CHAPTER FIVE

Refunding Operation

Occurs when a company issues debt at current low rates and uses the proceeds to repurchase one of its existing high-coupon rate debt issues. Often these are callable issues, which means the company can purchase the debt at a call price lower than the market price.

Reinvestment Rate Risk

Occurs when a short-term debt security must be "rolled over." If interest rates have fallen then the reinvestment of principal will be at a lower rate, with correspondingly lower interest payments and ending value.

Trustee

Official (usually a bank) who represents the bondholders and makes sure the terms of the indenture are carried out.

Revenue Bond

Type of municipal bonds that are secured by the revenues derived from projects such as roads and bridges, airports, water and sewage systems, and not-for-profit health care facilities.

Mortgage Bond

A bond for which a corporation pledges certain assets as security. All such bonds are written subject to an indenture.

Treasury Inflation-Protected Securities (TIPS)

A bond issued by the U.S. government with a principal amount that is based on an inflation index such as the consumer price index (CPI). This causes interest rates and the final principal payment to automatically rise when the inflation rate rises, thus protecting the bondholders against inflation.

Foreign bonds

A bond sold by a foreign borrower but denominated in the currency of the country in which the issue is sold. Thus, a U.S. firm selling bonds denominated in Swiss francs in Switzerland is selling foreign bonds.

Floating-rate Bonds

A bond whose coupon payment may vary over time. The coupon rate is usually linked to the rate on some other security, such as a Treasury security, or to some other rate, such as the prime rate or LIBOR.

Original Maturity

A bond's number of years until maturity at the time it is issued.

Warrants

A call option, issued by a company, that allows the holder to buy a stated number of shares of stock from the company at a specified price. Warrants are generally distributed with debt, or preferred stock, to induce investors to buy those securities at lower cost.

Inverted Yield Curve

A downward-sloping yield curve. Also called an abnormal yield curve.

Abnormal Yield Curve

A downward-sloping yield curve. Also called an inverted yield curve.

Indenture

A legal document that spells out the rights of both bondholders and the issuing corporation.

Liquidity Premium (LP)

A liquidity premium is added to the real risk-free rate of interest, in addition to other premiums, if a security is not liquid.

Bond

A promissory note issued by a business or a governmental unit.

Treasury bills (T-bills)

A short-term security issued by the federal government. A T-bill has a maturity of 52 weeks or less at the time of issue, and it makes no payments at all until it matures. Thus, T-bills are sold initially at a discount to their face, or maturity, value. T-bills have no default risk.

Pollution Control Bonds

A tax-exempt bond sold by state and local governments whose proceeds are made available to corporations for pollution control projects deemed (by Congress) to be in the public interest.

Development Bonds

A tax-exempt bond sold by state and local governments whose proceeds are made available to corporations for specific uses deemed (by Congress) to be in the public interest.

Leveraged Buyouts (LBOs)

A transaction in which a firm's publicly owned stock is acquired in a mostly debt-financed tender offer, resulting in a privately owned, highly leveraged firm. Often, the firm's own management initiates the LBO.

Make-whole Call Provision

Allows a company to call a bond, but it must pay a call price that is essentially equal to the market value of a similar noncallable bond. This provides companies with an easy way to repurchase bonds as part of a financial restructuring, such as a merger.

Debenture

An unsecured bond; as such, it provides no lien against specific property as security for the obligation. Debenture holders are therefore general creditors whose claims are protected by property not otherwise pledged.

Interest Rate Risk

Arises from the fact that bond prices decline when interest rates rise. Under these circumstances, selling a bond prior to maturity will result in a capital loss; the longer the term to maturity, the larger the loss.

Discount Bond

Bond prices and interest rates are inversely related; that is, they tend to move in the opposite direction from one another. A fixed-rate bond will sell at par when its coupon interest rate is equal to the going rate of interest, . When the going rate of interest is above the coupon rate, a fixed-rate bond will sell at a "discount" below its par value. If current interest rates are below the coupon rate, a fixed-rate bond will sell at a "premium" above its par value.

