Chapter 7 Bonds & their Valuation Flashcards
Bonds
Long term debt capital.
Borrower obtains funds and in turn agrees to repay principal, make interest payments on specific dates to holders of the bond(lenders)
Who issues bonds?
- Federal govt- Treasury bonds (0 default risk & rates are used as benchmarks)
- State & Munis-Municipal bonds issued by municipalities & certain non-govt authorities
- Corporations- Bonds
- Foreign entities-*county risk premium
Types of Corporate Bonds
- Mortgage (secure bond)- Bond is back by a claim on specific assets. Indenture is a form of agreement that spells out bond holder rights
- Debentures (Senior unsecured)- unsecured (by any mortgage) long term bond that is senior to the subordinated debt .
- Subordinated Debenture (Subordinated or Junior unsecured)- long term bond that has claim only after all of the senior (Mortgage, Debenture) claims are settled
How are bonds traded?
Over the counter market ( OTC) No organized bond market By and among large financial institutions WSJ reports developments in markets Bloomberg reports prices & yields
Par value
Face amount of bond paid at maturity
Coupon rate
Stated interest rate (generally fixed) paid by the issuer. Multiply by par value to get dollar payment of interest .
Covenants
Restrictions on debtor to protect the lender’s interest
Call
Borrower’s option to buy the bond back at an agreed to price before the bond reaches maturity
Call provision may be deferred and/or contain a declining call premium
Put
Lender’s option to sell the bond back to the borrower at an agreed to price prior to maturity
Sinking fund
Requires borrower to retire a portion of bonds at face value (par) on a scheduled basis before maturity. May select bonds by lottery.
Provision to pay off loan over life rather than all at maturity
Reduces risk to investor
Shortens avg maturity
But not good for investors if rate declines after issuance
Convertible
Lender’s option to exchange the bond for firm’s common stock
Warrant
Long-dated option to buy a stated number of shares of common stock at a specified price . Some are “detachable” and can be sold off
Income bond
Pays interest only when the borrower reaches earnings targets
Indexed bond
Coupon rate is based upon the rate of inflation
Zero coupe bond
A bond that pays no annual interest . Also called a bullet bond.
Floating rate bond
Interest rate of the bond is based on a benchmark such as PRIME
1 way for borrowers to avoid inflation risk
Premium
Price>par
YTM< current yield
Discount
Opposite of premium
When does a bond sell at par value?
When its current yield =its YTM
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Market rate of interest on a bond
Current yield
Annual coupon payment / Current bond price
Capital gains yield
(Bond price 1- Bond price 0)/ bond price 0
YTM (or Expected total return)
Interest rate that equilibrates bond’s value with its expected future cash flows
= current yield(CY) + Capital Gains Yield(CGY)
Default risk
Risk of not timely receiving interest and principal.
Measured by probability of default.
Influenced by:
-borrower’s financial strength
-Terms of the bond contract, which are spelled out in the covenants
Liquidity risk
Risk of not being able to timely sell the bond except at a large discount
Inflation risk
Risk that the rate of inflation will exceed the coupon rate and erode the purchasing power of your coupons
Price risk aka interest rate risk or Maturity risk)
Risk of a decline in a bond’s price due to an increase in interest rates
Reinvestment risk
Risk that a decline in interest rates will lead to a decline in income from a bond portfolio as bonds expire and proceeds are re-invested at a lower rate, hence reducing income.
Short term and high coupon bonds have _____ price risk and_______reinvestment risk
Low price risk and High reinvestment risk
Long term and Low coupon bonds have ________price risk and ________reinvestment risk.
High price risk and Low reinvestment risk
