Chapter 7 Finance: Interest Rates and Bond Valuation
what are income bonds?
coupon payments depend on company income only paid if company has sufficient income
What are treasury notes three most important features?
default free Taxable highly liquid
Why are the yields of municipal bonds much lower than the yields of taxable bonds?
due to the large tax benefit
what dies the value of the floating bond depend on?
exactly how the coupon payments adjustments are defined
what is collateral?
general term that frequently means securities that are pledged as security for repayment of debt. any asset pledge on debt
what is the inflation linked bond?
have coupons that are adjusted according to the rate of inflation. (principal amount maybe adjusted as well).
waht is note used for?
if the maturity for unsecured bond is 10years or less
what are short term debt securities?
maturity occurs in one year or less. unfunded debt
what is a put bond?
Put bond gives the owner of bond the right to force the issuer to buy back the security (usually at face value) prior to the maturity date
How did the trade report compliance engine make the bond market more transparent?
TRACE shows the trade information for corp bonds
To determine the real rate. How many pizzas at $5 per pizza can we buy with 115.50? After inflation (5% per year) pizza increase to $5.25, now how many pizzas can we buy?
The investment is $100 intiaially. Before i take the invesment i could buy 100/5 = 20 pizzas after investment (one year later at 5% inflation rate) i could buy 115.50/5.25 = 22 pizzas rate of return 20/22 = .909 or 9.09 percent richer
what occurs to bond when interest rates decline?
the bond is worth more
What does it mean to say that the bond with the lower coupon has a higher interest rate risk?
the bond with the higher coupon has larger cash flow early in life, so its value is less dependent on the face value amount and fluctuation in interest rate.
Is the call price above or below face/par value?
the call price is generally above
What occurs to the cash flow of bond when interest rates fluctuate in the market?
the cash flows from bonds stay the same.
what is the second to last and the last quoted item in TRACE?
the change in asked price from the previous day (in 32nd ticks) the yield to maturity
What is the interest rate risk premium?
the compensation investors demand for bearing interest rate risk Increases with the length of maturity
What is the real rate of interest?
the compensation investors demand for forgoing the use of their money think of it as the pure time value of money after adjusting for inflation basic component underlying every interest rate, regardless of matutity
What is the second main difference bxt debt and equity?
the corporations payment of interest on debt is considered a cost doing business and is fully tax deductible. Dividends paid to stockholders are NOT tax deductible.
what are floating rate bonds?
the coupon payments are adjustable. the adjustments are tied to an interest rate index
what is the bid-ask spread?
the difference between the bid price and the asked price represents dealers proft
what is call premium
the difference bxt the call price and the stated value the amount of call premium may become smaller over time
what is bearer form?
the form of bind issue in which the bind is issued without record of the owners name. payment is made to whomever sends in the coupons attached to the bonds
What is registered form?
the form of bond issued in which the registrar of the company records ownership of each bond payments made directly to the owner
what does it mean to say that The difference in interest rate risk increases at a decreasing rate?
the graph has a steep upward slop (bxt year 1 and 10) and then begins to level off around year 20-30
two common features of floaters?
the holder has the right to redeem the note at par on the coupon payment date after some specified amount of time. this is call a put provision 2. the coupon rate has a floor and a ceiling (max or min),
what does NCAA mean?
"no coupon at all" not good for investors "junk or defaulted" bond
Positive protective covenants
"thou shalt" it specifies action the company agrees to take or a condition the company must abide by 1. the company must maintain its working capital at or above some specified minimum level 2. the company must periodically furnish audited financial statements to the lender 3. the firm must maintain any collateral of security in good condition
What is the present value of these cash flows in the appropriate real discount rate?
(1.1) = (1+r) *(1.04) 1.0577 = 1+r r = 5.77% PV = 25,000 [1-(1/1.0577^3)]/0.0577 = $67,110.68
CORPORATE BONDS ARE USUALLY CALLABLE
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DETERMINANT OF BOND YEILDS
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Formula for Fisher effect?
1 + R = (1+r) * ( 1+h) R is the nominal rate r is the real rate h is the inflation rate
What are securities issued by corps classified as?
1. equity securities 2.debt securitities
Bond Yields represent the combined effect of no fewer than six things, what are these six things?
1. expected future inflation 2. interest rate risk 3. default risk 4. taxability 5. lack of liquidity
What must the trust company do? (3)
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 the payment
Three common types of sinking fund?
1. some sinking funds start about 10 years after the initial issuance 2. some sinking funds establish equal payments over the life of the bond 3. high-quality bond issues establish payments to the sinking fund that are not sufficient to redeem the entire issue. As a consequence, there is a large balloon payment at maturity.