Premium Bond

Bond prices and interest rates are inversely related; that is, they tend to move in the opposite direction from one another. A fixed-rate bond will sell at par when its coupon interest rate is equal to the going rate of interest, . When the going rate of interest is above the coupon rate, a fixed-rate bond will sell at a "discount" below its par value. If current interest rates are below the coupon rate, a fixed-rate bond will sell at a "premium" above its par value.

Convertible Bonds

Bond that is convertible into shares of common stock, at a fixed price, at the option of the bondholder.

Tax-exempt Bonds

Bonds issued by industrial development agencies and pollution control agencies whose proceeds are made available to corporations for uses deemed (by Congress) to be in the public interest. The interest paid to investors is exempt from federal income taxes.

Treasury bonds (T-bonds)

Bonds issued by the federal government; sometimes called T-bonds or government bonds. A T-bond makes an equal payment every 6 months until it matures, at which time it makes an additional lump-sum payment of its par value. If the maturity at the time of issue is less than 10 years, the security is called a note rather than a bond. T-bonds have no default risk.

Agency debt

Debt issued by federal agencies such as the Tennessee Value Authority. Agency debt is not officially backed by the full faith and credit of the U.S. government, but investors assume that the government implicitly guarantees this debt, so these bonds carry interest rates only slightly higher than Treasury bonds.

GSE debt

Debt issued by government-sponsored enterprises (GSEs) such as the Tennessee Valley Authority or the Small Business Administration; not officially backed by the full faith and credit of the U.S. government.

Subordinated Debentures

Debentures that have claims on assets, in the event of bankruptcy, only after senior debt (as named in the subordinated debt's indenture) has been paid off. Subordinated debentures may be subordinated to designated notes payable or to all other debt.

Secured Debt

Debt for which a corporation pledges certain assets as security.

Corporate bonds

Debt issued by corporations and exposed to default risk. Different corporate bonds have different levels of default risk, depending on the issuing company's characteristics and on the terms of the specific bond.

New-issue Bond

Describes a bond that has been issued recently, usually within one month. Such bonds are actively traded, whereas bonds that have been issued further in the past often have very little trading because they are held in portfolios until maturity.

On-the-run Bonds

Describes a bond that has been issued recently, usually within one month. Such bonds are actively traded, whereas bonds that have been issued further in the past often have very little trading because they are held in portfolios until maturity.

Outstanding Bond

Describes a bond that has not been issued within the past month or two. Such bonds usually are not actively traded because they often are held in portfolios until maturity.

Seasoned Bond

Describes a bond that has not been issued within the past month or two. Such bonds usually are not actively traded because they often are held in portfolios until maturity.

Coupon Payment

Dollar amount of interest paid to each bondholder on the interest payment dates.

Payment-in-kind (PIK) Bonds

Don't pay cash coupons but pay coupons consisting of additional bonds (or a percentage of an additional bond).

Super Poison Put

Enables a bondholder to turn in, or "put," a bond back to the issuer at par in the event of a takeover, merger, or major recapitalization.

Sinking Fund Provision

Facilitates the orderly retirement of a bond issue. This can be achieved in one of two ways: (1) The company can call in for redemption (at par value) a certain percentage of bonds each year. (2) The company may buy the required amount of bonds on the open market.

Deferred Call

Feature stating that a callable bond may not be called until a specified number of years after issue have passed. This is also known as call protection.

Project Financing

Financing method in which the project's creditors do not have full recourse against the borrowers; the lenders and lessors must be paid from the project's cash flows and equity.

Redeemable at Par

Gives investors the right to sell the bonds back to the corporation at a price that is usually close to the par value. If interest rates rise, then investors can redeem the bonds and reinvest at the higher rates.

Call Provision

Gives the issuing corporation the right to call the bonds for redemption. The call provision generally states that if the bonds are called then the company must pay the bondholders an amount greater than the par value, or a call premium. Most bonds contain a call provision.

Junk Bonds

High-risk, high-yield bond issued to finance leveraged buyouts, mergers, or troubled companies.

Original Issue Discount (OID) Bond

In general, any bond originally offered at a price that is significantly below its par value.

Municipal bonds

Issued by state and local governments. The interest earned on most municipal bonds is exempt from federal taxes and also from state taxes if the holder is a resident of the issuing state.

