Finance 300: Chapter 7

Note

An unsecured debt, usually with a maturity under 10 years.

Long-term debt

Debt securities with maturities of more than one year.

Short-term debt

Debt securities with maturities of one year or less. Sometimes referred to as unfunded debt.

Call premium

The amount by which the call price exceeds par value of a bond.

Fisher effect

The relationship between nominal returns, real returns and inflation. Formula: r = R+h + Rxh r: Nominal rates R: Real rates h: Inflation

Term structure of interest rates

The relationship between short and long-term interest rates. More specifically, it is the relationship between nominal interest rates and time to maturity (the pure time value of money). When long-term rates > than short-term rates: term structure is upward sloping When long-term rates < than short-term rates: term structure is downward sloping

Maturity

The specified date on which the principal amount of a bond is paid.

Coupon

The stated interest payment made on a bond.

Types of bond issuers

1. Federal governments: Treasurys 2. State and local governments: Munis 3. Businesses: Corporates

Coco and nono bonds

Coco: bonds which have a coupon payment Nono: zero coupon bonds Both of these types of bonds, however, are contingent convertible, putable, callable, subordinated bonds.

Bond ratings

Two leading bond-rating firms: 1. Moody's 2. Standard and Poor's These firms assess the creditworthiness of the corporate issuer. However, their ratings only consider the likeliness that a firm will default and are constructed from information supplied by the corporations. Investment-quality bond ratings: 1.*S&P*: High-grade: AAA, AA & Medium-grade: A, BBB 2.*Moody's*: High-grade: Aaa, Aa & Medium-grade: A, Baa Junk-quality bond ratings: 1.*S&P*: Low-grade: BB, B, CCC & Very low-grade: CC, C, D 2.*Moody's*: Low-grade: Ba, B, Caa & Very low-grade: Ca, C

Warrant

A bond feature that gives the buyer of a bond the right to purchase stock in the company at a fixed price.

Put bond

A bond that allows the holder to force the issuer to buy back the bond at a stated price.

Bond

A standardized debt instrument.

Floating-rate bonds

Bonds that have adjustable coupon payments. The adjustments are tied to an interest rate index. The value of this type of bond depends on how the coupon payment adjustments are applied. Floater features: 1. Holder has the right to redeem the note at par on the coupon payment date after some specified amount of time. Called a "put" provision. 2. Coupon rate is capped at a floor and a ceiling. Upper and lower rate bounds are often called the collar.

Inflation-linked bond

Bonds that have coupons that are adjusted according to the rate of inflation.

Structured notes

Bonds that are based on stocks, bonds, commodities or currencies.

Equity vs. Debt

1. Debt is not an ownership interest in the firm. Creditors generally do not have voting power. 2. The corporation's payment of interest on debt is considered a cost of doing business and is fully tax deductible. Dividends paid to stockholders are not tax deductible. 3. Unpaid debt is a liability of the firm. If it is not paid, the creditors can legally claim the assets of the firm, resulting in liquidation or reorganization of the firm.

Parts of the indenture

1. The basic terms of the bonds 2. The total amount of bonds issued 3. A description of property used as security 4. The repayment arrangements 5. The call provisions 6. Details of the protective covenants

Factors that determine the shape of the term structure

1. The real rate of interest: High real rate of interest --> the high interest rates 2. The rate of inflation: a. High future inflation--> long-term nominal rates > short-term nominal rates--> upward sloping term structure b. Low future inflation--> long-term nominal rates < short-term nominal rates--> downward sloping term structure 3. Interest rate risk: The longer the term to maturity, the greater the interest rate risk, thus the higher the interest rate risk premium. However, these increase at a decreasing rate.

Convertible bond

A bond that can be swapped for a fixed number of shares of stock any time before maturity at the holder's option.

Call-protected bond

A bond that during a certain period, cannot be redeemed by the issuer.

Zero coupon bonds

A bond that pays no coupons at all and therefore must be offered at a much lower price than its stated value.

Premium bond

A bond that sells for greater than face value. This occurs whenever a bond's coupon rate is greater than the market rate for a bond.

Discount bond

A bond that sells for less than face value. This occurs whenever a bond's coupon rate is less than the market rate for a bond.

Current yield

A bond's annual coupon divided by its price.

Deferred call provision

A call provision that prohibits the company from redeeming a bond prior to a certain date.

Yield curve

A graphical representation of the term structure.