What 6 provisions are generally included on the the indenture?
1. the basic term 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
The nominal rate is 15.5% and the inflation rate is 5%, what is the real rate.
1.155 =(1 +r)*(1.05) 1.1 = 1+r r= 0.1 or 10%
Bind vs. note?
10 years or less maturity --> note more then 10 years to maturity --> bond
If investors require a 10% real rate return and the inflation rate is 8% what must be the approximate nominal rate? The exact nominal rate?
10% + 8 % = about 18% 1+R = 1.1 * 1.08 = 1.188 R= 0.188 18.8%
What is usually the face value of coporate bonds?
1000
What are zero coupon bonds?
A bond that makes no coupon payments and is thus initially priced at a deep discount. although no interest is paid, zero coupon bonds calculations use semiannual periods to be consistent with coupon calculations
What is the highest rating a frim can have?
AAA or Aaa and such debt is judged to be the best quality and to have the lowest degree of risk factor
what is default premium risk?
Because bonds are not default free the portion of a nominal interest rate or bond yield that represents compensation for the possibility of default
If a bond has 1. Face Value F 2. a coupon C paid per period 3. t periods to maturity 4. a yield of r per period what is its value?
Bond Value = C* [1-1/(1+r)^t]/r + F/(1+r)^t Present value of the coupons + Present Value of the Face amount
what is the current yield of a bond?
Bonds annual coupon/ price of bond Higher then yield for maturity on premium bonds because ignored the loss lower then yield for maturity on discount bonds because ignored the gain
What is the first main difference bxt debt and equity?
Debt is NOT ownership interest in firms. Creditors don't have voting power
How do determine how much a bond should sell for? ex. Butsin issues a bond with $80 coupon, 8 percent interest rate for the next 10 years. In ten years Butsin will pay $1,000 to the owner, what should the bond sell for?
Determine Present Value of the Bond PV = 1000 (1+1.08)^10 = $463.19 find the present value of the annuity Annuity PV = 80 * (1-1/1.08^10)/.08 = $536.81 $436.19 + $536.81 = $1,000 (face value)
How do we determine effect of inflation on the present value?
Either discount nominal cash flows at a nominal rate or discount real cash flows at a real rate?
The benefits and downfalls of equity
Equity = ownership interest. potential for greater reward. paid after creditors. tax payment on dividends
Suppos taxable bonds are currently yielding 8% whilea te the same time munis of comparable risk and maturity are yielding 6%. Which is more attractive to an investor in the 40 % tax brackets.
Munis: 8 * (1-.40) = 4.8 percent prefers the municipal bond
How does time affect interest rate risk?
The longer the time until maturity, the greater the interest rate risk. Interest rate premium increases at a decreasing rate along with the interest rate
what is the yield to maturity?
The rate requires in the market on the bond It is the interest rate by which the present values of all the future cash flows are equal to the bond's price.
What determines the shape of the term structure of interest rates?
The real rate of interest the rate of inflation The interest rate premium
Whats is the fisher effect?
The relationship between nominal returns, real returns and inflation.
We could also solve this using the growing annuity formula.
The withdrawals are increasing by 4% so we have PV = 26,000 [ (1- (1.04/1.1)^3) / .1-.04] = 26,000 (2.5812) = $67,111.65
what are municipal notes/bonds?
They are short-term securities that are normally issued to assist a municipality in financing a project or in managing its cash flow. almost always callable have default risk coupon exempt from federal ( but not state) taxes.
what is the largest securities market in the world?
US treasury market
How do we find a bonds yield to maturity?
We must use trial and error, because there is no way to solve for r explicitly. Look at the info we know. the bond is discounted and the coupon is $80 on 1000 face value, that means the interest rate is at more then 8%. go from there to check answers.`
What are cross over of spkit rating bonds?
a bond is rating one way by one agency and another way by a different agency
what is a cat bond?
a bond issued by reinsurance companies to insure insurance companies
What is a deferred call provision?
a call provision prohibiting the company from redeeming a bond prior to a certain date.
what is a protective convenant?
a part of the indenture limiting certain actions that might be taken during the term of the loan usually to protect the lenders interests
What is the treasury yield curve?
a plot of yields on treasury notes and bond relative to maturity based on coupon bond yields
How is debt securities classified?
according to the collateral and mortgages used to protect the binholder
What occurs when the real rate of interest is high?
all interest rates will tend to be higher and vice versa Doesnt determine shape of term structure but does influence overall interest rates!
