(PVIF)
Where P= price of bond
I = coupon interest payment
M = principal payment
k_d = required rate of return (i)
the interest rate that a bond issuer must offer in order to get investors interested.
________ are predominantly set by market forces, and is determined by the price at which issuers and investors agree.
required rate of return
The discount rate that equates the PV of a bond’s cash flows with it’s price
YTM
What kind of stock is this:
- No voting rights
- Dividends are fixed
- Offers firm a little more flexibility than fixed income. Even though the firm is required to pay the dividend, they can delay payment for –___ and common stock holders. Once they are doing alright again, they must pay the _____ holders before the common stock
- Dividends are not tax deductible
- Intermediate position between common stock and L-T debt
preferred stock
is the process that links risk and return to determine the worth of an asset
Valuation
There are three key inputs to the valuation process:
- Cash flows (returns)
- Timing
- A measure of risk, which determines the required return
ROE for fixed-income
Yield
Valuation of a Bond equation
P_o = I (PVIFA) + M (PVIF)
Where: P= price of bond I = coupon interest payment M = principal payment k_d = required rate of return (i)
Advantages and Disadvantages of Long-Term Debt Financing
Advantages:
Low cost
Leverage increases EPS
Owners maintain control
Disadvantages:
Increased financial risk
Restrictions by lenders
Preferred stock advantages and disadvantages
Advantages
Don’t have to pay interest (or dividends)
Disadvantages
Not tax deductible (interest expense is)
Restrictions on issuer (like a contract)
Covenants
Represents bondholders
Trustee
Where “in line” does a bond stand? (order of payment)
Priority
A financial instrument that represents: an ownership position in a publicly-traded corporation (stock), a creditor relationship with governmental body or a corporation (bond), or rights to ownership as represented by an option.
Security
