Finance Ch. 7
An unsecured debt usually with a maturity under 10 years
Note
Treasury bid and ask prices on a Treasury bond are sometimes given in terms of yields, so there would be a bid yield and an ask yield. WHich do you think would be higher?
Prices and yields move in opposite directions. Since the bid PRICE must be lower, the bid YIELD must be higher
What is the major difference between public issue and privately placed bonds?
Privately placed bonds is directly placed with a lender and not offered to the public, and because this is a private transaction, the specific terms are up to the parties involved
A ___ ___ is that part of the indenture or loan agreement that limits certain actions a company might otherwise wish to take during the terms of the loan
Protective covenant
A ___ bond allows the holder to force the issuer to buy back the bond at a stated price. For example, if a change in bond rating occurs
Put bond
The ____ ___ on an investment is the percentage change in how much you can buy with your dollars---in other words, the percentage change in your purchasing power
Real rate
Interest rates or rates of return that have been adjusted for inflation
Real rates
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
Registered form
The ___ ___ bond is a relatively new type of structured note. One type generally offers a high coupon rate, but the redemption at maturity can be paid in cash at par value or paid in shares of stock.
Reverse convertible bond
A ____ ___ 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. The trustee does this by either buying up some of the bonds in the market or calling in a fraction of the outstanding bonds.
Sinking fund
Why might an investor be more concerned with the nominal rate of return rather than the real rate of return?
Some investors have obligations that are denominated in dollars; that is, they are nominal. Their primary concern is that an investment provide the needed dollar amounts. Pension funds, for example, often must plan for pension payments many years in the future. If those payments are fixed in dollar terms, then it is the nominal return on an investment that is important
The portion of a nomina interest rate or bond yield that represents compensation for unfavorable tax status
Taxability premiums
The relationship between nominal interest rates on default-free, pure discount securities and time to maturity; that is, the pure time value of money
Term structure of interest rates
When interest rates rise, what happens to the PV of the bond's remaining cash flows?
The PV declines
What is the main difference between the Treasury Yield Curve and the Term Structure
The Term Structure is based on pure discount bonds, whereas the yield curve is based on coupon bond yields
READ
The amount of the total amount of the discount is the foregone coupon payments if the bond were issued with present market conditions
What is the benefit and cost of the issuer from including a Put Provision in the bond?
The benefit is that it lowers the coupon rate. The cost is that it may have to buy back the bond at an unattractive price
What does it mean if the current yield is lower than the YTM?
The current yield considers only the coupon portion of your return; it doesn't consider the built-in gain from the price discount; for a premium bond the reverse is true, meaning that current yield would be higher because it ignores the built-in loss
What is the equation for the Fisher Effect?
1 + R = (1+r)(1+h) R stands for the nominal rate r stands for the real rate h stands for inflation
What do we need to know about a bond to determine its value at a specific point in time? (4 things)
1. # of periods remaining until maturity 2. Face Value 3. Coupon 4. Market interest rate for bonds with similar features
What are the 2 reasons that the number of bond issues far exceeds the number of stock issues
1. A corporation would typically have only one common stock issue outstanding; however, a signle large corporation could easily have a dozen or more note and bond issues outstanding 2. The bond market is not transparent
What are the 3 basic components that determine the shape of the term structure
1. Real rate of interest (the compensation investors demand for forgoing the use of their money) 2. Rate of inflation 3. Interest rate risk
What are 3 examples of possible sinking fund arrangements
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. Some high-quality bond issues establish payments to the sinking fund that are not sufficient to redeem the entire issue
What are the 2 features of floating rate bonds
1. The holder has the right to redeem the note at par on the coupon payment date after some specified amount of time---called a PUT provision 2. The coupon rate has a floor and a ceiling, meaning that the coupon is subject to a minimum and maximum
What two things does the sensitivity of interest rate risk depend on?
1. The time to maturity --- the longer the time to maturity, the greater the interest rate risk 2. Coupon rate --- the lower the coupon rate, the greater the interest rate risk
What are two important things to know about US Treasury Bonds
1. There is no default risk 2. Exempt from state income taxes, but not federal income taxes
What are the 2 drawbacks of bearer bonds?
1. They are difficult to recover if lost or stolen 2. Because the company does not know who owns its bonds, it cannot notify bondholders of important events
What are 3 things to know about Munis (municipal bonds)
1. They have varying degrees of default risk and are rated like corporate bonds 2. Their coupons are exempt from federal income tax, but they are taxed at the state level 3. They are almost always callable
What are the costs for the issuer of including a call provision?
A higher coupon
The price a dealer is willing to take for a security
Ask price
READ
At the current time, public bonds issued in the US by industrial and financial companies are typically debentures. However, most utility and railroad bonds are secured by a pledge of assets
The form of bond issue in which the bond is issued without record of the owner's name; payment is made to whomever holds the bond (usually mails in the coupon)
Bearer form
Why is the term structure sometimes "humped"?
Because rates increase at first, but then begin to decline as we look at longer and longer-term rates.
The price a dealer is willing to pay for a security
Bid Price
The difference between the ask price and the bid price --- it represents the dealer's profit
Bid-ask spread
What is the equation in word to calculate bond value?
