Chapter 7 Interest Rates and Bond Valuation Flashcards
What are bonds?
Debt securities
What are coupons?
The regular interest payments made for a bond
What is the face value / par value of a bond?
The value to be paid out at the end of the loan.
A bond that sells for its par value is called a par bond
What is the coupon rate on the bond?
The annual coupon divided by the face value
Coupon value / Face Value = Coupon Rate
How do interest rates affect the price of bonds?
As bond interest rates rise the present value of the bond’s remaining cash flows declines.
As bond interest rates decrease the present value of the bond’s remaining cash flows increases.
What is YTM?
Yield to maturity - the market interest rate that equates a bond’s present value of interest payments and principal repayment with its price
How do we determine the Interest Rate Risk of a bond?
By measuring how sensitive it is to interest rate changes.
What two factors affect the Interest Rate Risk of a bond?
- The longer the time to maturity, the greater the interest rate risk
- The lower the coupon rate, the greater the interest rate risk
What do we usually call securities issued by a corporation?
Debt securities, equity securities
What are some of the differences between debt and equity?
- Debt is not an ownership interest in the firm
- 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
- Unpaid debt is a liability of the firm. Thus one of the costs of issuing debt is the possibility of financial failure. Which does not occur with equity
What are the two major forms of long term debt?
Public issue and privately placed
What are the three responsibilities of a trustee?
- Make sure the terms of the Indenture are being obeyed
- Manage the sinking fund
- Represent the bondholder in the case of a default
What are the general provisions included in an Indenture agreemnet?
- Basic terms of bonds issuance
- # of bonds issued
- Description of property used as security if the bonds are secured
- Repayment
- Call Provisions
- Portective Covenants
What are collateral and mortgage securities?
Collateral is a general term taht means securities pledged as security for payment of debt.
Mortgage securities are secured by a mortgage on the real property of the borrower. The property may be real estate, transportation equipment, or other property
What is a debenture?
An unsecured bond
When do we use the term note?
When the maturity of the unsecured bond is less than ten years when it is originally issued
What is a sinking fund?
A sink fund is an early repayment system.
It is an account managed by the bond trustee for the purpose of repaying the bonds.
The company makes annual payments to the trustee, who tehn uses the funds to retire a portion of the debt. They do this by either buying up some of the bonds in the market or calling in a fraction of the outstanding bonds
What does seniority indicate?
Pereference in position over other lenders.
In the event of a default, holders of subordinated debt must give preference to other specified creditors.
What does a sinking fund do from an inverstor’s viewpoint?
Reduces the risk that the company will be unable to repay the principal at maturity
What does the call provision do?
Allows the company to repurchase “call” part or all of the bond issued at stated prices over a specified period.
Corporate bonds are often callable
Is the call price generally more or less than the bond’s stated value?
More
This is called the call premium
What does the Canada Call do?
Stipulates that, in the event of a call, the issuer must buy the bonds from holders priced at a yield of the current Canada curve plus a fixed credit spread that is usually 1/4 of the issuance spread
What does a protective covenant do?
Part of the indenture or loan agreement that limits certain actions a company might otherwise wish to take during the term of the loan.
What do protective covenants usually do?
Reduce the agency costs faced by bondholders. Reduce the risk of the bonds
What are some examples of negative covenants? (Thou shalt not)
- The firm must limit the amount of dividends it pays according to some formula
- The firm cannot pledge any assets to other lenders
- The firm cannot merge with another firm
- The firm cannot sell or lease any major assets without approval by the lender
- The firm cannot issue additional long-term debt
What are some examples of positive covenants (thou shalt)
- The company must maintain its working capital at or above some specified minimum level
- The company must periodically furnish audited financial statements to the lender
- The firm must maintain any collateral or security in good condition
What are bond ratings?
They are ratings that concern only credit risk.
Therefore they do not cover interest related risk for a bond
What is the tier list for rated bonds?
AAA
AA
A
BBB
BB
B
CCC/CC/C
D
What minimum rating must a bond have to be deemed investment grade?
BBB
What is another name for junk bonds?
High yield bonds
Due to their risk they tend to have much higher rates than regular safer bonds
What is a Stripped bond or zero-coupon bond?
A bond that pays no coupons
For tax purposes must the owner pay taxes on interest accrued every year for Stripped bonds?
Yes, even though no interest is actually received
Why are Stripped bonds attractive to certain investors?
Tax exempt investors with long term dollar denominated liabilities such as pension funds find them attractive.
Aditionally people with RRSPs and TFSAs
What are Floating-Rate Bonds?
Bonds with adjustable coupon rates
The adjustments are tied to the Treasury bill rate or another short term interest rate
Is there somestimes some lag when it comes to Floating Rate bonds?
Yes due to the adjustments being made on previous data that can span a few months sometimes
The majority of floaters have these two traits
- The holder has the right to redeem their note at par ont he coupon repayment date after some specified amount of time
- The coupon rate has a max and min
What are income bonds?
Bonds where coupon payments depend on company income
What is a convertible bond?
A bond that can be swapped for a fixed number of shares of stock at any time before maturity at the holder’s option
What are asset backed bonds?
Bonds that are backed by illiquid assets such as , accounts receivable, credit card debt, or mortgages
What are retractable bonds?
They are also called put bonds
They allow the holder to force the issuer to buy the bond back at a stated price. The put feature sets a floor price for the bond
What are CoCo bonds?
Contingent convertible bonds which are putable, callable and subordinated.
Valuing these bonds is quite complex and using YTM is often meaningless
Is the trading volume for bonds bigger than that of stocks?
Yes
Why does bond market have little or no transparency?
Because most trading of bonds takes place Over the Counter (OTC)
What are the clean and dirty prices?
Dirty price - price of a bond including accrued interest, the price the buyer actually pays
Clean price - price of a bond net of accrued interest, this is the price that is typically quoted
What is the difference between Real Rates and Nominal Rates?
Real rates - include inflation
Nominal rates - do not include inflation
What is the definition of the nominal rate?
The percentage change in the number of dollars you have
What is the term structure of interest rates?
The relationship between nominal interest rates on default free, pure discount securities and time to maturity.
Pure time value of money
When are term structures upward sloping
When long term rates are higher than short term rates
What is the Fisher effect?
The relationship between nominal returns, real returns, and inflation
What is the Fisher effect formula?
1 + R = (1 + r) * (1 + h)
R = nominal rate
r = real rate
h = inflation rate
When are term structures downward sloping?
When short term rates are higher than long term rates
What is the inflation premium?
The portion of a nominal interest rate that represents compensation for expected future inflation
What is the interest rate risk premium?
The compensation investors demand for bearing interest rate risk
The longer the tirm to maturity the greater the interest rate risk
Is the shape of the yield curve a reflection of the term structure of interest rates?
Yes
Default Risk Premium
The portion of a nominal interest rate or bond yield that represents compensation for the possibility of default
What is a liquidity premium?
The portion of a nominal interest rate or bond yield that represents compensation for lack of liqudity
