Business Finance Chapter 7

Subordinated Debentures

Bonds having a claim on assets only after the senior debt has been paid in full in the event of liquiditation

Corporate bonds

Bonds issued by corporations. They are exposed to default risk.

Municipal Bonds

Bonds issued by state and local governments. One advantage: The interest earned on most munis is exempt from federal taxes and from state taces if the holder is a resident of the issuing state.

Treasury bonds

Bonds issued by the federal government, sometimes referred to as government bonds. Treasuries have no default risk.

How can the sinking fund requirements be handled?

1. It can call in for redemption, at par value, the required $5000000 of bonds. The bonds are numbered serially, and those called for redemption ould be determined by a lottery administered by the trustee. 2. The company can buy the required number of bonds on the open market

When only does the yield to maturity equal the expected rate of return?

1. Probability of default is zero 2. The bond can´t be called If there is some default risk or the bond may be called, there is some chance that the promised payments to maturity will exceed the expected return.

Original Issue Discount Bond (OID)

Any bond originally offered at a price below its par value.

Junk bonds

High-risk, high-yiels bonds.

Default risk

is often referred to as credit risk. The larger this risk the higher the interest rate investors demand.

What is a refunding operation?

Companies issue bonds when the interest rates are high. The interest rates drop, and now when the bonds are callable, use the proceeds of the new issue to retire the high-rate issue, and reduce its interest expense.

Warrants

Long-term options to buy a stated number of shares of common stockat a specified price

What is a call premium

The additional sum, the issuer must pay the bondholders, is called a call premium. It is often equal to one year´s interest. The par value plus the premium have to be paid.

Investment horizon

The period of time an investor plans to hold a particular investment.

For what does the bond sell if intererst rates have fallen?

Then the bond will sell for more than its par value. In this case a firm would use the call option.

For what does the bond sell when interest rates rise?

Then the bonds will sell at a price below par, so the firm and and will buy the bonds in the open market.

What does a bond sell at when the coupon rate is greater than the current market rate?

They sell at a premium

Foreign bonds

Bonds issues by foreign governments or by foreign corporations. Are exposed to default risk.

Investment-Grade bonds

Bonds rated triple-B or higher; many banks and other institutional investors are permitted by law to hold only nvestment-grade bonds

Duration

The weighted average of the time it takes to receive each of the bond´s cash flows.

When do companies call bonds?

When interest rates have declined significantly since the bonds were issued.

Debenture

A long-term bond that is not secures by a mortgage on specific property.

What is a bond?

A long-term debt instrument. It is a long-term contract under which a borrower agrees to make payments of interest and principal on specific dates to the holders of the bond.

Call provision

A provision in a bond contract that gives the issuer the right to redeem the bonds under specified terms prior to the normal maturity date. The call provision generally states that the issuer must pay the bondholders an amount greater than the par value if they are called.

Sinking fund provision

A provision in a bond contract that requires the issuer to retire a portion of the bond issue each year. A failure to meet the sinking fund requirement constitutes a default, which may throw the company into bankruptcy.

Maturity date

A specified date on which the par valueof a bond must be repaid.

Indexed purchasing power bond

A bond that has interest payments based on an inflation index so as to protext the holder from inflation.

Different names of bonds

A bond that has just been issued is known as a new issue. Once it has been issued it is an outstanding bond, also called a seasoned issue.

Income bond

A bond that pays interest only if it is earned. Riskier than regular bonds

Premium bond

A bond that sells above its par value; occurs whenever the going rate of interest is below the coupon rate.

Discount bond

A bond that sells below its par value; occurs whenever the going rate of interest is above the coupon rate

When is a company more likely to call its bonds?

A company is more likely to call its bonds if they are able to replace their current high-coupon debt with less expensive financing. A bond is more likely to be called if its price is above par. Because a price above par means that the going market interest rate (YTM) is less than the coupon rate.

What if the bond´s market rate rd is equal to its coupon rate?

A fixed rate bond will sell at its par value.

Who issues bonds?

Bonds are issued by corporations and government agencies that are looking for long-term debt capital.

Convertible bonds

Bonds that are exchangeable at the option of the holder for the issuing firm´s common stock

Zero coupon bonds

Bonds that pay no annual interest but are sold at a discount below par, thus compensating investors in the form of capital appreciation.

Fixed-rate bonds

Bonds whose interest rate is fixed for their entire life

Putable bonds

Bonds with a provision that allows investors to sell them back to the company prior to maturity at a prearranged price.

When is a bond likely to be called?

If current interest rates are well below an outstanding bond´s coupon rate, a callable bond is likely to be called, and investors will estimate its most likely rate of return as the yield to call rather than the yield to maturity.

On which bonds is the price risk higher?

Price risk is higher on bonds that have long maturities than on bonds that will mature in the near future. The longer the maturity, the longer before the bon dwill be paid off and the bondholder can replace it with another bond with a higher coupon.

How is the reinvestment risk on bonds

Reinvestment risk is obviously high on callable bonds. It is also high on short-term bonds because the shorter the bond´s maturity, the fewer the years before the relatively high old coupon bonds will be replaced with the new low-coupon issues.

deferred call

Some bonds are immediately callable, in most cases, bonds are often not callable until several years after issue, generally 5 to 10 years. This is known as deferred call. Such bonds are said to have call protection.

Par Value

The face value of a bond. The par value generally represents the amount of money the firm borrows and promises to repay on the maturity date.

Original Maturity

The number of years to maturity at the time a bond is issued.

Yield to maturity

The rate of return earned on a bond if it is held to maturity. It can also be viewed as the bond´s promised rate of return, which is the return that investors will receive if all of the promised payments are made.

Yield to call

The rate of return earned on a bond when it is called before its maturity date.

Price (interest rate) risk

The risk of a decline in a bond´s price due to an increase in interest rates.

Reinvestment Risk

The risk that a decline in interest rates will lead to a decline in income from a bond portfolio

Coupon Payment

The specified number of dollars of interest paid each year.

Coupon Interest rate

The stated annual interest rate on a bond. Annual coupon payment divided by the par value, the result is the coupon interest rate.

How is it when interest rates rise and fall?

We see that an increase in the market interest rate rd causes the price of an outstanding bond to fall, whereas a decrease in the rate causes the bond´s price of an outstanding bond to rise.

Mortgage bond

a bond backed by fixed assets. First mortgages bonds are senior in priority to claims of second mortgage bonds.

Indenture

a formal agreement between the issuer and the bondholders

Floating-rate bonds

bonds whose interest rate fluctuates with shifts in the general level of interest rates.

The situation in the market with a par bond, discount bond and premium bond

rd = coupon rate,, fixed rate bond sells at par; hence it is a par bond rd > coupon rate, fixed rate bond sells below par; hence it is a discount bond rd < coupon rate, fixed rate bond sells above par; hence it is a premium bond

For bonds with similar coupons, how is the differential interest rate sensivity?

the longer a bond´s maturity, the more its price changes in response to a given change in interest rates.