Chapter 7
Negative Covenant
A bond covenant that prohibits the firm from doing something "Though shall not"
Corporate bond dealers are now required to report trade information through what is known as the ...
... Trade Reporting and Compliance Engine (TRACE) FINRA provides a daily snapshot
Debt securities are classified according to the ...
... collateral and mortgages used to protect the bondholder
The person/firm making the load is called the ...
... creditor/lender
The corporation borrowing the money is called the ...
... debtor/borrower
When a bond sells for less than its face value, it is said to be a ...
... discount bond
Securities issued by corporations may be classified rough as ..
... equity securities and debt securities
When coupon rate < than the market rate, the value of the bond should be ...
... less than the face value
Financial rates, such as interest rates, discount rates, and rates of return, are almost always quoted in ...
... nominal terms
Debt Securities are typically called ...
... notes, debentures, or bonds
Bond prices and interest rates always move in ...
... opposite directions
Most trading in bonds take place ...
... over the counter (OTC)
A financial market is transparent if it is ...
... possible to easily observe its prices and trading volume *Bond market has little to no transparency
When a bond sells for more than its face value, it is said to be a ...
... premium bond *Investors are willing to pay a premium to get this extra coupon amount*
Long-Term Debt Securities are ...
... promises made by the issuing firm to pay principal when due and to make timely interest payments on the unpaid balance
The LOWER the coupon rate ...
... the GREATER the interest rate risk
The LONGER the time to maturity ...
... the GREATER the interest rate risk Ex: 30 years vs. 1 year
Because of the enormous tax break they receive ...
... the yields on municipal bonds are much lower than the yields on table bonds
Estimate Market Value of a Bond
1) First find Present Value 2) Then find Annuity Present Value Ex: PV = 1000/(1.08)^10 PV = $463.19 APV = 80 x (1 - 1/1.08)^10 APV = $536.81 Total Bond Value = $463.19 + $536.81 Total Bond Value - $1000
The number of bond issues exceeds the number of stock issues
1. A corporation usually has only one common stock issue outstanding, but could have a dozen or more bond issues 2. Federal, state, and local borrowing is enormous
1. Why do we say bond markets may have little or no transparency? 2. In general, what are bid and asks prices? 3. What is the difference between a bond's clean price and dirty price?
1. Because it is not easy to observe neither the bond prices nor the trading volume. Transactions are negotiated between the parties with no centralized reporting. 2. Bid: what a dealer is willing to pay. Ask: what a dealer is willing to take 3. A clean price is the price usually quoted. It is the price net of accrued interest. The dirty price includes accrued interest
The main differences between debt and equity are:
1. Debt is not an ownership in the firm - no voting rights 2. The corporation's payment of interest on debt is considered a cost of doing business and is fully tax deductible-- Unlike dividends, which are NOT tax deductible 3. Unpaid debt is a liability to the firm. If not paid, the creditors can legally claim the assets of the firm *Financial failure does not arise when equity is issued*
1. What does a bond rating say about the risk of fluctuations in a bond's value resulting from interest rate changes? 2. What is a junk bond?
1. Nothing. They are not dependent. They only address default risk 2. Bonds rated below investment grade or not rated at all
Two major forms of long-term debt are :
1. Public-Issue 2. Privately Placed The main difference is that privately placed debt is directly placed with a lender and not offered to the public
Terms of a Bond:
1. Registered Form 2. Bearer Form *Corporate bonds usually have a face value of $1000* *The par value of a bond is almost always the same as the face value, and the terms are used interchangeably*
Kinds of Sinking Funds:
1. Some start about 10 years after the initial issuance 2. Some funds establish equal payment over the life of the bond 3. Some high-quality bond issues establish payments to the sinking fund that are not sufficient to redeem the entire issue -- End up paying a balloon payment at maturity
1. What are the distinguishing features of debt compared to equity? 2. What is the indenture? What are protective covenants? Give some examples. 3. What is a sinking fund?
