Lecture 1 : Debt and Bonds Flashcards
What is a financial security?
A tradeable financial asset
What type of financial security typically has a known payment structure?
Bonds
What are the cash flows associated with bonds, and when are they due?
- Coupons (generally twice/year)
- Principal Repayment (at maturity)
Where do bond holders lie in terms of priority in the event of bankruptcy?
High priority
What type of financial security has a residual claim on the firm?
Stocks
Is there an obligation to maintain dividends?
No
Where do stock holders lie in terms of priority in the event of bankruptcy?
Low priority
Compare debt and equity in regards to claim on cashflows.
Debt: fixed claim
Equity: residual claim
Compare debt and equity in regards to their priority given bankruptcy.
Debt: Higher priority
Equity: Lowest priority
Compare debt and equity in terms of the tax deductibility of their payments.
Debt: Tax deductible
Equity: Not tax deductible
Name 4 types of debt securities.
- Bank Debt
- Leases
- Commercial Paper
- Corporate Bonds
Name 2 types of hybrid securities.
- Convertible Debt
- Preferred Stock
Name 2 types of equity securities.
- Common Stock
- Warrants
What are referred to as “money market” securities?
Short-term debt
What type of debt does not typically have periodic interest payments?
Short-term debt
How long is short-term debt?
Less than one year to matrity
What is the face value of a bond?
Amount (or par value) of a single bond, typically $1,000
What is the principal amount of a bond?
Total value of all bonds sold by the company
What is the coupon?
Amount of interest paid to the bond holder
What is a fixed coupon?
Rate of interest does not change
What is a floating coupon?
Interest is tied to some benchmark rate (prime, LIBOR)
What is the Canada and US quoting convention?
Annual percentage rate (APR), with semi-annual compounding
What’s the difference between a secured and unsecured security?
Secured: backed by an asset (e.g. mortgage)
Unsecured: no specific asset; general claim. Also called a debenture
Who gets paid first senior bonds or subordinated bonds?
Senior bonds
What are bond covenants?
Laid out in the indenture/contract and typically restrict corporate activities (mergers, payouts) and include ratios and other financial metric standards
What is a convertible bond?
Exchangable into equity
How do you value any asset?
Sum the NPV of all future cash flows generated over its life
How do we discount each future cash flow?
Using the required returnH
How is the discount rate determined?
By the perceived risk of the cash flows
What 3 things do you need to know to value an asset?
- What are the cash flows
- When are the cash flows
- What discount rate to find PV of cash flows
What is the price/present value formula of a bond?
Price = PV = coupon / (1+r)^1 + coupon / (1+r)^2 + … + (FV + coupon) / (1+r)^t
Answer the 3 pieces of information for the following question:
What is the price of a 2-year bond that pays a 7% coupon semi-annually and has a face value of $1,000? The required return (YTM) on comparable bonds is 6% APR.
- What are the expected cashflows
- coupon payment = (7% / 2) * $1,000 = $35
- Final payment at maturity = $1,000 - When and how frequently do the cash flows arrive?
- Four semi annual coupon payments, plus principal - What is the appropriate discount rate?
- 6% / 2 = 3%
What is the price of a bond if the discount rate is equal to the coupon rate?
The face value
What is the YTM?
The return that the bond investor can expect if holding the bond until maturity (assuming all cash flows received are reinvested at the discount rate)
What is the current required return of a bond?
YTM
What is the discount rate that sets the future cash flows equal to the price today?
YTM
What two functions in excel give YTM?
RATE: coupon payment (pmt), number of payments (nper), price today (pv), face value (FV)
IRR: uses the array of cash flows
If a bond with a fixed coupon rate has its YTM go up, what happens to the price?
Decreases
If a bond with a fixed coupon rate has its YTM go down, what happens to the price?
Increases
How would you establish the required rate of return for a new bond?
