Chapter 6: Interest rates and required returns

secured bonds (3)

1.) Mortgage bonds 2.) Collateral trust bonds 3.) Equipment trust certificates

Traditional bonds

typical bonds that have been around for years.

trustee

the 3rd party to a bond indenture. A paid individual, corporation, or commercial bank trust department that acts as the 3rd party to a bond indenture and can take actions on behalf of the bondholder if the terms of the indenture are violated in any way.

discount

the amount by which a bond sells below its par value. When required return is grater than the coupon interest rate, the bond value will be less than its par value, and will

4 factors that influence cost of bonds to the issuing company.

1.) Bond maturity: LT debt pays higher interest rates than ST debt. 2.) offering size: Inverse effect. Administrative costs per dollar borrowed decrease with increase in offering size. Risk to bondholders may increase, as larger offering means a greater chance of default. 3.) Issuer's risk: Greater default risk results in greater interest rate 4.) Cost of money: Basis for determining a bond's interest coupon rate.

unsecured bonds (3)

1.) Debentures 2.) Subordinated debentures 3.) Income bonds

Reasons why a bonds coupon rate will deviate from the required rate

1.) Economic conditions have changed since the bond was issued. 2.) Firm's risk has changed

2 ways that companies can borrow internationally:

1.) Eurobond 2.) Foreign bond

3 theories used to describe the general shape of the yield curve

1.) Expectations theory 2.) Liquidity preference theory 3.) Market segmentation theory

3 factors that influence interest rates

1.) Inflation 2.) Risk 3.) Theory of liquidity preference

What 3 factors is the slope of the yield curve dependent on at any point in time?

1.) interest rate expectations 2.) liquidity preference 3.) comparative equilibrium of supply and demand is short and long run market segments.

Deflation

A decrease in price levels

inverted yield curve (Downward Sloping)

A downward-sloping yield curve indicates that short term interest rates are higher than long term rates. Occurs very infrequently and is a sign that the economy is weakening

flat yield curve

A flat curve indicates that rates do not vary significantly at different securities.

Liquidity Preference

A general tendency for investors to prefer short term, more liquid securities. If investors would prefer to buy short term securities rather than long term securities, interest rates (cost to borrow) will be lower on ST securities.

Yield Curve

A graphic depiction of the term structure of interest rates.

Corporate bond

A long-term debt instrument indicating a corporation has borrowed a certain amount of money and promises to repay it in the future under clearly defined terms and conditions.

current yield

A measure of the bond's cash return for the year. Calculated by dividing the bond's annual interest payment by its current price.

Conversion feature of bonds

Allows bondholders to change each bond into a stated number of shares of common stock. This is done when market price =of stock is such that conversion will result in a profit for the bondholder

sinking-fund requirement

An example of a restrictive provision. Provides for systematic retirement of bonds prior to their stated maturity date. Corporation makes semiannual or annual payments that are used to retire bonds by purchasing them in the marketplace.

normal yield curve

An upward sloping curve. Short term interest rates are lower than long term rates.

Valuation

The process that links risk and return to determine the worth of an asset. 3 inputs= cash flow, timing, and measure of risk

Subordinated debentures

Claims are not satisfied until those of the creditors holding senior debts have been fully satisfied.

Yield to maturity

Compound annual rate of return earned on a debt security purchased on a given day, and held until maturity.

Higher expected rate of inflation does what to demanded nominal rate of return?

Demanded nominal interest rate increases.

Call feature

Gives the issuing company the opportunity to repurchase bonds prior to maturity.

subordination

In a bond indenture, the stipulation that subsequent creditors agree to wait until all claims of the senior debt are satisified.

Higher level of risk does what to demanded rate of return?

Increases it

stock purchase warrants

Instruments that give their holders the right to purchase a certain number of share's of the issuers common stock at a specified price over a certain period of time.

Foreign bond

Issued by a foreign corporation or government and is denominated in the investor's home currency and sold in the investor's home market.

Euro bond

Issued by an international corporation and sold to investors in countries with currencies other than the currency in which the bond is denominated.

Liquidity preferance theory

Long-term interest rates are generally higher than short term rates are (upward sloping yeild curve) because investors perceive short term investments to be more liquid and less risky than long term rates. Borrowers must offer higher rates on long term bonds in order to entice investors away from short term liquid securities.

bond indenture

Offers a form of protection to the bondholders. A legal document that specifies both the rights of the bond holders and the duties of the issuing corporations

Income bonds

Payment of interest is required only when earnings are available. Issued in reorganization of a failing firm in most cases.

restrictive covenants

Provisions in a bond indenture that place operating and financial constraints on the borrowing entity. Protect bondholder against increases in risk.

Mortgage bonds

Secured by real estate or buildings

Collateral trust bonds

Secured by stock and or bonds that are owned by the issuer. Collateral value is generally 25 to 35 percent greater than the bond value.

market segmentation theory

Suggests that the market for loans is segmented on the basis of maturity and that the supply and demand for loans within each segment determine it's prevailing interest rate. The slope of the yield curve is determined by the general relationship between the prevailing rates in each segment.

Nominal rate of interest

The actual rate of interest charged by the supplier of funds and paid by the demander. differs from real rate due to inflation and risk.

call premium

The amount by which the bond's call price exceeds the bonds par value. Compensates bondholders for having the bond called away from them.

Interest rate/ required return represent what?

The cost of money. Interest rate tends ti be applied to debt instruments such as bank loans or bonds, while required return tends to be applied to almost any kind of investment such as common stock.

What is the value of an asset?

The present value of all future cash flows it is expected to provide over the relevant time period.

Real rate of interest

The rate that creates equilibrium between the supply of savings and the demand for investment funds in a perfect world, without inflation, where the suppliers and demanders of funds have no liquidity preference, and there is no risk.

Term structure of interest rates

The relationship between the maturity and rate of return for bonds of similar levels of risk.

call price

The stated price at which the bond may be repurchased prior to maturity.

Expectations theory

The yield curve reflects expectations from investors about future interest rates. An expectation of a rising interest rate results in an upward sloping yield curve, and an expectation of declining rates results in a downward-sloping yield curve.

Debentures

Unsecured bonds that only creditworthy companies can issue.

Equipment trust certificates

Used to finance rolling stock such as airplanes, boats, railroad cars, ect. A trustee buys the asset with funds raised through the sale of trust certificates and then leases it to the firm. A form of leasing.

When will a bonds value differ from its par value?

When the coupon rate deviates from the required rate of return

A (Blank) relationship exists between the quality of the bond and the rate of return it must offer to bondholders

inverse

contemporary bonds

newer more innovative types of bonds.

standard debt provisions

provisions in a bond indenture specifying certain record-keeping and general business practices that the bond issuer must follow. Normally, they do not place a burden on a financially sound business.

Coupon interest rate

the percentage of the bonds par value that will be paid annually. It is typically paid in 2 equal semi annual payments, as interest.