1. Sometimes it is not clear if a particular security is debt or equity. So one reason that corporations try to create a debt security that is really equity is to obtain the tax benefits of debt and the bankruptcy benefits of equity. As a general rule, equity represents an ownership interest, and it is a residual claim. This means that equity holders are paid after debt holders. As a result of this, the risks and benefits associated with owning debt and equity are different 2. The indenture is the written agreement between the corporation (the borrower) and its creditors. It is sometimes referred to as the deed of trust.3 Usually, a trustee (a trust company) is appointed by the corporation to represent the bondholders. The trust company must (1) make sure the terms of the indenture are obeyed. (2) manage the sinking fund. (3) represent the bondholders in default; that is, if the company defaults on its payments to them. Indenture Written agreement between the corporation and the lender detailing the terms of the debt issue. 3. A sinking fund is an account managed by the bond trustee for the purpose of repaying the bonds. The company makes annual payments to the trustee, who then uses the funds to retire a portion of the debt. Since it involves regular purchases, a sinking fund improves the marketability of the bonds
Floaters also have these features:
1. The holder has the right to redeem the note at par on the coupon payment date after some specified amount of time - called PUT 2. The coupon rate has a floor and a ceiling, meaning that the coupon is subject to a minimum and a maximum -- said to be "capped" -- and the upper and lower rates are sometimes called the COLLAR
Indentures include the following:
1. The 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
1. What are the cash flows associated with a bond? 2. What is the general expression for the value of a bond? 3. Is it true that the only risk associated with owning a bond is that the issuer will not make all the payments? Explain.
1. There are two: (1) Regular interest payments called coupons and (2) the face value to be paid at the end 2. Bond value = PV of the coupons + PV of the face value 3. No!!! There is an interest rate risk in proportion to the length of time to maturity.
Drawbacks to bearer bonds:
1. They are difficult to recover if they are lost or stolen 2. Because the company does not know who owns its bonds, it cannot notify bondholders of important events *Bearer bonds were once dominant, but they are now less common*
1. Why might an income bond be attractive to a corporation with volatile cash flows? Can you think of a reason why income bonds are not more popular? 2. What do you think would be the effect of a put feature on a bond's coupon? How about a convertibility feature? Why?
1. They are similar to conventional bonds, except that coupon payments are dependent on company income - coupons are paid to bondholders only if the firm's income is enough. Lack of demand, certainly not a lack of offer. 2. Having an option like the "put" would probably cause it to pay out less as a general rule. -This would make the bond worth more. - First for the option (or flexibility), and second, because the stock of the company may now actually be worth more
1. What is the term structure of interest rates? What determines its shape? 2. What is the Treasury yield curve? 3. What six components make up a bond's yield?
1.The term structure of interest rates is the relationship between interest rates or bond yields and different terms or maturities. The term structure of interest rates is also known as a yield curve, and it plays a central role in an economy. Long term rates are higher than short term rates- upward sloping; When short term rates are higher- downward sloping; the real rate of interest and the rate of inflation; interest rate risk 2. A plot of yields on Treasury notes and bonds relative to maturity Shape of yield curve reflects the term structure of interest rates. 3. 1. real rate of interest + five premiums representing compensation for (1) expected future inflation (2) interest rate risk (3) default risk (4) taxability (5) lack of liquidity
Bond Value
= C x [1-1/(1 + r)^t] / r + F / (1 + r)^t = PV of coupons + PV of face amount
Zero Coupon Bonds
A bond that makes no coupon payments and is thus initially priced at a deep discount
Call-Protected Bond
A bond that, during a certain period, cannot be redeemed by the issuer