Duration

Measures the average number of years that a bond's PV of cash flows (coupons and principal payments) remains outstanding. If the term structure is flat and can only shift up or down, then duration also measures the percentage change in a bond's price due to a percentage change in interest rates.

Zero Coupon Bonds

Pays no coupons at all but is offered at a substantial discount below its par value and hence provides capital appreciation rather than interest income.

Bond Insurance

Protects investors against default by the issuer and provides credit enhancement to the bond issue.

Restrictive Covenants

Provisions in a bond indenture that cover such points as the conditions under which the issuer can pay off the bonds prior to maturity, the levels at which certain ratios must be maintained if the company is to issue additional debt, and restrictions against the payment of dividends unless earnings meet certain specifications. Also called a bond covenant or a covenant.

Bond Rating

Reflects the probability that a bond will go into default. Bonds rated AAA have the least probability of defaulting.

Capital Gains Yield

Results from changing prices and is calculated as , where is the beginning-of-period price and is the end-of-period price.

Investment-grade Bonds

Securities with ratings of Baa/BBB or above.

Coupon Interest Rate

Stated rate of interest on a bond; defined as the coupon payment divided by the par value.

Expectations Theory

States that the slope of the yield curve depends on expectations about future inflation rates and interest rates. Thus, if the annual rate of inflation and future interest rates are expected to increase, then the yield curve will be upward sloping; the curve will be downward sloping if the annual rates are expected to decrease.

Pure Expectations Theory

States that the slope of the yield curve depends on expectations about future inflation rates and interest rates. Thus, if the annual rate of inflation and future interest rates are expected to increase, then the yield curve will be upward sloping; the curve will be downward sloping if the annual rates are expected to decrease.

Chapter 11

The 11th chapter of the bankruptcy statutes, regulates reorganization in a bankruptcy. Filed by a borrower to prevent a lender from filing a bankruptcy claim and seizing assets.

TED Spread

The 3-month LIBOR rate minus the 3-month T-bill rate. It is a measure of risk aversion and measures the extra compensation that banks require to induce them to lend to one another.

Chapter 7

The 7th chapter of the bankruptcy statutes, regulates liquidation in a bankruptcy. Filed by a borrower to prevent a lender from filing a bankruptcy claim and seizing assets.

Current Yield

The annual coupon payment divided by the current market price.

Quoted Interest Rate

The annual rate of interest stated in a contract, quoted for a security, or reported by the press. It is also called the going interest rate, the market interest rate, and the nominal annual interest rate.

Market Interest Rate

The annual rate of interest stated in a contract, quoted for a security, or reported by the press. It is also called the going interest rate, the quoted rate, and the nominal annual interest rate.

Going Interest Rate

The annual rate of interest stated in a contract, quoted for a security, or reported by the press. It is also called the market interest rate, the quoted rate, and the nominal annual interest rate.

Nominal Interest Rate

The annual rate of interest stated in a contract, quoted for a security, or reported by the press. When used in a time line with annual cash flows, it is called . When referring to debt, the nominal annual rate is called the required rate of return on debt, . When used in the context of expected inflation, the nominal rate is the rate that actually is observed in financial markets and is often denoted by (for nominal)—it is the rate you see, whereas expected inflation and the real rate (i.e., the one that would exist if there were no inflation) are not directly observable. In the context of project analysis, if net cash flows from a project include increases due to expected future inflation, then the cash flows should be discounted at the nominal cost of capital to estimate NPV, and the internal rate of return resulting should be compared with the nominal cost of capital., The nominal rate is also called the going interest rate, the market interest rate, and the quoted interest rate.

Yield to Maturity (YTM)

The rate earned on a bond if it is held to maturity.

Event Risk

The chance that some sudden event will occur and increase the credit risk of a company, hence lowering the firm's bond rating and the value of its outstanding bonds. Some bonds reduce event risk by including a super poison put in the bond's covenant.

Yield Curve

The curve that results when yield to maturity is plotted on the y-axis with term to maturity on the x-axis.

Maturity Date

The date when the bond's par value is repaid to the bondholder. Maturity dates generally range from 10 to 40 years from the time of issue.

