S9: Bond Basics and Definitions Flashcards
Bonds
Debt instruments used by firms or governments to borrow money for their investments. It is a contractual relationship between the borrower and lender.
Face/principal/par value
The amount borrowed written on the loan, to be repaid at the end of the bond’s term
Maturity
How long until the bond is repaid by the borrower/debtor
Coupons
The interest payments made on the bond, determined by the coupon rate
Coupon rate
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
Yield to Maturity (AKA Yield)
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)
Discount Bond
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
Premium Bond
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
Indenture
Bond’s written agreement between the borrower and the lender, often several 100 pages and includes basic terms and total amount of the bond
Basic terms
Coupon rate, principal, term to maturity, etc.
Total amount of the bond
How much total $ was raised by the firm
Collateral (Component of bond indenture)
Property or rights the lenders get if the borrowers can’t pay - most corporate debt doesn’t offer collateral
Secured bond
Offers collateral, lower IR bc less risky
Debentures/unsecured bond
No collateral, higher IR bc more risky
Call Provisions (Component of bond indenture)
Allow the firm to call a bond and repay it early, often at a call premium
Call premium (Component of bond indenture)
When a firm calls a bond early, they may pay a bit extra over the bond’s face value
Deferred call provisions/call protected bonds (Component of bond indenture)
Prohibit bonds from being called within a set of years after the bond is issued for the 1st time, less risky for investors
Sinking fund (Component of bond indenture)
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
Trustee
Someone who is repurchasing bonds on behalf of the firm, a financial institution
Seniority (Component of bond indenture)
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)
Protective covenants (Component of bond indenture)
Limit certain actions of the firm that it may undertake during the term of the loan
Negative covenants
Prohibit actions - such as limiting amount of dividends, additional debt issuance, preventing mergers with other firms, or pledging of collateral to another lender
Positive covenants
Require actions - such as keeping working capital above certain levels or maintaining the collateral
Credit Rating Agencies
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
Top 3 credit rating agencies
Moody’s, S&P Global, Fitch
Default
Failure of a firm or government issuer to make payments to lenders
Investment Grade
Bonds that are safer and offer lower rates of return
Speculative Grade (AKA Junk Bonds)
Riskier and offer higher rates of return (Subordinate, callable, debenture (unsecured), without protective covenants, highly leveraged firm)
Treasury Bills (T-Bills)
Government bonds that have maturity up to a year. They are discount bonds paying no coupons issued by the federal government
Treasury Notes and Bonds
Government bonds that have longer maturities and pay coupons twice yearly
Treasury Notes Duration
Up to 10 years
Treasury Bonds Duration
10-30 years
Primary Treasury Market
www.TreasuryDirect.gov
Secondary Treasury Markets
Buy from other bondholders
Over the counter (Secondary Treasury Markets)
Between dealers who buy and sell bonds from various parties to add to their inventory
Bid Prices (Secondary Treasury Markets)
The price dealer will pay you the investor for a bond if you have one to sell
Ask Price (Secondary Treasury Markets)
The price dealer will ask that you the investor pay for a bond if you want to buy one
Bid-Ask Spread (Secondary Treasury Markets)
Difference between bid and ask price, how the dealer makes their $ (Ask > Bid)
Asked Yield (Secondary Treasury Markets)
The annual rate of return if you buy a bond at its ask price and hold it to maturity
Municipal Bonds (Munis)
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
The Yield Curve
Shows relationship of term structure of interest rates
Term Structure of Interest Rates
Relationship between interest rates and time to maturity
Normal Shape/Normal Times
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
Inverted Shape/Pre-Recession Times
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
How are price and yield (return) related?
INVERSELY
