Finance Ch. 6

Deferred call provision

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

What is the largest securities market in the world?

The US Treasury market

Why do we say bond markets may have little or no transparency?

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.

Maturity

Date on which the principal amount of a bond is paid

Nominal rates

Rates that have not been adjusted for inflation.

Why might an income bond be an attractive issue for a corporation with volatile cash flows?

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.

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 under 10 years.

Treasury yield curve

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

Sinking fund

An account managed by the bond trustee for early bond redemption.

The pure time value of money because it shows the relationship between ST and LT interest rates. It is composed of 1) real rate of interest 2) the rate of inflation 3) interest rate risk If LT interest rates are expected to be higher, the term structure slopes upward. If the interest rates in the short term are expected to be higher then there will be a downward slope.

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What is the term structure of interest rates? What determines it's shape?

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What are six components that make up a bonds yield?

1 real rate of interest +5 premiums representing compensation for: 2 expected future inflation 3 interest rate risk 4 default risk 5taxability 6 lack of liquidity

Call protected bond

A bond that currently cannot be redeemed by the issuer.

Current yield

A bonds annual coupon divided by its price. Ex.// $80/955.14= 8.38%

What is the difference between a bonds clean price and dirty price?

A clean price is the price usually quoted. It is the price net of accrued interest. The dirty price includes accrued interest.

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

What is a treasury yield curve?

A plot of maturity yields relative to maturity.

What are bid and ask prices?

Bid: what a dealer is willing to pay. Ask: what a dealer is willing to take.

What is the general expression for the value of a bond?

Bond value = PV of the coupons + PV of the face value. Bond Value = C x [1-1 / (1+r)^t] / r + F / (1+r)^t Where C is the coupon payment and F is the face value.

What do you think would be the effect of a "put" feature on a bond's coupon? How about a convertibility feature? Why?

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.

Real rates

Interest rates or rates of return that have been adjusted for inflation.

Why aren't income bonds popular?

Lack of demand, certainly not a lack of offer.

Junk bond

Less than a BBB rating by S&P or less than a Baa rating by Moody's

Is it true that the only risk associated with owning a bond is that the issuer will not make all the payments?

No!!! There is an interest rate risk in proportion to the length of time to maturity.

What does a bond rating say about the risk of fluctuations in a bonds value resulting from interest rate changes?

Nothing. They are not dependent.

What are the distinguishing features of debt as compared to equity?

Payment of interest on debt is tax deductible - cost of doing business - and debt holders are not like equity owners because unpaid debt is a liability.

Coupon

Stated interest payment made on a bond. If the coupon is constant and paid yearly it is called a "level coupon bond"

What does the configuration of the fisher effect reveal?

That the nominal rate, R, has three components.

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 the bond. Ex// $120/1,000=12%

Interest rate risk premium

The compensation investors demand for bearing interest rate risk.

Bid-ask spread

The difference between the bid price and the asked price.

What are some examples of protective covenants?

The firm cannot merge with another firm; the firm must maintain any collateral or security in good condition.

Bearer form

The form of bond issue in which the bond is issued without record of the owners 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 directly to the owner of record.

What is a sinking fund?

The fund that must be started during the debt period so as to pay off the face value and/or call provisions.

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 future inflation.

Bid

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, also known as 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/par value

The principal amount to be repaid at the end of the term.

Yield to Maturity

The rate required in the market for a bond. Present value= 1000/1.08^10= 1000/2.1589=463 Annuity present value= 80 x (1-1/2.1589) /.08= 536.81 Then: total bond value = 463.19+536.81 = 1,000 If we raise the interest rate by 2% then the total bond value = 884.82 so it's current value decreased.

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. 1+R=(1+r)x(1+h) R=nominal rate r=real rate

Interest Rate Risk

The risk that arises for bond owners from fluctuating interest rates. The longer the time to maturity the greater the interest rate risk. The lower the coupon rate, the greater the interest rate risk.

What is the indenture?

The written agreement between a firm and it's creditors - as in Deed of trust. It includes all the provisions and scheduled for payments.

Indenture

The written agreement between the corporation and the lender detailing the terms of the debt issue.

What are the cash flows associated with a bond?

There are two: (1) Regular interest payments called coupons and (2) the face value to be paid at the end.

What are the three components of the nominal rate?

There is the real rate on the investment, r. There is the compensation for the decrease in the value of money originally invested because of inflation - h. There must be compensation for the fact that even the dollars earned on the investment are also worth less because of the inflation.