Lecture 3 Debt Financing

Question 1

Corporate bonds

Answer 1

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

Question 2

Par value

Answer 2

Face value or principal value

To be repaid in full at maturity

Question 3

Coupon

Answer 3

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

Question 4

Term to maturity

Answer 4

The end date of the bond’s life

Question 5

Bond price

Answer 5

Quoted as % of the face value

Question 6

Collateral - bond characteristic

Answer 6

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

Gives protection to the bond holders in the event of defaults

Question 7

Indenture - bond characteristic

Answer 7

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)

Question 8

Zero coupon bond

Answer 8

No coupon payment

Only one cash flow at maturity date

Priced deeply at a discount of the par value.

Question 9

Perpetuities

Answer 9

A bond that pays fixed coupon periodically over an unlimited horizon

Question 10

Yield to Maturity

Answer 10

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

Question 11

Reinvestment risk

Answer 11

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

Question 12

Reinvestment risk definition

Answer 12

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

Question 13

Which bonds involve high reinvestment risk?

Answer 13

Long term bonds
Bonds with high coupon rates
Callable bonds

Question 14

Interest rate risk

Answer 14

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

Question 15

Credit risk

Answer 15

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

Question 16

Bond prices and interest rates

Answer 16

Bond prices change when interest rates change

Bond price and interest rates are inversely related to each other

Duration and convexity

Question 17

Convexity

Answer 17

To do with bond prices and interest rates inverse relationship

Measure of price volatility

Question 18

Duration - Macaulay Duration

Answer 18

Duration: a measure of interest rate risk

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

Question 19

Modified duration

Answer 19

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

Question 20

Durations as a measure of interest rate risk

Answer 20

+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.

Question 21

For very big changes in interest rate:

Answer 21

Duration underestimates the bond price change when interest rate decreases

Duration overestimates the bond price decrease when interest rate increases

Question 22

Interest rate risk alleviated by:

Answer 22

High coupon rates
Short term to maturity
High yield to maturity

Question 23

Interest rate risk aggravated by:

Answer 23

Low coupon rates
Long terms to maturity
Low yield to maturity

Question 24

Credit risk

Answer 24

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

Question 25

Default risk

Answer 25

Evaluated by credit rating assigned to a bond instrument or to the bond issuer

Question 26

Rating is downgraded then what

Answer 26

Bond yield increases and bond price increases?

Question 27

Rating is upgraded =

Answer 27

Bond yield decreases and bond price increases

Question 28

Bonds marketability is strongly influenced by their credit ratings:

Answer 28

Junk status (<=BB+)

Investment grade status (>=BBB-)

Question 29

Ratings are infrequently revised

Answer 29

Lack of timeliness

Question 30

CRA’s conflict of interest problem

Answer 30

Rating might not be reliable

Question 31

Default premium

Answer 31

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

Question 32

Default premium equation

Answer 32

Yield corporate - yield government

Question 33

Yield corporate

Answer 33

Yield of the corporate bond

Question 34

Yield government

Answer 34

Yield of a default free government bond with the same coupon rate and time to maturity