S9: Bond Basics and Definitions

Question 1

Bonds

Answer 1

Debt instruments used by firms or governments to borrow money for their investments. It is a contractual relationship between the borrower and lender.

Question 2

Face/principal/par value

Answer 2

The amount borrowed written on the loan, to be repaid at the end of the bond’s term

Question 3

Maturity

Answer 3

How long until the bond is repaid by the borrower/debtor

Question 4

Coupons

Answer 4

The interest payments made on the bond, determined by the coupon rate

Question 5

Coupon rate

Answer 5

Determined by prevailing interest rates in the economy at the time the bond is issued (the riskier the bond, the higher the investor requires the coupon rate to be). Normally relative to T-Bills

Question 6

Yield to Maturity (AKA Yield)

Answer 6

The annual rate of return one earns when buying a bond at a given price, collecting all coupons, and receiving the face value at the end of the term to maturity (Can be different if bond is not purchased at face value)

Question 7

Discount Bond

Answer 7

You pay less than the face value of the bond, therefore the YTM will be higher than the coupon rate because they are inversely related

Question 8

Premium Bond

Answer 8

You pay more than the face value of the bond, therefore the YTM will be lower than the coupon rate because they are inversely related

Question 9

Indenture

Answer 9

Bond’s written agreement between the borrower and the lender, often several 100 pages and includes basic terms and total amount of the bond

Question 10

Basic terms

Answer 10

Coupon rate, principal, term to maturity, etc.

Question 11

Total amount of the bond

Answer 11

How much total $ was raised by the firm

Question 12

Collateral (Component of bond indenture)

Answer 12

Property or rights the lenders get if the borrowers can’t pay - most corporate debt doesn’t offer collateral

Question 13

Secured bond

Answer 13

Offers collateral, lower IR bc less risky

Question 14

Debentures/unsecured bond

Answer 14

No collateral, higher IR bc more risky

Question 15

Call Provisions (Component of bond indenture)

Answer 15

Allow the firm to call a bond and repay it early, often at a call premium

Question 16

Call premium (Component of bond indenture)

Answer 16

When a firm calls a bond early, they may pay a bit extra over the bond’s face value

Question 17

Deferred call provisions/call protected bonds (Component of bond indenture)

Answer 17

Prohibit bonds from being called within a set of years after the bond is issued for the 1st time, less risky for investors

Question 18

Sinking fund (Component of bond indenture)

Answer 18

An account managed by the trustee into which the borrowing firm can make payments to retire portions of the debt early. The trustee can, on behalf of the firm, repurchase bonds from WILLING shareholders on behalf of the firm who wish to get the par-value back early and retire the bonds

Question 19

Trustee

Answer 19

Someone who is repurchasing bonds on behalf of the firm, a financial institution

Question 20

Seniority (Component of bond indenture)

Answer 20

The order of which bondholders are paid in the event of default (Senior debt holders -> Junior/subordinate debt holders -> residual claimants (Equity holders, preferred then common stock holders)

Question 21

Protective covenants (Component of bond indenture)

Answer 21

Limit certain actions of the firm that it may undertake during the term of the loan

Question 22

Negative covenants

Answer 22

Prohibit actions - such as limiting amount of dividends, additional debt issuance, preventing mergers with other firms, or pledging of collateral to another lender

Question 23

Positive covenants

Answer 23

Require actions - such as keeping working capital above certain levels or maintaining the collateral

Question 24

Credit Rating Agencies

Answer 24

Assign rating to borrowers (firms or government) based on their riskiness and probability of default. The riskier the issuer, the higher the bond yield must be for investors to take on risk of investing

Question 25

Top 3 credit rating agencies

Answer 25

Moody’s, S&P Global, Fitch

Question 26

Default

Answer 26

Failure of a firm or government issuer to make payments to lenders

Question 27

Investment Grade

Answer 27

Bonds that are safer and offer lower rates of return

Question 28

Speculative Grade (AKA Junk Bonds)

Answer 28

Riskier and offer higher rates of return (Subordinate, callable, debenture (unsecured), without protective covenants, highly leveraged firm)

Question 29

Treasury Bills (T-Bills)

Answer 29

Government bonds that have maturity up to a year. They are discount bonds paying no coupons issued by the federal government

Question 30

Treasury Notes and Bonds

Answer 30

Government bonds that have longer maturities and pay coupons twice yearly

Question 31

Treasury Notes Duration

Answer 31

Up to 10 years

Question 32

Treasury Bonds Duration

Answer 32

10-30 years

Question 33

Primary Treasury Market

Answer 33

www.TreasuryDirect.gov

Question 34

Secondary Treasury Markets

Answer 34

Buy from other bondholders

Question 35

Over the counter (Secondary Treasury Markets)

Answer 35

Between dealers who buy and sell bonds from various parties to add to their inventory

Question 36

Bid Prices (Secondary Treasury Markets)

Answer 36

The price dealer will pay you the investor for a bond if you have one to sell

Question 37

Ask Price (Secondary Treasury Markets)

Answer 37

The price dealer will ask that you the investor pay for a bond if you want to buy one

Question 38

Bid-Ask Spread (Secondary Treasury Markets)

Answer 38

Difference between bid and ask price, how the dealer makes their $ (Ask > Bid)

Question 39

Asked Yield (Secondary Treasury Markets)

Answer 39

The annual rate of return if you buy a bond at its ask price and hold it to maturity

Question 40

Municipal Bonds (Munis)

Answer 40

Issued by state and local governments, but they can default. Coupon payments are tax exempt from federal income taxes, and therefore attractive for higher tax-bracket investors

Question 41

The Yield Curve

Answer 41

Shows relationship of term structure of interest rates

Question 42

Term Structure of Interest Rates

Answer 42

Relationship between interest rates and time to maturity

Question 43

Normal Shape/Normal Times

Answer 43

Investors prefer shorter term bonds and their prices are higher than long term bonds with same coupon rates because IRs are expected to rise and investors don’t want their money “locked up” at a lower rate than what is to come

Question 44

Inverted Shape/Pre-Recession Times

Answer 44

Investors prefer longer term bonds and their prices are higher than short term bonds with same coupon rates because IRs are expected to fall and investors want their money “locked up” at a higher rate than what is to come

Question 45

How are price and yield (return) related?

Answer 45

INVERSELY