Lecture 3 Debt Financing Flashcards
Corporate bonds
A long term fixed-obligation debt instrument, whereby the bond issuer agrees to pay fixed amounts of interests at specified periods and a fixed amount of the principal at the maturity date.
- Issued publicly or privately
- Terms to maturity:
Maturity < 1 year money market instruments
Maturity > 1 year and less than 10 years corporate notes
Maturity > = 10 years: corporate bonds
Par value
Face value or principal value
To be repaid in full at maturity
Coupon
Interests paid annually or semi-annually, defined as a percentage of par value.
Term to maturity
The end date of the bond’s life
Bond price
Quoted as % of the face value
Collateral - bond characteristic
The assets that are ledges as a security for payment of debt.
Gives protection to the bond holders in the event of defaults
Indenture - bond characteristic
Call provision: bonds redeemed before maturity date
Sinking fund: principal is repaid over a specified period
Protection covenants: conditions that limit certain actions by the issuers (pay dividends, involved in M&A deals, asset sales, large debt offerings etc)
Zero coupon bond
No coupon payment
Only one cash flow at maturity date
Priced deeply at a discount of the par value.
Perpetuities
A bond that pays fixed coupon periodically over an unlimited horizon
Yield to Maturity
The rate of return that sets the present value of future cash flows equal to the bond price.
YTM is the investment return if the bondholder:
- Buys and holds the bond until maturity
- Reinvests all coupons at the rate equal to YTM
Reinvestment risk
Yield to maturity is the promised return, not the realised return
Realised return differs from, yield to maturity if:
1) the investor sells the bond before maturity or
2) investor fails to reinvest coupon payments at YTM = the reinvestment risk
Reinvestment risk definition
- the probability that the bond holder has to reinvest the interim cash flows at a rate less than YTM
Which bonds involve high reinvestment risk?
Long term bonds
Bonds with high coupon rates
Callable bonds
Interest rate risk
The sensitivity of bond prices to the changes in the interest rates
Credit risk
Investors do not receive the promised interests and principal in full and on time
Bond prices and interest rates
Bond prices change when interest rates change
Bond price and interest rates are inversely related to each other
Duration and convexity
Convexity
To do with bond prices and interest rates inverse relationship
Measure of price volatility
Duration - Macaulay Duration
Duration: a measure of interest rate risk
Macaulay duration is measured in years and the weighted average term to maturity of the bond
Modified duration
The percentage change in the bond price P when the interest rate changes by one percentage point.
Durations as a measure of interest rate risk
+Fairly precise for very minor changes in the interest rate
- Becomes less reliable for bigger changes in the interest rate
- The actual price decrease for a unit increase in interest rate is less than the actual price increase for the same unit decrease in the interest rate.
For very big changes in interest rate:
Duration underestimates the bond price change when interest rate decreases
Duration overestimates the bond price decrease when interest rate increases
Interest rate risk alleviated by:
High coupon rates
Short term to maturity
High yield to maturity
Interest rate risk aggravated by:
Low coupon rates
Long terms to maturity
Low yield to maturity
Credit risk
The probability that bond holders do not receive the promised payments in full and on time
Default risk
Evaluated by credit rating assigned to a bond instrument or to the bond issuer
Rating is downgraded then what
Bond yield increases and bond price increases?
Rating is upgraded =
Bond yield decreases and bond price increases
Bonds marketability is strongly influenced by their credit ratings:
Junk status (<=BB+)
Investment grade status (>=BBB-)
Ratings are infrequently revised
Lack of timeliness
CRA’s conflict of interest problem
Rating might not be reliable
Default premium
The interest rate differential between a corporate bond and a default free bond with similar characteristics
Also known as yield spread
A traditional indicator of market perception of default risk
Default premium equation
Yield corporate - yield government
Yield corporate
Yield of the corporate bond
Yield government
Yield of a default free government bond with the same coupon rate and time to maturity
