FIN 320 Chapter 6

Treasury yield curve

A plot of the yields on Treasury notes and bonds relative to maturity

Maturity

the number of years until the face value is paid. (The date on which the principal amount of a bond is paid.)

In common usage, the word bond refers to...

... all kinds of secured and unsecured debt

When looking at a bond, you should keep two things in mind:

1. All other things being equal, the longer the time to maturity, the greater the interest rate risk 2. All other things being equal, the lower the coupon rate, the greater the interest rate risk.

The main difference between debt and equity are as follows:

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 its not paid, the creditors can legally claim the assets of the firm. This action can result in liquidation or reorganization, two of the possible consequences of bankruptcy. Thus, one of the costs of issuing debt is the possibility of financial failure. This possibility does not arise when equity is issued.

Floating rate-bonds also have two following features:

1. The holder has the right to redeem the note at par on the coupon payment date after some specified amount of time. This is called a put provision. 2. The coupon rate has a floor and a ceiling, meaning that the coupon is subject to a minimum and a maximum. In this case, the coupon rate is said to be "capped" and the upper and lower rates are sometimes called the collar.

The sensitivity of price depends on two things:

1. the time to maturity 2.the coupon rate

Call protected bond

A bond that currently cannot be redeemed by the issuer.

Level Coupon bond

A bond that is constant and paid every year

Zero Coupon Bond

A bond that makes no coupon payments and thus is initially priced at a deep discount

Current Yield

A bond's annual coupon divided by its price

Deferred call provision

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

Protective covenant

A part of the indenture limiting certain actions that might be taken during the term of the loan, usually to protect the lender.

Sinking Fund

An account managed by the bond trustee for early bond redemption

Call provision

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

Debenture

An unsecured debt, usually with a maturity of 10 years or more.

Note

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

Semiannual Coupons

Bonds issued in the United States usually make coupon payments twice a year.

Nominal Rates

Interest rates or rates of return that have not been adjusted for inflation.

Structured notes

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

Interest Rate Risk Premium

The compensation investors demand for bearing interest rate risk.

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; payment is made dirtily to the owner of record

Liquidity premium

The portion of a nominal interest rate or bond yield that represents compensation for lack of liquidity.

Default Risk Premium

The portion of a nominal interest rate or bond yield that represents compensation for the possibility of default.

Taxability premium

The portion of a nominal interest rate or bond yield that represents compensation for unfavorable tax status.

Inflation Premium

The portion of a nominal interest rate that represents compensation for expected future inflation

Yield to Maturity (YTM)

The rate required in the market on a bond.

Term Structure of Interest Rates

The relationship between nominal interest rates on default-free, pure discount securities and time to maturity; that is, the pure time value of money.

Fisher effect

The relationship between nominal returns, real returns, and inflation.

Discount Bond

When a bond sells for less than face value

Par Value Bond

a bond that sells for its par value. Govt bonds usually have much larger face, or par, values.

Municipal notes are

also known as "munis" and they have a varying degree of default raise, and, in fact, they are rated much like corporate issues.

Convertible bond

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

Floating-rate bonds (floaters)

coupon payments are adjustable. The adjustments are tied to an interest rate index such as the Treasury bill interest rate or the 30-year Treasury bond rate.

The person or firm making the loan is called the _______

creditor (or lender)

The corporation borrowing the money is called the ________

debtor (borrower)

Securities issued by corporations may be classified roughly as _____ ________ and _______ _________.

equity securities; debt securities

Real rates

interest rates or rates of return that have been adjusted for inflation

Bid-asked spread

is the difference between the bid price and the asked price.

Asked "ask" price

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

Debt securities are typically called:

notes, debentures, or bonds.

How much interest rate risk a bond has depends on how __________ its price is to interest rate changes.

sensitive

Call premium

the amount by which the call price exceeds the par value of the bond

Coupon rate

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

A put bond allows

the holder to force the issuer to buy the bond back at a stated price

Bid price

the price a dealer is willing to pay 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.

Face Value or Par Value

the principal amount of a bond that is repaid at the end of the term. (usually $1,000 for corporate bonds)

Interest Rate Risk

the risk that arises for bond owners from fluctuating interest rates

A bond's coupon is

the stated interest payment made on a bond.

The indenture is

the written agreement between the corporation (the borrower) and its creditors

Inflation-linked bond

these have coupons that are adjusted according to the rate of the inflation. (The principal amount may be adjusted as well.

Short-term debt is sometimes referred to as ______ ________

unfunded debt