Deferred Call Provision
A call provision prohibiting the company from redeeming a bond prior to a certain date
Collateral
A general term that refequently means securities that are pledged as security for payment of debt Ex: Collateral trust bonds often involved a pldge of common stock held by the corporation *Commonly used to refer to any asset pledged on a debt*
Junk Bond
A lower-rated, potentially higher-paying bond
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's interest
Treasury Yield Curve
A plot of the yields on treasury notes and bonds relative to maturity
Put Bond
Allows the holder to force the issuer to buy back the bond at a stated price Ex: International Paper Co. has bonds outstanding that allow the holder to force International Paper to buy the bonds back at 100% of face value if certain "risk" events happen
Sinking Fund
An account managed by the bond trustee for early bond redemption
Call Provision
An agreement giving the corporation the option to repurchase a bond at a specified price prior to maturity
Debenture
An unsecured debt, usually with a maturity of 10 years of more *No specific pledge of property is made* *Have a claim only on property not otherwise pledged -- the property that remains after mortgages and collateral trusts are taken into account
Note
An unsecured debt, usually with a maturity under 10 years
CoCo Bonds and NoNo Bonds
Are contingent convertible, putable, callable, subordinated bonds CoCo bonds - have a coupon payment NoNo bonds - Zero coupon payment
Mortgage Securities
Are secured by a mortgage on the real property of the borrower
If two bonds with different coupon rates have the same maturity, then the value of the one with the lower coupon is proportionately more dependent on the face amount to be received at maturity
As a result, its value will fluctuate more as interest rates change
Either discount nominal cash flows at a nominal rate or discount real cash flows at a real rate
As long as you are consistent, you will get the same answer
Make-Whole Call
Bondholders receive approximately what the bonds are worth if they are called
Structured Notes
Bonds that are based on stocks, bonds, commodities, or currencies
Sukuk
Bonds that have been created to meet a demand for assets that comply with Shariah, or Islamic law. Shariah does not permit the charging or paying of interest. Typically bought, held to maturity and extremely illiquid
Convertible Bond
Can be swapped for a fixed number of shares of stock anytime before maturity at the holder's option
Death Bond
Companies purchase life insurance policies from individuals who are expected to die within the next 10 years. They sell bonds that are paid off from the life insurance proceeds received when the policyholders pass away
A bond's credit rating can change as the issuer's financial strength improves or deteriorates
Credit ratings are important because defaults really do occur, and when they do, investors can lose heavily
Reverse Convertible
Offers a high coupon rate, but the redemption at maturity can be paid in cash at par value or paid in shares of stock Ex: One recent General Motors (GM) reverse convertible had a coupon rate of 16%, which is a very high coupon rate in today's interest rate environment. However, at maturity, if GM's stock declined sufficiently, bondholders would receive a fixed number of GM shares that were worth less than par value
Warrent
Gives the buyer of a bond the right to purchase shares of stock in the company at a fixed price *Would be valuable if the stock price climbed substantially*
Public bonds issued in the U.S. by industrial and financial companies are typically debentures
However, most utility and railroad bonds are secured by a pledge of assets
Tax Break Example:
In March 2014, long-term Aa-rated corporate bonds were yielding about 4.38%. At the same time, long-term Aa munis were yielding about 4.09%. Suppose an investor was in a 30% tax bracket. All else being the same, would this investor prefer a Aa corporate bond or a Aa municipal bond? The muni pays 4.09% on both pretax and aftertax. The corporate issue pays 4.38% before taxes, but it only pays .0438 x (1 - .30) = .0301 or 3.01% once we account for the 30% tax bite Given this, the muni has a better yield
The value of a floating-rate bond depends on exactly how the coupon payment adjustments are defined
In most cases, the coupon adjusts with a lag to some base rate
What is the largest securities market in the world?
