chapter 7 - key concepts (bonds and their valuation)

Question 1

what is a bond?

Answer 1

A long-term debt instrument in which a borrower agrees to make payments of principal and interest, on specific dates, to the holders of the bond.

Question 2

explain what causes interest rates to go up/down in relation to BONDS (and their movement)

Answer 2

When interest rates go up bond prices go down
When interest rates go down bond prices go up (people more willing to get bonds now)

Question 3

which entities issues bonds?

Answer 3

1. US Government – Treasury bonds
2. Corporations - issued by corporations
3. Local governments – called municipal bonds, bonds issued by state and local governments
   4.Foreign bonds – bonds issued by non-US govs

Question 4

what are the five key features of a bond

Answer 4

1. par value: stated face amount of the bond, which is paid at maturity
2. coupon interest rate: The stated interest rate on a bond
3. maturity date: bonds have a specified maturity date on which the par value must be repaid
4. issue date: when the bond was issued.
5. yield to maturity: rate of return earned on a bond held until maturity (also called the “promised yield”). = I/YR

Question 5

par value (one of the five key features of a bond explained)

Answer 5

Par value: stated face amount of the bond, which is paid at maturity

Par value = face value = outstanding value

Typically assume a par value of $1000

Generally, the amount of money the firm borrows and promises to repay on the maturity date (future value)

Question 6

coupon interest rate (one of the five key features of a bond explained)

Answer 6

The stated interest rate on a bond

Set at the time of bond issuance

Typically fixed over the life of the bond and doesn’t change

Question 7

maturity date (one of the five key features of a bond explained)

Answer 7

Maturity date: bonds have a specified maturity date on which the par value must be repaid

Time until maturity declines as time progresses

If issued 30 years ago, and 10 years have passed, then there are 20 years left

Question 8

issue date (one of the five key features of a bond explained)

Answer 8

Issue date: when the bond was issued.

Maturity Date – Issue Date = N

N – number of years, on calculator

Question 9

yield to maturity (one of the five key features of a bond explained)

Answer 9

Yield to maturity: rate of return earned on a bond held until maturity (also called the “promised yield”). = I/YR

The interest rate

Question 10

what is the opportunity cost of debt and why does this matter?

Answer 10

(review) opportunity cost - rate of return you could earn on an alternative investment of similar risk

the opportunity cost of debt is simply equal to the preset interest rate agreed to between the corporation and its lenders (bondholders).

opportunity cost of debt capital: the discount rate (ri) is the opportunity cost of capital, and is the rate that could be earned on alternative investments of equal risk.

If interest rates go up, bond prices go down (they are inverse):
- 5% interest rate
- 8% new; unhappy;
- 2% Happy (bond prices go up)
*We want an interest rate drop!

Question 11

does coupon yield ever change?

Answer 11

though the coupon rate remains fixed, the bond’s yield will fluctuate over time as a result of changing bond prices.

Question 12

when does the value of a bond equal its par value?

Answer 12

when bonds are first issued, the coupon is generally set at a level that causes the bond’s market price to equal its par value.

A new bond is called a new issue; existing bonds are called outstanding bond or seasonal issue.

Question 13

premium bond (defined)

Answer 13

premium bond is a bond that is selling above par value.

• This bond has increased in value.
• The coupon rate on this bond is greater than the coupon rate on a newly issued corporate bond.
• Because we want a higher interest rate, investors prefer discount bonds and will pay a premium for it.

Question 14

discount bonds (defined)

Answer 14

a discount bond is a bond that is selling below par value.

• The coupon rate on a newly issued corporate bonds will be greater than the previously issued coupon bond.
• This bond has declined in value.

Question 15

after you buy a bond, do you want interest rates to
increase or decrease?

Answer 15

to decrease

if interest rates go down, bond prices go up (they are inverse)

Question 16

what is yield to maturity?

