Lecture 6-Debt Flashcards
What is a bond?
-A security that obligates the issuer to make specified payments to the bondholder
What are coupons in relation to bonds?
-The regular interest payments made to the bondholder ( in £s)
What is the maturity in relation to bonds?
-The length of time (or quoted as a Maturity date) over which payments will be made (in Years)
What is the face value in relation to bonds?
-The principal payment at the maturity of the bond (in £s)
What is the coupon rate in relation to bonds?
The annual coupon payments as a percentage of the face value (a %)
What are government bonds called?
Gilts
Different maturities for government bonds
Shorts (< 5 years)
Medium term (5-15 years)
Long term (>15 years)
Undated (perpetuities)
What are domestic bonds?
Issued by resident company, in the currency of that country e.g.
Tesco issues bond in the UK denominated in Sterling
What are foreign bonds?
Bonds issued in a country, in the currency of that country by a non-resident e.g.
Boeing issues bond in the UK denominated in Sterling
Cadbury issues bond in Japan denominated in Yen
These bonds must obey rules of the country in which they are issued
What are Eurobonds?
Bonds issued in a currency different to that of the country they are issued in e.g.
Renault issues a Sterling denominate bond in France
BP issues a US$ denominated bond in the UK
Toyota issues a Euro denominated bond in Japan
With introduction of the Euro, are increasingly referred to as International bonds
What is bond pricing?
The price of a bond is simply the PV of all the cash flows generated by the bond (i.e. the coupons and face value payment)
The discount used to find PV for bond pricing
- the required rate of return on debt (𝑟_𝑑)
- We will see later this rate is equivalent to the Yield to Maturity (YTM) on the bond
What to remember with the discount rate (RROR on debt) and coupon rate
The coupon rate IS NOT the discount rate (i.e. it is not the required rate of return on debt) used in the present value calculations
The coupon rate merely tells us what cash flows the bond will produce
Different face values for different countries
- In the US the face values are $1000
- Uk face values are £100
How are bonds and annuities linked?
Except for the payment of the final face value, bond payments are very similar to an annuity
Fixed payments, every year, starts next year
Semi annnual payments for bonds
An 8% bond (face value £100) will pay £4 every 6-months rather than £8 once a year
How are bonds traded?
Companies issue bonds in the primary markets to raise capital
But bonds can be bought and sold in the secondary market just like shares
The price you buy the bond at (whether in the primary or secondary market) is not the face value, i.e. not £100
Prices of bonds (with face values of £100) tend to range between £90 - £110
But can be much higher/lower
What is the current yield?
The annual coupon payment divided by the current bond price
-Represents return the investor makes purely from receiving the coupons
Equivalent to dividend yield on a share
What is yields to maturity?
- represents the total return you expect to make on the bond, i.e. includes the coupon return and the capital return
- As the life of the bond gets longer, the YTM seems to increase
Generally longer bonds have higher yields –but this is not always true!
Why do bond prices change from day to day?
As the bond gets closer to maturity, its price will always approach its face value
As the general level of interest rates change, bond prices will adjust so that the YTM for a new investor always represents a “fair” return
Rules about bond prices
When the coupon rate is > YTM
Bond price will be always be above £100
As the bond gets closer to maturity
Bond price falls, getting closer to £100
What is interest rate risk?
When interest rates rise – bond prices fall
When interest rates fall – bond prices rise
-Long term bonds have more interest rate risk than short term bonds
Low coupon bonds have more interest rate risk than high coupon bonds
What is the duration of bond meant to measure?
- Interest rate risk
- Greater duration means a greater interest rate risk
- Bonds with higher durations will need to have higher YTMs
What is default risk in relation to bonds?
if someone defaults on paying the coupons and the face value at maturity
The risks associated with gilts and corporate bonds
- Gilts practically default risk free
- Company bonds will have some default risk
What is the default premium
Difference between the YTM on a corporate bond and an otherwise identical government bond
-The riskier the issuer, i.e. the greater the risk of default, the greater the default premium will be:
Thus the higher the overall required rate of return on the bond will be
How do bond investors estimate risk of default?
Specialist rating agencies will (for a fee) provide a rating, examples are:
Standard & Poor’s, Moody’s, Fitch
Ratings can apply to
Governments
Companies
Specific Bonds
AAA credit rating
Highest credit quality, , lowest level of credit risk
D credit rating
-Issuers are unlikely pay their dues and default on payment
What are investment grade bonds?
-Bonds rated BBB or better
Considered to be fairly safe
On average less than 0.1% of AAA and 3.5% fof BBB bonds default within 5-10 years
What are junk bonds?
- Bonds rated below BBB
- Consider to be risky
- Can be high rates of default for junk bonds
- Nearly a third of B rated bonds and over half of CCC rated bonds default within 5-10 years
How big is the default premium?
For AAA rated bonds
Default premium fairly steady at 1-1.5%
For BBB rated bonds
Default premium varies between 1.5-3.5%
For Junk bonds
Default premium has been very volatile
Anything from 2.5% to 10%!
How can an investor reduce risk default of a bond?
Secure the bond against assets (Debentures)
A fixed charge against specified assets
A floating charge against assets in general
Bond covenants as a way to reduce bond default risk
Restrict the firm from issuing more debt
Set maximum dividend pay-outs
Set targets for company performance
Restrict sale of assets
What are the different types of coupons?
-The majority of bonds offer fixed regular coupons
-No coupon payment at all
Just the face value (£100) at maturity/ Prices are always below £100
Often called ”Pure Discount Bonds”
-Floating rate bonds
Coupon rate can change over the life of the bond e.g. may be linked to LIBOR
What are the different types of bonds?
Irredeemable bonds
- Has no maturity date (like a perpetuity!)
- So price is just C/YTM
- Some gilts are irredeemable
Callable bonds
- The company can buy these back before the maturity date if they want to
- Usually company has to pay a pay premium to do this
-Convertible bonds
Holder of the bond can (under predetermined conditions) convert the bonds into shares
Example: Company issues 10yr bond in 2014 and states that any time after 5th year bondholders can
- Swap if share price has gone up a lot and the 12 shares are worth more than the bond
- Keep the bonds if they are worth more than the shares
- Because of the extra benefit, the initial return (YTM) will be lower
Rules to remember about Bond prices
If CR > YTM then price is > £100
If CR = YTM then price is = £100
If CR < YTM then price is < £100
What happens if the interest ate goes up and vice versa for bonds?
-As interest rates go UP, bond prices go DOWN
What does the YTM depend on?
The general level of interest rates
The interest rate risk
The default risk
