Chapter 7 Flashcards
Bond
When a corporation wishes to borrow money from the public long-term basis, it usually issues or sells debt securities called bonds
Coupon
Interest payments are called the bond’s coupons. Because the coupon is constant and paid every year, this type of bond is also called: level coupon bond
Coupon rate
The annual coupon amount divided by the face value is called the coupon rate of the bond
Time to maturity
Number of years until the face value is paid
Change of interest rate and value of bonds
When interest rate rises, PV of the bond’s cash flow goes down.
When interest rate decreases, PV of the bond’s cash flow goes up.
Bond value formula
Bond value = present value of coupons + present value of face amount
C/r * (1-(1/(1+r)^t)) + FV/(1+r)^t
Discount bond
When a bond is sold for less than its face value it is said to be discounted bond
Premium bond
Bond sold at premium, more than its face value is called premium bond
Bond price and market interest rate relationship
Bond price and market interest rate move in opposite directions.
The risk of bond’s price change arises from fluctuating market interest rate.
Time to maturity, coupon rate and the interest rate
- 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 (and larger the face value), the greater the interest rate risk.
Debt and equity
Equity and debt: securities issued by corporations are classified roughly as equity securities and debt securities.
Dept isn’t an ownership interest in the firm. Creditors generally do not have voting power.
The corporation’s payment of interest on debt is considered a cost of doing business and is fully tax deductible. Dividends are not tax deductible.
Unpaid debt is a liability of the firm. If not paid, creditors can legally claim the assets of the firm.
What does bond generally include?
Face value, coupons, maturity…
Registration: corporate bonds are usually in registered form; the ownership of each bond is recorded.
Security
Debts can be backed by specific assets of the issuer to secure the payment of interest and the repayment of the principal - collaterals.
Seniority
It is the hierarchy among different bonds outstanding in terms of their priority of repayment in the event of a default or bankruptcy. It has a higher priority than another bond’s claim.
Protective covenants
It’s a part of the indenture that controls certain actions of the issuer company may take to protect the lenders’ interests.
Bond ratings
Later-based system to evaluate creditworthiness: highest rating is AAA/Aaa; very good quality is AA/Aa; investment grade bonds are rated at least BBB; low-grade or “junk” bonds are rated below investment grade
Government bonds
When the government wishes to borrow money for more than one year, it sells treasury notes and bonds to the public
Zero coupon bonds
A bond that pays no coupons at all, however its price is lower than its face value
Floating-rate bonds
The conventional bonds have fixed obligations because the coupon rates and the face value are fixed. The payments of floating-rate bonds are tied to a predetermined index.
The fisher effect
The relationship between nominal returns, real returns and inflation
1+R=(1+r)(1+h)
R=r+h+rh
Term structure of interest rates
When long-term rates are higher than short-term rates, we say that the term
structure is upward sloping.
When short-term rates are higher, we say it is downward sloping.
Bond yields
(1) expected future inflation
(2) interest rate risk
(3) default risk
(4) taxability
(5) lack of liquidity.