Liquidity

The degree to which a security can be quickly sold at its "fair" value. Active markets provide liquidity.

Bond Spread

The difference between the yield of a bond relative to another bond with less risk.

Call Premium

The extra amount above the par value that a company must pay if it calls a bond that has a call provision. The premium generally declines over time.

Indexed Bonds

The interest rate of such a bond is based on an inflation index such as the consumer price index (CPI), so the interest paid rises automatically when the inflation rate rises, thus protecting the bondholders against inflation. The final principal payment is also linked to inflation. Also called a purchasing power bond.

Purchasing Power Bonds

The interest rate of such a bond is based on an inflation index such as the consumer price index (CPI), so the interest paid rises automatically when the inflation rate rises, thus protecting the bondholders against inflation. The final principal payment is also linked to inflation. Also called an index bond.

Maturity Risk Premium (MRP)

The net effect upon a bond's yield due to interest rate risk and reinvestment risk. Interest rate risk seems to dominate, because investors usually require a higher yield for bonds with longer maturities.

Par Value

The nominal or face value of a stock or bond. The par value of a bond generally represents the amount of money that the firm borrows and promises to repay at some future date. The par value of a bond is often $1,000, but it can be $5,000 or more.

Inflation Premium (IP)

The premium added to the real risk-free rate of interest to compensate for the expected loss of purchasing power. The inflation premium is the average rate of inflation expected over the life of the security.

Default Risk Premium (DRP)

The premium added to the real risk-free rate to compensate investors for the risk that a borrower may fail to pay the interest and/or principal on a loan when they become due.

Nominal Risk-free Interest Rate

The quoted interest rate on a U.S. Treasury security, which is default-free and very liquid. In the context of short-term securities, the risk-free rate refers to a U.S. Treasury bill, which is default-free, very liquid, and has a short time until maturity (although it still is exposed to inflation risk). In the context of long-term securities, the risk-free rate refers to a U.S. Treasury bond, which is default-free, very liquid, and has a long time until maturity (although it still is exposed to inflation risk and price volatility caused by interest rate volatility).

Risk-free Interest Rate

The quoted interest rate on a long-term U.S. Treasury bond, which is default-free, very liquid, and has a long time until maturity. It is exposed to inflation risk. It is also exposed to price volatility caused by interest rate volatility. The quoted risk-free rate of interest on a short-term U.S. Treasury bond, which is default-free and very liquid. Note that includes the premium for expected inflation and interest rate volatility related to maturity: .

Yield to Call (YTC)

The rate of interest earned on a bond if it is called. If current interest rates are well below an outstanding callable bond's coupon rate, then the YTC may be a more relevant estimate of expected return than the YTM because the bond is likely to be called.

Yield

The rate of return that fairly compensates an investor for purchasing or holding debt, taking into consideration its risk, timing, and the returns available on other similar investments. It is also called the required rate of return on debt , the quoted market interest rate, the going rate, and the nominal interest rate.

Required Rate of Return on Debt

The rate of return that fairly compensates an investor for purchasing or holding debt, taking into consideration its risk, timing, and the returns available on other similar investments. When referring to debt, is also called the yield, the quoted market interest rate, the going rate, and the nominal interest rate.

Real Risk-free Interest Rate

The rate that a hypothetical riskless security pays each moment if zero inflation were expected. The real risk-free rate is not constant—r* changes over time depending on economic conditions.

Term Structure of Interest Rates

The relationship between yield to maturity and term to maturity for bonds of a single risk class.

Lien

The right of a creditor to claim a specific asset in the event of default on the debt.

Default Risk

The risk that a borrower may not pay the interest and/or principal on a loan when it becomes due. If the issuer defaults, investors receive less than the promised return on the bond. Default risk is influenced by the financial strength of the issuer and also by the terms of the bond contract, especially whether collateral has been pledged to secure the bond. The greater the default risk, the higher the bond's yield to maturity.

Normal Yield Curve

When the yield curve slopes upward, it is said to be "normal," because it is like this most of the time.

Call Protection

eature stating that a callable bond may not be called until a specified number of years after issue have passed. This is also known as a deferred call provision.