Chapter 7: Interest Rates and Bond Valuation Flashcards
Why are bonds issues?
When a corporation or government wishes to borrow money from the public on a long-term basis, it usually does so by issuing debt securities called bonds
A bond is normally an ________ loan
interest-only
meaning the borrower pays the interest every period, but none of the principal is repaid until the end of the loan
Coupons
bonds coupons
The stated interest payment made on a bond
Example: $1000 bond with a 5% interest. $1000 x 0.05 = $50 interest per year
Face Value
AKA Par Value
The principal amount of a bond that is repaid at the end of the term.
Example: If you spend $1000 initially to buy the bond, at the end of the 10 year term (or any period) they give you back the $1000
Coupon Rate
The annual coupon divided by the face value of a bond
Example: $50 interest per month / $1000 face value = 0.05 or 5%
Maturity
Specified date at which the principal amount of a bond is paid.
Example: In 10 years you get your original $1000 back
A corporate bond may have a maturity of, say 5, 7, 10, or 30 years when it is originally issued. Once the bond has been issued, the number of years to maturity declines as time goes by
When interest rates ______, the present value of the bond’s remaining cash flows declines, and the bond is worth less
rise
When interest rates _____, the bond is worth more
fall
Yield to Maturity (YTM)
AKA Bond’s Yield
The market interest rate that equates a bond’s present value of interest payments and principal repayment with its price.
Example of Present value calculation of a bond
Cards 10 + 11+ 12
Present Value = $1000 / 10.56^10
= $579.91
This was a $1000 bond with a 10 year term with a 5.6% rate
Annuity Present Value to figure out the bonds second half
Annuity Present Value = $56 x (1-1/1.056^10) / 0.056
Annuity Present Value to figure out the bonds second half
Annuity Present Value = $56 x (1-1/1.056^10) / 0.056
Total Bond Value =
$579.91 (slide 10) + $420.09 (slide 11) = $1,000
When the bond’s coupon rate is equal to the going interest rate in the market, the bond will sell for its _______.
face value
Discount
A bond that sells for less than its face value
This could be due to the interest rate going up (5.7% to 7.5%)
Premium
Selling a bond at a price higher than what it was bought for
Aka the interest rate went down, so the bond went up
Interest rates below the bond’s coupon rate cause the bond to sell at a premium
Most bonds are issued at close to ___, with the coupon rate set equal to the prevailing market yield or interest rate at that time
par
Bond Value =
present value of the coupons + Present value of the face amount
Bond Value = (equation)
C x (1 - 1 / (1 + r)^t / r) + F / ( 1 + r)^t
F = Face value paid at maturity C = Coupons paid per period T = Periods to maturity r = Yield of r per period
Interest rate risk
The risk that arises for bond owners from fluctuating interest rates (market yields)
How much interest rate risk a bond has depends on how sensitive its price is to interest changes, and the sensitivity is directly dependent on two things:
1) The time to maturity
2) The coupon rate
Keep the following in mind when looking at a bond:
1) All other things being equal, the longer the time to maturity, the greater the interest rate risk.
2) All other things being equal, the lower the coupon rate, the greater the interest rate risk.
If two bonds with different coupon rates have the same maturity, the value of the one with the lower coupon is proportionately more dependent on the face amount to be received at maturity
As a result, all other things being equal, its value fluctuates more as interest rates change
Put another way, the bond with the higher _____ has a larger cash flow early in its life, so its value is less sensitive to changes in the discount rate.
coupon
Securities issued by corporations may be classified roughly as either:
1) equity securities
2) debt securities
Debt
At the crudest level, represents something that must be repaid; the result of borrowing money
Creditor / Lender
The person or firm making the loan
Debtor / Borrow
The corporation borrowing the money
From a financial point of view, the main differences between debt and equity are the following:
1) Debt is not an ownership interest in the firm. Creditors generally do not have voting power.
2) The corporation’s payment of interest on debt is considered a cost of doing business and is fully tax deductible. Dividends paid to shareholders are not tax deductible.
3) Unpaid debt is a liability of the firm. If it is not paid, the creditors can legally claim the assets of the firm. This action can result in liquidation or reorganization, two of the possible consequences of bankruptcy. Thus, one of the costs of issuing debt is the possibility of financial failure. This possibility does not arise when equity is issued.
As a general rule, equity represents an ownership interest, and it is a residual claim.
This means that equity holders are paid after debt holders.
The maturity of a long-term debt instrument refers to the length of time the debt remains outstanding with some unpaid balance.
Debt securities can be short term (maturities of one year or less) or long term (maturities of more than one year)
Debt securities are typically called:
notes, debentures, or bonds
The two major forms of long-term debt are
public issue
privately placed
The main difference between public-issue and privately placed debt is that
the latter is directly placed with a lender and not offered to the public. Since this is a private transaction, the specific terms are up to the parties involved.
Indenture (aka deed of trust)
Written agreement between the corporation and the lender detailing the terms of the debt issue.
Usually, a trustee (a trust company) is appointed by the corporation to represent the bondholders.
The trust company must do three thing:
(1) make sure the terms of the indenture are obeyed,
(2) manage the sinking fund (described later), and
(3) represent the bondholders in default; that is, if the company defaults on its payments to them.
The bond indenture document
-Can run several hundred pages in length
Includes:
1) The basic terms of the bonds.
2) The amount of the bonds issued.
3) A description of property used as security if the bonds are secured.
4) The repayment arrangements.
5) The call provisions.
6) Details of the protective covenants.
TERMS OF A BOND
Corporate bonds usually have a face value (that is, a denomination) of $1,000. This is called the principal value, and it is stated on the bond certificate.
So, if a corporation wanted to borrow $1 million, it would have to sell 1,000 bonds
SECURITY
Debt securities are classified according to the collateral and mortgages used to protect the bondholder.
Collateral
is a general term that, strictly speaking, means securities (for example, bonds and stocks) pledged as security for payment of debt
Examples: putting down someones phone to get the ball back, putting your house on the line to repay debt, etc/
Mortgage Securities
are secured by a mortgage on the real property of the borrower. The property involved may be real estate, transportation equipment, or other property.
