Chapter 5: Bonds, Bond Valuation, and Interest Rates

Bond

A promissory note issued by a business or a governmental unit. -The value of a bond is found as the present value of an annuity (the interest payments) plus the present value of a lump sum (the principal payment). The bond is evaluated at the appropriate periodic interest rate over the number of periods for which interest payments are made. -Some special types of long-term financing include zero coupon bonds, which pay no annual interest but are issued at a discount; see Web Extension 5A for more on zero coupon bonds. Other types are floating-rate debt, whose interest payments fluctuate with changes in the general level of interest rates, and junk bonds, which are high-risk, high-yield instruments issued by firms that use a great deal of financial leverage.

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.

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 by property not the 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.

Convertible Bonds

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

Redeemable at Par

Gives investors the rights 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 higher rates.

A Call Provision

Gives the issuing corporation the right to redeem the bonds prior to maturity under specified terms, usually at a price greater than the maturity value (the difference is a call premium). A firm will typically call a bond if interest rates fall substantially below the coupon rate.

Junk Bonds

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

Premium Bond

If the current interest rates are below the coupon rate, a fixed-rate bond will sell at a premium above its par value.

Mortgage Bond

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

Abnormal Yield Curve

a downward sloping yield curve. Also called an inverted yield curve. The shape of the yield curve depends on two key factors: (1)expectations about future inflation and (2)perceptions about the relative risk of securities with different maturities.

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.

Market Interest Rate

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

Maturity Date

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

Normal Yield Curve

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

Secured Debt

debt for which a corporation pledges certain assets as security.

Bankruptcy

economic bankruptcy occurs when a company is insolvent because (1) its debt and other claims exceed the market value of it's assets or (2) it does not have enough cash to meet its interest and principal payment obligations. Legal bankruptcy occurs when a company or its creditors file for bankruptcy in the US Bankruptcy Court.

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.

A Sinking Fund

is a provision that requires the corporation to retire a portion of the bond issue each year. The purpose of the sinking fund is to provide for the orderly retirement of the issue. A sinking fund typically requires no call premium.

Reinvestment Rate Risk

occurs when a short term debt security must be rolled over. If interest rates have fallen then reinvestment of principal will be at a lower rate, which corresponds to lower interest payments and ending value.

Bond Insurance

protects investors against default by the issuer and provides credit enhancements 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 covenant.

Bond Rating

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

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 and future 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 rates to decrease.

Pure Expectations Theory

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

Yield Curve

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

Call Premium

the extra amount above the par value that company must pay if it calls a bond that has no call provision. The premium generally declines over time.

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.

Yield to Maturity (YTM)

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

Yield to Call

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

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.

Insolvent

Condition that occurs if (1) a company's total debt and other claims exceed the market value of its assets or (2) a company does not have enough cash to meet its interest and principal payments.

Subordinate Debentures

Debentures that have claims on assets, in the event of bankruptcy, only 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.

Corporate Bond

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.

Coupon Payment

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

Capital Gains Yield

Results from changing prices and is calculated as (P1-P0)/P0, where P0 is the beginning of period price and P1 is the end of period price.

Investment Grade Bonds

Securities with ratings of Baa/BBB or above.

Inflation Premium

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.

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 the similar investments. It is also called the required rate of return on debt (rd), the quoted market interest rate, the going rate, and the nominal interest rate.

Real Risk-Free Interest Rate (r*)

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.

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, rd. When the going rate of interest is above the coupon rate, the fixed-rate bond will sell at a discount below its par value.

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.