Finance 300 Ch. 7

Which of the following risk premiums compensates for the inability to easily resell a bond prior to maturity?

Liquidity.

Put bond

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

Income bonds

Coupon depends on income of corporation

Bonds

A debt instrument issued by corporations or governments to borrow money for investments. Generally an interest-only loan, with regular interest payments (called coupons) and the principal payment at the end.

Protective covenants

A part of the indenture limiting certain actions that might be taken during the terms of the loan Usually to protect investors Two types: positive and negative covenants

Coupon rate

Annual interest rate

Protective covenants

Are primarily designed to protect bondholders.

Structured notes

Bonds based on stocks, commodities, or currencies

Repayment

Bonds can be repaid: At maturity In part or in entirety before maturity Sinking fund: account managed by the bond trustee for the purpose of repaying the bonds. Firm makes annual payments to the trustee, who then uses funds to retire portion of the debt. Arrangements for repayment come in many different forms.

Convertible bond

Can be swapped for a fixed number of shares

Quoted bond prices

Clean price: price of a bond net excluding accrued interest Dirty price: price of bond including interest; known as full or invoice price. Price the buyer actually pays.

Security

Collateral: securities that are pledged as security for payment of debt. (Commonly used to refer to asset pledges on a debt) Mortgage securities: secured by a mortgage on a real property of the borrower (your house). Unsecured debt: Debentures: original maturity of 10+ years Notes: original maturity under 10 years

Floating rate bonds (floaters)

Coupon rates are adjustable from base rate Collar: coupon rate has a floor and a ceiling. Coupon rate is capped Inflation linked bond: coupons adjusted according to rate of inflation. Ex: TIPS (treasury inflation protected securities)

Current yield vs. yield to maturity

Current yield = annual coupon / price Yield to maturity = current yield + capital gains yield

Bond ratings

Debt rating: assessment of the creditworthiness of the corporate issuer. Based on how likely the firm is to default and protection creditors have in the event of default.

Other risk factors

Default risk premium: compensation for possibility of default. Demand a higher yield as risk won't receive promised payments. Junk bonds are called high-yield buy really its high promised yield. Taxability premium: compensation for unfavorable tax treatment Liquidity premium: compensation for lack of liquidity (some bonds are easily tradeable without losing value)

Debt vs. equity

Equity Ownership interest Common stockholders vote for the board of directors and other issues Dividends are not considered a cost of doing business and are not tax deductible Dividends are not a liability of the firm, and stockholders have no legal recourse if dividends are not paid An all equity firm can not go bankrupt merely due to debt since it has no debt Debt Not an ownership interest Creditors do not have voting rights Interest is considered a cost of doing business and is tax deductible Creditors have legal recourse if interest of principal payments are missed Excess debt can lead to financial distress and bankruptcy

Warrant

Gives the buyer of the bond the right to purchase shares of stock in the company at a fixed price

A newly issued bond has a 7 percent coupon with semiannual interest payments. The bonds are currently priced at par. The effective annual rate provided by these bonds must be:

Greater than 7 percent.

Relationship between coupon and yield

If YTM = coupon rate, then par value = bond price If YTM > coupon rate, then par value > bond price. (Why? The discount provides yield above coupon rate. Price below par value is called a discount bond) If YTM < coupon rate, then par value < bond price. (Why? Higher coupon rate causes value above par. Price above par value, called a premium bond)

Real rates are defined as nominal rates that have been adjusted for which of the following?

Inflation.

You expect interest rates to decline in the near future even though the bond market is not indicating any sign of this change. Which one of the following bonds should you purchase now to maximize your gains if the rate decline does occur?

Long-term; zero coupon.

Last year, you purchased a TIPS at par. Since that time, both market interest rates and the inflation rate have increased by .25 percent. Your bond has most likely done which of the following since last year?

Maintained a fixed real rate of return.

Zero coupon bonds

Make no periodic interest payments (coupon rate = 0) The entire yield-to-maturity comes from the difference between the purchase price and the par value

DLQ Inc. bonds mature in 12 years and have a coupon rate of 6 percent. If the market rate of interest increases, then the:

Market price of the bond will decrease.

Interest rates

Nominal: not adjusted for inflation, percentage change in the number of dollars you have Real: have been adjusted for inflation, percentage change in how much you could buy with your dollars

Municipal bonds:

Pay interest that is federally tax free.