Protective covenant

A part of the indenture that limits certain actions a company might otherwise wish to take during the term of the loan, usually to protect the lender's interest. Classified into two types: 1. Negative covenant: "Thou shalt not." Limits actions a company might take. Ex: The firm cannot pledge any assets to other lenders. 2. Positive covenant: "Thou shalt." Specifies actions the company agrees to take. Ex: The company must maintain its working capital at or above some specified minimum level.

Reverse convertible bond

A relatively new type of bond that which offers a high coupon rate, but the redemption at maturity can be paid in cash at par value or paid in shares of stock.

Sinking fund

An account managed by the bond trustee for the purpose of repaying the bonds, often before maturity. Basically, the company makes annual payments to the trustee who then uses the funds to retire a portion of debt, either by buying up some of the bonds in the market or calling in a fraction of the outstanding bonds.

Call provision

An agreement giving the corporation the option to repurchase a bond at a specified price prior to maturity.

Debenture

An unsecured bond, for which no specific pledge of property is made. Usually has a maturity of 10 years or more.

Repayment

Bonds may be repaid at maturity, at which time the bondholder will receive the face value of the bond. Or, bonds may be repaid in part or in entirety before maturity (often through a sinking fund).

Income bonds

Bonds that are similar to conventional bonds except the coupon payments are dependent upon company income. Coupons are paid to bondholders only if the company's income is sufficient.

Factors that influence a bond's present value

Determined by: 1. Number of periods remaining until bond's maturity. 2. Face value of bond 3. The coupon 4. The market interest rate for bonds with similar features (YTM)

Trustee

Entity, usually a bank, that is appointed by the corporation to represent the bondholders. Functions: 1. Make sure the terms of the indenture are obeyed. 2. Manage the sinking fund. 3. Represent the bondholders if the company defaults on its payments to them .

Collateral

General term used to refer to securities or assets that are pledged for the repayment of a loan or debt.

Senority

In general terms, indicates preference in position over other lenders, and debts can be sometimes labeled as senior or junior to indicate the order of preference. In the case of default, subordinated debt must give preference to other creditors. However, debt cannot be subordinated to equity.

Real rates

Interest rates or rates of return that have been adjusted for inflation. How will your purchasing power change?

Nominal rates

Interest rates or rates of return that have not been adjusted for inflation. How will the number of dollars change?

Interest rate risk

Often also called price risk. Is the risk that arises for bond owners from fluctuating interest rates. Depends on exactly how sensitive a bond's price is to interest rate changes. Sensitivity of a bonds price to this kind of risk depends directly on: the time to maturity and the coupon rate. Note: 1. All other things equal, the longer the time to maturity, the greater the interest rate risk. 1. All other things equal, the lower the coupon rate, the greater the interest rate risk.

Face value (or par value)

The amount or principal of a bond that will be repaid when a bond reaches maturity.

Coupon rate

The annual coupon divided by the face value of a bond.

Interest rate risk premium

The compensation investors demand for bearing interest rate risk.

Borrower (or debtor)

The corporation or entity borrowing the money.

Bid-ask spread

The difference between the bid price and the ask price. Represents the dealer's profit.

Bearer form

The form of bond issue in which the bond is issued without record of the owner's name; payment is made to whomever holds the bond.

Registered form

The form of bond issue in which the registrar of the company records ownership of each bond ( and any changes in ownership); payment is made directly to the owner of record.

Indenture

The legal written agreement between the corporation and the lender, detailing the terms of the debt issue. Sometimes referred to as the deed of trust.

Time to maturity

The number of years until the bond's face value is paid.

Lender (or creditor)

The person or firm providing the loan.

Liquidity premium

The portion of a bond yield that represents compensation for lack of liquidity.

Default risk premium

The portion of a bond yield that represents compensation for the possibility of default. The lower the rating of a bond the higher the yield of that bond.

Taxability premium

The portion of a bond yield that represents compensation for unfavorable tax status.

Inflation premium

The portion of a nominal interest rate that represents compensation for the erosionary effects of expected future inflation.

Bid price

The price a dealer is willing to pay for a security.

Ask price

The price a dealer is willing to take for a security.

Dirty price

The price of a bond including accrued interest, also known as the full or invoice price. This is the price the buyer actually pays.

Clean price

The price of a bond net of accrued interest; this is the price that is typically quoted.

Yield to maturity (YTM)

The rate required in the market for bonds with similar features.