Answer 16

Yield to maturity: rate of return earned on
a bond held until maturity (also called the “promised yield”). = I/YR

Note: the price of the bond is changing up and down over time, so you have the option of
1) Selling the bond at the current market price
2) Holding the bond and receiving the interest payments

Question 17

what is yield to call?

Answer 17

The rate of return earned on a bond when it is called before its maturity date.
Use the call price rather than the maturity value

Question 18

when do you use (yield to maturity OR yield to call) for a PREMIUM OR DISCOUNT bond?

Answer 18

YTC on premium bonds.
YTM on par and discount bonds.

Question 19

when does yield to maturity equal the investor’s expected rate of return?

Answer 19

when does ytm = expected rate of return?
when:
1) the probability of default is zero and
2) the bond cannot be called

Question 20

what is a call provision?

Answer 20

Allows issuer to refund (call for redemption) the bond under certain conditions

Typically corporate and municipal bonds use this feature

Question 21

what is a call premium?

Answer 21

Penalty paid by the corporation if they call the bond early.
Typically equal to 1 year of interest payments

Question 22

why do companies prefer call provisions over call premiums?

Answer 22

Why would companies prefer call provisions?
- Protects them against interest rate declines

Example: Company issues a bond at 10% when interest rate were high. Now rates have fallen at the company could issue a bond at 4%
- Company is paying 6% more interest
- Company at a competitive disadvantage compared to other companies that can issue bonds at lower rates

Companies that issue bonds with call provisions have to provide sweeteners/restrictions to get investors to buy bonds…

Question 23

do investors like call provisions?

Answer 23

no they could lose money because company is protected from interest rate declines

Investors – want interest rates to decline, bond values to rise
Investors aren’t stupid and don’t have to buy bonds
Companies that issue bonds with call provisions have to provide sweeteners/restrictions to get investors to buy bonds

Question 24

why do companies call bonds?

Answer 24

Companies call bonds when interest rates drop
Investors generally don’t like it when companies call bonds

Question 25

why do they pay higher interest for call provisions?

Answer 25

Investors are aware of reinvestment risk and, as a result, demand higher coupon interest rates for callable bonds than those without a call provision. The higher rates help compensate investors for reinvestment risk.

Companies that issue bonds with call provisions have to provide sweeteners/restrictions to get investors to buy bonds

Question 26

when is a bond more likely to be called? (important)

Answer 26

Issuers are more likely to call a bond when rates fall since they don’t want to keep paying above-market rates. So premium bonds are those most likely to be called.

Question 27

what is reinvestment risk?

Answer 27

The risk that a decline in interest rates will lead to a decline in income from a bond portfolio.

If an investor’s primary goal is to generate income, then declines in interest rates are dangerous because it reduces income.
Short-term bonds have greater reinvestment risk because you get your money back more quickly and have to reinvest the money.

Question 28

what is price risk?

Answer 28

the risk of a decline in a bond’s price due to an increase in interest rates.

Price risk is greater for bonds with longer maturities.

Question 29

do long-term bonds have small or large reinvestment risk?

Answer 29

long-term bonds have less reinvestment risk because you get your money back slower.

Question 30

do short-term bonds have small or large reinvestment risk?

Answer 30

Short-term bonds have greater reinvestment risk because you get your money back more quickly and have to reinvest the money.

reinvestment rate risk is higher with short-term bonds than with long-term bonds

Question 31

high coupon bonds vs. low coupon bonds

Answer 31

idk what to put here

Question 32

convertible bond (Know the definitions of the five different types of bonds and why companies/investors would want to issue or buy these bonds)

Answer 32

Bonds that can be exchanged for common stock of the firm, at the holder’s option.

• Give up the bond, get shares
• Allows investors to make more money – capital gains instead of interest
• These bonds typically have lower coupon interest rates than non-convertible bonds

Question 33

warrant (Know the definitions of the five different types of bonds and why companies/investors would want to issue or buy these bonds)

Answer 33

Long-term options to buy a stated number of shares of common stock at a specified price.