Seniority

Preference in position over other lenders. Labeled as senior or junior Subordinated: paid off only after specified creditors have been compensated. Note: Debt CANNOT be subordinated to equity.

Interest rate risk

Price risk Change in price due to changes in interest rates Long-term bonds have more price risk than short-term bonds Low coupon rate bonds have more price risk than high coupon rate bonds Reinvestment rate risk Uncertainty concerning rates at which cash flows can be reinvested Short-term bonds have more reinvestment rate risk than long-term bonds High coupon rate bonds have more reinvestment rate risk than low coupon rate bonds

Bond valuation principle

Primary principle: value of financial securities = PV of expected future cash flows. Bond value is determined by the present value of the coupon payments plus the present value of the par (face) value. Bonds of similar risk will be priced to yield the same return. If you know the price of one bond, you can estimate its YTM and use that to find the price of another bond of similar risk. As interest rates increase, bond prices decrease.

Par value

Principal repaid, usually $1,000 per bond Discount bond: price < par value Premium bond: price > par value

A deferred call provision is which one of the following?

Prohibition which prevents bond issuers from redeeming callable bonds prior to a specified date.

Components of term structure

Real rate of interest: compensation investors demand for forgoing the use of their money Inflation premium: compensation investors demand for reduction in purchasing power due to inflation (expected future inflation) Interest rate risk premium: compensation for holding long-term bonds and bearing risk of loss resulting from change in interest rates

Terms of a bond

Registered form: Registrar of the company records ownership of each bond; payment is made directly to the owner of record. Bearer form: The bond is issued without record of the owner's name; payment is made to whomever holds the bond.

Maturity date

Specified date on which principal is repaid

Coupon payment

Stated interest payment

Bond markets

The U.S. Treasury market is the largest securities market in the world = $40 trillion in value Bonds are primarily traded OTC The bond market is NOT transparent TRACE (trade reporting and compliance engine): required reporting of trade info, FINRA (financial industry regulatory agency) provides daily snapshot of TRACE

Yield to maturity

The YTM is the rate required in the market on a bond, also called the yield. The coupon rate is often different from the yield. When the value = the principal, however, the coupon rate equals the yield.

Round Dot Inns is preparing a bond offering with a coupon rate of 6 percent, paid semiannually, and a face value of $1,000. The bonds will mature in 10 years and will be sold at par. Given this, which one of the following statements is correct?

The bonds will sell at a premium if the market rate is 5.5 percent. (Because the coupon rate is greater than the interest payment)

Which one of these is a negative covenant that might be found in a bond indenture?

The company cannot lease any major assets without bondholder approval.

Fisher effect

The relationship between nominal returns, real returns, and inflation 1 + R = (1 + r) x (1 + h) R = nominal rate r = real rate h = inflation rate

Term structure of interest rates

The relationship between the interest rate and the investment term is called the term structure of interest rate

The yield curve and the economy

The shape of the yield curve is influenced by interest rate & inflation expectations Because interest rates tend to fall in response to an economic slowdown, an inverted yield curve is often interpreted as a negative forecast for economic growth Each of the last six recessions in the United States was preceded by a period in which the yield curve was inverted.

The bond indenture

The written agreement between the corporation and the lender detailing the terms of the debt issue Trustee represents bondholders and must: Ensure terms are obeyed Manage sinking fund Represent bondholder in default Legal document Generally includes: basic terms of the bond, total amount of bonds issued, description of property used as security (collateral), repayment arrangements, call provisions, protective covenants.

Types of bonds - government

Treasury securities: Federal government debt Municipal securities Debt or state and local governments Varying degrees of default risk, rated similar to corporate debt Interest received is tax-exempt at the federal level

A six-year, $1,000 face value bond issued by Taylor Tools pays interest semiannually on February 1 and August 1. Assume today is October 1. What will be the difference, if any, between this bond's clean and dirty prices today?

Two month's interest.

Kurt has researched T-Tek and believes the firm is poised to vastly increase in value. He has decided to purchase T-Tek bonds as he needs a steady stream of income. However, he still wishes that he could share in the firm's success along with the shareholders. Which one of the following bond features will help him fulfill his wish?

Warrant.

Call provision

an agreement giving the corporation the option to repurchase a bond at a specified price prior to maturity. Why would a firm want to include a call provision? Corporate bonds are typically callable Call premium: difference between call price and stated value (par value) Deferred call provision: prohibiting the company from redeeming a bond prior to a certain date. Call protected bond: A bond that, during a certain period, cannot be redeemed by the issuer.