Lecture 3 Debt Financing Flashcards

1
Q

Corporate bonds

A

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
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2
Q

Par value

A

Face value or principal value

To be repaid in full at maturity

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3
Q

Coupon

A

Interests paid annually or semi-annually, defined as a percentage of par value.

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4
Q

Term to maturity

A

The end date of the bond’s life

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5
Q

Bond price

A

Quoted as % of the face value

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6
Q

Collateral - bond characteristic

A

The assets that are ledges as a security for payment of debt.

Gives protection to the bond holders in the event of defaults

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7
Q

Indenture - bond characteristic

A

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)

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8
Q

Zero coupon bond

A

No coupon payment

Only one cash flow at maturity date

Priced deeply at a discount of the par value.

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9
Q

Perpetuities

A

A bond that pays fixed coupon periodically over an unlimited horizon

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10
Q

Yield to Maturity

A

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
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11
Q

Reinvestment risk

A

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

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12
Q

Reinvestment risk definition

A
  • the probability that the bond holder has to reinvest the interim cash flows at a rate less than YTM
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13
Q

Which bonds involve high reinvestment risk?

A

Long term bonds
Bonds with high coupon rates
Callable bonds

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14
Q

Interest rate risk

A

The sensitivity of bond prices to the changes in the interest rates

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15
Q

Credit risk

A

Investors do not receive the promised interests and principal in full and on time

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16
Q

Bond prices and interest rates

A

Bond prices change when interest rates change

Bond price and interest rates are inversely related to each other

Duration and convexity

17
Q

Convexity

A

To do with bond prices and interest rates inverse relationship

Measure of price volatility

18
Q

Duration - Macaulay Duration

A

Duration: a measure of interest rate risk

Macaulay duration is measured in years and the weighted average term to maturity of the bond

19
Q

Modified duration

A

The percentage change in the bond price P when the interest rate changes by one percentage point.

20
Q

Durations as a measure of interest rate risk

A

+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.
21
Q

For very big changes in interest rate:

A

Duration underestimates the bond price change when interest rate decreases

Duration overestimates the bond price decrease when interest rate increases

22
Q

Interest rate risk alleviated by:

A

High coupon rates
Short term to maturity
High yield to maturity

23
Q

Interest rate risk aggravated by:

A

Low coupon rates
Long terms to maturity
Low yield to maturity

24
Q

Credit risk

A

The probability that bond holders do not receive the promised payments in full and on time

25
Default risk
Evaluated by credit rating assigned to a bond instrument or to the bond issuer
26
Rating is downgraded then what
Bond yield increases and bond price increases?
27
Rating is upgraded =
Bond yield decreases and bond price increases
28
Bonds marketability is strongly influenced by their credit ratings:
Junk status (<=BB+) Investment grade status (>=BBB-)
29
Ratings are infrequently revised
Lack of timeliness
30
CRA's conflict of interest problem
Rating might not be reliable
31
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
32
Default premium equation
Yield corporate - yield government
33
Yield corporate
Yield of the corporate bond
34
Yield government
Yield of a default free government bond with the same coupon rate and time to maturity