• Keep the original bond and get stock as well (have to pay additional money for the shares)
• These bonds typically have lower coupon interest rates as well

Question 34

putable bond (Know the definitions of the five different types of bonds and why companies/investors would want to issue or buy these bonds)

Answer 34

Bonds that allow holders to sell the bond back to the company prior to maturity at a prearranged price
- Not very common

Question 35

indexed bond (Know the definitions of the five different types of bonds and why companies/investors would want to issue or buy these bonds)

Answer 35

Interest rate paid is based upon the rate of inflation.
TIPs, I-bonds

Question 36

zero coupon bond (Know the definitions of the five different types of bonds and why companies/investors would want to issue or buy these bonds)

Answer 36

Bonds that pay no interest. Provide capital appreciation and trade below par values
$1000, 10 years. $800 (?)

Question 37

what is default risk

Answer 37

If an issuer defaults, investors receive less than the promised return. Therefore, the expected return on corporate and municipal bonds is less than the promised return.

Question 38

what are bond ratings? (highest and lowest ratings)

Answer 38

Bond ratings are designed to reflect the probability of a bond issue going into default.

highest: AAA AA A (BBB) then Aaa Aa A Baaa
lowest/junk bonds: Ba B Caa C then BB B CCC C

Question 39

what are junk bonds

Answer 39

Junk bonds are high-risk, high-yield bonds while investment grade bonds are higher quality bonds with less default risk.

ex: lowest/junk bonds - Ba B Caa C then BB B CCC C

Question 40

what are some factors that effect defult risk?

Answer 40

Factors affecting default risk and bond ratings:

Financial performance
- Debt ratio
- TIE ratio
- Current ratio

Qualitative factors: Bond contract terms
- Secured vs. unsecured debt
- Senior vs. subordinated debt
- Guarantee and sinking fund provisions
- Debt maturity

Question 41

chapter 11 vs chapter 7 bankruptcy

Answer 41

Chapter 11 Bankruptcy:
If company can’t meet its obligations…
- It files under Chapter 11 to stop creditors from foreclosing, taking assets, and closing the business and it has 120 days to file a reorganization plan.
- Court appoints a “trustee” to supervise reorganization.
- Management usually stays in control.

**Company must demonstrate in its reorganization plan that it is “worth more alive than dead.” –> If not, judge will order liquidation under Chapter 7. Chapter 7 Liquidation ***

Question 42

what is the priority claim if a company liquidate?
who gets paid first? last?

Answer 42

Priority of claims in liquidation
1. Secured creditors/bondholder from sales of secured assets (paid first)
2. Trustee’s costs lawyers
3. Wages, subject to limits
4. Taxes
5. Unfunded pension liabilities
6. Unsecured creditors (bondholders)
7. Preferred stock
8. Common stock (paid last)

1, 6, 7, and 8 are important to know

Question 43

why are secured bonds safer than unsecured
bonds

Answer 43

Secured bonds are seen as less risky than unsecured bonds because investors in them are at least partially compensated for their investment in the event of default by the issuer.

Types of secured bonds include mortgage bonds and equipment trust certificates.

Question 44

what is a reorganization plan?

Answer 44

In a liquidation, unsecured creditors generally receive nothing. This makes them more willing to participate in reorganization even though their claims are greatly scaled back.

reorganization plan: If both the majority of the creditors and the judge approve, the company “emerges” from bankruptcy with lower debts, reduced interest charges, and a chance for success.

Question 45

types of problems to solve
* 1. calculating the value of a bond
* 2. calculating the yield to maturity for a bond
* 3. calculated the yield to call for a bond

Answer 45

1. calculating the value of a bond
   - the price of the bond can be found by solving for the PV of these cash flows.
2. calculating the yield to maturity for a bond
   - solve i/yr (?)
3. calculating the yield to call for a bond
   - solve i/yr (?)