What is interest rate risk?
all other things equal, the longer the time to maturity the greater the interest rate risk All other things being equal, the lower the coupon rate, the greater the interest rate risk. a relatively small change in interest rate leads to a large change in bond value
What is a call provision?
allows the company to repurchase or call part of the bond issued at stated prices over a specific period. Give corp. the option to repurchase before maturity.
how is the implicit interest determined?
amortizing the loan calculate bonds value at beginning of each year and then find the change in the bond value from year to year appealing because interest rates start off larger and get smaller as they go down.
What is a sinking fund?
an account managed by the bind trustee for early bond redemption begins to pay of bonds/buy back bonds on the market before maturity
What is a debt rating?
an assessment of the creditworthiness of the corporate issuer. Concerned only with default not based on interest rate risk based on how likely a company is to default and the protection against default
What type of loan is a bond usually?
an interest only loan. every payment you are paying the interest and not the principle. when the bond is at maturity, you pay the principle.
what is a debenture?
an unsecured bind for which no specific pledge of property is made holders have a claim only to the property that remains after collateral or mortgage trusts are taken into account.
Thus, what might an upward sloping term structure indicate?
anticipated increases in inflation
Why don't US treasury bond have no default risk?
because the treasury can always come up with the moey to make payments
When is bond trading larger then stock trading?
because, in general, corp have more outstanding bonds then stock
what are convertible bonds?
bonds that can be converted into shares of common stock at some predetermined ration at the discretion of the bondholder
fallen angel?
bonds that drop from higher rating to "junk"
what are warrants?
buyer of bond gets right to purchase stock in company st fixed prices often issued at low coupon rates
What is seniority in debt?
indicates preferences in position over other lenders, (can be label senior or junior) subortinants paid off only after junior and seniors debt always paid before equity
what might a downward sloping term structure indicate?
inflation will be falling in the future
What is the value of a bond based largely on?
interest rates
When is the term structure of interest rates a "hump"
interest rates increas at first but then begin to decline as we look at longer and longer tern rates,
What are nominal rates?
interest rates of return that have not been adjusted for inflation the percentage change in the number of dollars you have
What are real rates?
interest rates that have been adjusted for inflation is the percentage change in how much you can buy with your dollars. the % change in your buying power
A bond's credit ratings can change if...
issuers financial standing improves or deteriorates
negative protective covenants?
negative --> "thou shall not" it limits of prohibits actions the companies might take Examples of Negative? The firm must limit the amount of dividend paid according to formula the firm cannot pledge any assets to lenders the firm cannot merge with another firm the firm cannot sell or lease any major assets without approval from lender the firm cannot issue additonal long-term debt
is the bond market transparent?
no transactions are privately negotitated bxt parties
the difference between the nominal rate and the real rate?
nominal --> percentage change in the number of dollars you had real rate --> the percentage change in how much you buy with your dollars.% change in buying power
Lets say the inflation is 5 percent / year and investment is available that will be worth 115.50 in one year. It it cost 100 today, what is the rate f return?
nominal is 15.5%
In what terms are financial rates, interest rates and discount rates almost always quoted in?
nominal terms (R)
What are debt securities typically called?
notes, bonds, debentures,
what are long term debt securities?
over one year to maturity
What type of market is the bond market? o
over the counter
What is a blanket mortgage?
pledges all the real property owned by the company
what is transparency of market?
possible to easily observe its prices and trading volumes
What are all long term debt securities?
promises made by the issuing firm to pay principal when due ad to make timely interest payments on unpaid balance
What bonds are usually debentures?
public bonds
What are the two main forms of long term debt?
public issue and privately issued directly placed with the lender, not offered to public)
What is a call protected bond?
the bond in the stage of deferred cell provision
What is the present value of these cash flows in the appropriate nominal discount rate is 10%
pv = 26,000/(1.1) + 27,040/(1.1)^2 + 28,121.6/1.1^3 = $67,111.65 NOTICE WE DISCOUNTED THE NOMINAL CASH FLOWS AT THE NOMINAL RATE
Approximately the nominal rate is equal to?
r+h
What is debt?
result of borrowing money. must be paid
what are mortgage securities?
secured by a mortgageon the real property of the borrower, the property involved is usually real estate involves a mortgage trust indenture of trust deed
what is bond strictly speaking?
secured debt
what is a bond generally speaking?
secured or unsecured debts
What must the owner of the bond do to receive payments?
send in one of the coupons attached to the bonds to the corporation for payment
What is one type of arrangement for call premium?
set it to the annual coupon rate and the have it become smaller over time (moving toward zero)
what must we know in order to determine the value of a bond at a particular time?
t (time) Face value the coupon and the market interest rate for bonds with similar features
What else is unique (taxwise) about treasury bonds?
