week 15 Flashcards
what is bond indenture
contract between issuing company and bondholders includes
basic terms of bonds
total amount of bonds issued
a description of bond security, if bond is secured or unsecured
sinking fund provision
embedded options
details of protective covenants
what are bond classifications
security and seniority
what is the security bond classification
collateral - secured by financial securities
mortgage - secured by real property, normally land or buildings
debentures - unsecured
notes - unsecured debt with original maturity less than 10 years
what is seniority bond classification
senior vs junior, lower rank
what does required return depend on
bond characteristics
coupon rate, risk usually equal to yield at issue
what are 0 coupon bonds
make no periodic interest payments
coupon rate = 0%
yield to maturity comes from the difference between the purchase price and par value
cannot sell for more than par value
sometimes called 0s or deep discount bonds
what are floating rate bonds
coupon rates floats depending on some index value
eg adjustable rate mortgages and inflation-linked treasuries
less price risk with floating rate bonds, coupon floats so less likely to substantially differ from YTM
coupons may have a collar, rate cannot go above ceiling or floor
what are semi-annual coupons
bonds that make payments twice a year
what are additional bond features
callable
putable
convertible
what is a callable bond
grants the issuers the right to retire the bond before scheduled maturity date
allows issuers to change maturity of a bond
what is a putable bond
grants bondholders the right to sell the bond back to the issuers at par value on designated date
allows investors to change maturity of a bond
what is a convertible bond
gives the bondholders right to exchange the bond for common stock at a pre-specified price
allows investors to take advantage of favourable movements in the stock price
why do some bonds have lower tax rates
some bonds have lower/no taxes
yields are usually lower as investors do not demand additional yield to be compensated for tax
comparisons of bonds must use after tax yields
what are bond markets
mainly over the counter transactions with dealers and brokers connect electronically
large number of bond issues but low daily volume in single issues
getting up to date prices difficult, particularly on small company or municipal issues
what are clean prices
no interest included
what are dirty prices
include accrued interest
what is the bid price
the price that dealers are willing to pay for the security
what is the ask price
what the dealer is willing to sell the bond for
what is the bid-ask spread
profit made by dealers on the transaction
what are the ask and bid yield
the YTM based on ask and bid prices
what are the risks associated with investing in bonds
interest rate
reinvestment
default
call
inflation
exchange rate
liquidity
volatility
what is interest rate risk
risk that arises from fluctuating interest rates
how much interest rate risk a bond has depends on how sensitive it is to interest rate changes
what does sensitivity to interest rate changes depend on
time to maturity - longer time to maturity increases risk
coupon rate - lower coupon rate increases risk
why do high coupon rates carry less risk
larger cash flow earlier in its life, value is less sensitive to changes in discount rates
what is credit risk
the risk that the issuer of the bond may default
the calculation of the value of the bond using YTM is based on the assumption that there is no possibility of default
if there is any credit risk, investors will require a higher return
what are bond ratings
default risk is measured by quality ratings assigned by three rating companies: moodys, standard and poor and fitch
only concerned with possibility of default risk
highest rating is AAA
what are nominal interest rates
interest rates of returns which have not been adjusted for inflation
financial rates are almost always in nominal terms
what are real rates of return
interest rates of return that have been adjusted for inflation
percentage change in terms of purchasing power
what is the fisher effect
1 + R = (1+r) x (1+h)
1+R - nominal rate
1+r - real rate
1+h - percentage change in price level of goods
what is term structure
the relationship between time to maturity and yields, all else equal
effect of default risk, different coupons has been removed
what is yield curve
graphical representation of term structure
upward sloping - long rates > short rates
downward sloping - long rates < short rates
flat - long rates = short rates