- Start with Risk Free Rate (the rate on debt that has the least risk)
- Then add risk premium based on the credit risk of the issuer and risk of the specific bond
What range is considered investment grade bonds?
AAA to BBB-, anything below BBB- is considred high yield junk bonds
What is the difference between a callable and convertible bond?
Callable - issuer has the right to redeem the bond before its scheduled date
Convertible - gives the bond holder the option to convert the bond into a predetermind number of shares
What are the 4 types of risk?
- Credit Risk (risk of default)
- Liquidity Risk (can’t sell an asset when you want to)
- Infaltion Risk (change in price level; what $1 buys you)
- Market risk (interest rate changes)
What two financial ratios should you look at to determine a rough credit rating?
- Debt/Capital
- EBIT/Interest Payment
What are the steps to find the price of a bond given YTM?
- Determine expected cashflows (coupons + final payment @ maturity)
- Determine when CFs occur
- What is the appropriate discount rate? (If YTM is given it is YTM/2)
- Make a chart or use PV function
Who is the borrower/lender the issuer or the holder?
Bondholder = Lender
Bond Issuer = Borrower
What will happen if a coupon rate is set too high? Too low?
Too high - We pay more interest than we have to
Too low - Investors will not buy
What is the target coupon rate for a bond issuer?
Coupon Rate = YTM
How do you calculate price of bonds using PV formula (inputs)?
PV(rate, nper, pmt, fv)
(semi-annual discount rate, number of payments, coupon payment, face value)
How do you calculate IRR for a bond using rate function?
=RATE(nper,pmt,pv,[fv],[type])
(frequency * years, coupon payment, price * -1, face value, 0 end of period)
How would you find the YTM of a bond if you are given the coupon rate and the current price?
- Model out IRR using the -price at the start and then the coupon payments until maturity + repayment
- Use IRR function to find IRR
- Double IRR to find YTM
How to calculate the “money left on the table” if a bond is issued at the wrong coupon rate?
- Calculate bond price with correct rate
- Calculate bond price at incorrect bond price
- Take the difference to find the money left on the table per bond
- Multiply by # of bonds
What factors determine spreads on corporate debt (bonds)?
- Risk of deault
- Liquidity
- Bondholder protection (covenants)
What are two ways of estimating the target coupon rate when issuing a bond? (Roche)
Target = YTM
- Find current average YTM spread of comparable bonds (credit rating and time to maturity) THEN adding it to the current risk free rate
- Use yields from comparable firms
How do you find the price of a zero-coupon bond if you are given the YTM?
Discount the single cashflow (repayment) using the YTM
How do you find YTM of zero-coupon bond given price?
- Create IRR calculation table by using price as year 0 investment, and repayment (face value) as final year cashflow
- Calculate IRR using formula
- IRR x annual frequency of payments = YTM
If a company goes bankrupt, what type of investor is first in line to get (at least partially) some of their money back?
Debt holder
You are the CFO of a Canadian manufacturing company that is about to issue a new 5-year bond. Your boss, the CEO, tells you that she just read the following figures related to the Canadian economy:
the annual inflation rate is expected at 1.8% over the next 5 years
the economy is expected to grow on average 3.2% per year over the next five years
the yield to maturity (YTM) on 5-year Canadian government bonds is 1.2%
the stock market is expected to generate an average annual return of 6.5% over the next 5 years.
the spread (relative to the risk free rate) on bonds offered by other similar Canadian companies is currently at around 0.4%
She then asks you to provide her a quick estimate of the return that you think should be offered in your company’s new 5-year bonds. What is your best estimate for that required return?
1.6%`
You are a bond investor currently looking into investing in one of the two following two 10-year bonds:
The bond by company Y has a credit rating of AA-
The bond by company Z has a credit rating of BBB+
Which of the two bonds has a higher probability of defaulting (i.e., of investors not receiving their payments)? Which of the two bonds should have a higher YTM?
- Z
- Z