taxed only at the federal level on the coupons recieved. Not taxed at state level
What are treasury prices qouted in?
the 32nds so 137.29 actual means 137 29/32 so 137.90625
What is the the N and PMT for a bond with face vaule of 1000 that is 6 percent paid semiannually?
the PMT = 1000*6% = 60/2 = $30 the N is years to maturity * 2 so 10*2 = 20
What is the coupon rate of a bond?
the annual coupon divided by the face value of a bond interest payment/face value
Taxes of the zero coupon bond?
the issuer must deduct interest every year even though no interest is paid. the owner must pay taxes on interest every year even though no interest is actually recieved
what is the maturity of the long-term debt instrument?
the length of time debt is outstanding with unpaid balance
What occurs if investors believe the rate of inflation will be higher in the future?
the long-term nominal interest rates will tend to be higher than the short term rates
who is the borrower?
the person borrowing the money, making interest payments, and repaying the money
Who is the creditor/lender?
the person loaning the money
What is the inflation premium?
the portion of a nominal interest rate that represents compensation for expected future inflation
What is a taxability premium?
the portion of nominal interest rate or bond yeild that represents compensation for unfavorable tax status
What is a liquidity premium?
the portion or nominal interest rate or bond yield that represents compensation for lack of liquidity less liquid bonds have higher yields than more liquid bonds
What strongly influences the rate of the term structure?
the potential for future inflation
What occurs to bond when interest rates rise?
the present value of a bond's remaining cash flow declines bond is worthless
What is the dirty price?
the price of the bond including accrued interest also known as the full or invoice price the price the buyer actually pays
What is the clean price?
the price of the bond net the accrued interest. this is the price that is typically quoted
what is the bid price?
the price the dealer is willing to pay for the security
what is the asked price?
the price the dealer is willing to take for the security
What is the face value/par value of a bond?
the principal amount of a bond that is repaid at the end of the term. Also called par value
what three components doe the yield curve represent?
the real rate expected future inflation the interest rate risk premium
What are the three components of the nominal rate?
the real rate on the investment compensation for the decrease in the value of money originally invest because of inflation h compensations for the fact that the dollars earned on the investment are also worth less because of inflation (usually dropped because pretty small)
What is the term structure of interest rates? pure time value of money.
the relationship between the nominal interest rates on the default free, pure discount securities and time to maturity. That is the pure time value of money. involve no risk of default and a single lump sum for future payment.
what is the maturity?
the specified date on which the principal amount of a bond will be paid. usually 30 years for a corporation
What is the coupon of a bond?
the stated interest payment made on the bond.
what is the break even tax rate?
the tax rate at which an investor would be indifferent between a taxable and a nontaxable issue
What does the shape of the yield curve represent?
the term strucWture of interest rates
Suppose I want to withdraw money each year fort he next three years and I want each withdraw to have $25,000 worth of purchasing power as measured in current dollars. If the inflation rate is 4% what must occur to the withdrawals each year?
the withdrawals must increase by 4% each year. C1 =25,000 * 1.04 = 26,000 C2 = 25,000 * (1.04)^2 = 27,040 C3 = 25,000 * (1.04)^3 = 28,121.60 ect...
what is an indenture?
the written agreement between the corporation (borrower) and its creditors deed of trust
drawbacks to bearer form?
they are difficult to recover if they are lost or stolen because the company does not know who owns the bonds, it cannot notify the bondholders of important events
How do government or corporation borrow money long term?
they issue bonds
What is the straight-line basis for calculating interest expense?
total amount of interst "paid over the year" / the number of years
what are TIPS?
treasury inflation protected securities.
What is the third main difference bxt debt and equity?
unpaid debt is a liability of the firm. If it is not paid, the creditors can legally claim the assets of the firm. This action can result in liquidation or reorganization. or bankruptcy financial failure is not a possibility when equity is issued
what is the most common shape of the term structure?
upwards sloping
Who usually represents the bondholders?
usually a trustee appointed by corporation
Why do corporations try to create a debt security that is really and equity?
want to obtain tax benefits of debt while avoiding bankruptcy
How do we determine the made whole price?
we calculate the present value of the remaining interest and principal payments at a rate specificed in the indenture
What is a discount bond?
when a bond sells for less then its face value
what is a premium bond?
when a bond sells for more then face value
what is a "make-whole" call
when the bond is called the lender get the what the bond is worth. don't lose money and are "made whole"
When is the term structure of interest rates upward sloping?
when the longterm rates are higher than the short term rates
When is the term structure of interest rates downward sloping?
when the short term rates are higher than the long term
in most case how are coupons adjusted?
with a lag to a base rate