In terms of trading volume, it would be the U.S. Treasury Market
Seniority
Indicates preference in position over other lenders -- Often labeled as senior or junior -Subordinated lenders will be paid off only after the specified creditors have been compensated *Debt cannot be subordinated to equity*
Real Rates
Interest rates or rates of return that have been adjusted for inflation
Nominal Rates
Interest rates or rates of return that have not been adjusted for inflation
AAA
Is the highest rating a firm's debt can have -Best quality and lowest degree of risk
Short-Term Debt (Unfunded Debt)
Less than one year
Blanket Mortgage
Pledges all the real property owned by the company
1 + R = (1 + r) x (1 + h)
R = Nominal rate r = Real rate H = Inflation rate
The nominal rate is *approximately* equal to the real rate plus the inflation rate
R == r + H
Income Bonds
Similar to conventional bonds, except that coupon payments depend on company income -Coupons are paid to bondholders only if the firm's income is sufficient
The issuer of a zero coupon bond deducts interest every year even though no interest is actually paid
Similarly, the owner must pay taxes on interest accrued every year, even though no interest is actually recevied
Positive Covenant
Specifies an action the company agrees to take or a condition the company must abide by "Though shall"
Municipal Notes/Bonds
State and local governments borrow these -They have varying degrees of default risk -Are rated much like corporate issues -Almost always callable *Their coupons are exempt from federal income taxes, making them attractive to high-income, high-tax bracket investors
Inflation-Linked Bond
Such bonds have coupons that are adjusted according to the rate of inflation
Call Premium
The amount by which the call price exceeds the par value of a bond *May become smaller over time*
Coupon Rate
The annual coupon divided by the face value of a bond Ex: $120/$1000 = 12%
Interest Rate Risk Premium
The compensation investors demand for bearing interest rate risk
Floating-Rate Bonds (Floaters)
The coupon payments are adjustable
Bond Ratings
The debt ratings are an assessment of the creditworthiness of the corporate issuer *Creditworthiness is defined as how likely the firm is to default and the protection creditors have in the event of a default*
Bid-Ask Spread
The difference between the bid price and the asked price
Bearer Form
The form of bond issue in which the bond is issued without record of the owner's names and payment is made to whomever holds the bond *Just like registered form bonds, coupons are attached and must be sent to company to receive payment*
Registered Form
The form of bond issue in which the registrar of the company records ownership of each bond and payment is made directly to the owner of record *Coupons are attached and must be sent to company to receive payment*
The nominal rate on an investment is the percentage change in the number of dollars you have
The real rate on an investment is the percentage change in how much you can buy with your dollars -- in other words, the percent change in your buying power
The risks and benefits associated with owning debt and equity are different
The maximum reward for owning a debt security is ultimately fixed by the amount of the load, whereas there is no upper limit to the potential reward from owning an equity interest
Default Risk Premium
The portion of a nominal interest rate of bond yield that represents compensation for the possibility of default
Liquidity Premium
The portion of a nominal interest rate or bond yield that represents compensation for lack of liquidity
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
Bid Price
The price a dealer is willing to pay for a security
Asked Price
The price a dealer is willing to take for a security
Dirty Price
The price of a bond including accrued interest; 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
Bond ratings are only concerned with the possibility of default
The price of a highly rated bond can still be quite volatile
Face Value (Par Value)
The principal amount of a bond that is repaid at the end of the term Ex: $1000
Bond yields are quoted like APRs
The quoted rate is equal to the actual rate per period multiplied by the number of periods Ex: 10% compounded semiannually - 10% is the quoted rate (stated rate) - The investment actually pays 5% every six months -EAR = $1 x 1.05^2 = 1.1025 = 10.25%
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
Interest Rate Risk
The risk that arises for bond owners from fluctuating interest rates
Maturity
The specified date on which the principal amount of a bond is paid Ex: 30 years
Coupon
The stated interest payment made on a bond Ex: $120
Indenture (Deed of Trust)
The written agreement between the corporation and the lender detailing the terms of the debt issue *Legal document*
Catastrophe Bond (Cat Bond)
These bonds cover catastrophic events, such as a hurricane
When the government wishes to borrow money for more than one year, it sells what are known as Treasury notes and bonds to the public
Treasury bonds have no default risk and are exempt from state income taxes *The coupons you receive on a Treasury note or bond taxed only at the federal level
Under current tax law, the implicit interest is determined by amortizing the loan
We do this by first calculating the bond's value at the beginning of each year. The implicit interest each year is simply the change in the bond's value for the year
Bond
When a corporation or government wishes to borrow money from the public on a long-term basis, it usually does so by issuing/selling debt securities that are generally called bonds
When interest rates rise, the present value of the bond's remaining cash flows DECLINES, and the bond is worth LESS
When interest rates fall, the bond is worth MORE
The call price is HIGHER when interest rate are LOWER
and vice versa