Bond Value = PV of the coupons + PV of the face amount
Looking back at crossover bonds,s why do you think split ratings such as these occurred/
Bond ratings have a subjective factor to them. Split ratings reflect a difference of opinion among credit agencies
The amount by which the call price exceeds the par value of a bond
Call premium
A ____ ____ allows the company to repurchase or "call" part or all of the bond issue at stated prices over a specific period. Generally this price is above the bond's stated value
Call provision
A bond that, during a certain period, cannot be redeemed by the issuer
Call-protected bond
The price of a bond net of accrued interest; this is the price that is typically quoted
Clean price
____ is a general term that frequently means securities that are pledged as security for payment of debt
Collateral
A ____ bond can be swapped for a fixed number of shares of stock anytime before maturity at the bondholder's option.
Convertible bonds
The stated interest payment made on a bond
Coupon
The annual coupon divided by the face value of a bond
Coupon rate
A bond's annual coupon divided by its price
Current yield
What is the relationship between the current yield and YTM for premium bonds? What about for bonds selling at par value?
Current yield is defined as the annual coupon payment divided by the current bond price. For premium bonds, the current yield exceeds the YTM, for discount bonds the current yield is less than the YTM, and for bonds selling at par value, the current yield is equal to the YTM. In all cases, the current yield plus the expected one-period capital gains yield of the bond must be equal to the required return.
An unsecured bond for which no specific pledge of property is made. They have a claim on property not otherwise pledged---in other words, the property that remains after mortgages and collateral trusts are taken into account
Debenture
Other than interest rate risk, real rate, and inflation premium, what are 3 things that affect the Treasury Yield Curve
Default Risk Premium Taxability Premium Liquidity Premium
The portion of a nominal interest rate or bond yield that represents compensation for the possibility of default
Default risk premium
A call provision prohibiting the company from redeeming a bond prior to a certain date
Deferred call provision
The price of a bond including accrued interest, also known as the full price or invoice price. This is the price the buyer actually pays
Dirty Price
The relationship between nominal returns, real returns, and inflation
Fisher Effect
What are the benefits for the issuer of including a call provision? There are 2
Fist, the company can take advantage of interest rate declines by calling in an issue and replacing it with a lower coupon issue. Second, a company might wish to eliminate a covenant for some reason. Calling the issue does this
With ____-___ ___, the coupon payments are adjustable. The adjustments are tied to an interest rate index such as the Treasury Bill interest rate. The value of this bond depends on exactly how the coupon payment adjustments are defined. In most cases, the coupon adjusts with a lag to some base rate
Floating-rate bonds
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For tax purposes, the issuer of a zero coupon bond deducts interest every year even though no interest is actually paid, and the bondholder must pay taxes on interest accrued every year even though none was actually received
All else equal, the longer the time to maturity the ____ the interest rate risk
Greater
All else equal, the lower the coupon rate, the ___ the interest rate risk
Greater
____ bonds are similar to conventional bonds, except that coupon payments depend on company income. Specifically, coupons are paid to bondholders only if the firm's income is sufficient.
Income bonds
The ____ is the written agreement between the corporation (borrower) and its creditors. It generally includes the following provisions: The basic terms of the bond The total amount of bonds issued A description of property used as security The repayment arrangements The call provisions Details of the protective covenants
Indenture
The portion of a nominal interest rate that represents compensation for expected future inflation Investors thinking about lending money for various lengths of time recognize that future inflation erodes the value of the dollars that will be returned, as a result they demand compensation for this loss in the form of higher nominal rates. Big factor in the shape of the term structure
Inflation premium
The risk that arises for bond owners from fluctuating interest rates
Interest rate risk
The compensation investors demand for bearing interest rate risk
Interest rate risk premium
How does Moody's and S&P determine a corporation's bond rating?
Its based on how likely the corporation is to default and the protection creditors have in the event of default
Any bond rated lower than a BBB is called what?
Junk bond
What are the implications for bond investors of the lack of transparency in the bond market?
Lack of transparency means that a buyer or seller can't see recent transactions, so it is much harder to determine what the best bid and ask prices are at any point in time
The portion of a nominal interest rate or bond yield that represents compensation for lack of liquidity
Liquidity premium
What are the two leading bond-rating firms?
Moody's and Standard and Poor's (S&P)
_____ ____ are secured by a mortgage on the real property of the borrower.
Mortgage securities
Is it possible for the bid price to be higher than the ask price?
No. If the bid price were higher than the ask price, the implication would be that a dealer was willing to sell a bond and immediately buy it back at a higher price.
The ___ ___ on an investment is the percentage change in the number of dollars you have
Nominal rate
Interest rates or rates of return that have not been adjusted for inflation
Nominal rates
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The real rate of interest is the basic component underlying every interest rate, regardless of the time to maturity. When the real rate is high, all interest rates will tend to be higher, and vice versa. Thus, the real rate doesn't really determine the shape of the term strucutre; instead, it mostly influences the overall level of interest rates
What is good to know about Sukuk bonds
Their government does not allow for interest
Why do corporations try to create a debt security that is really an equity security?
To obtain the tax benefits of debt and the bankruptcy benefits equity
A plot of the yields on Treasury notes and bonds relative to maturity
Treasury Yield Curve
When long-term rates are higher than short-term rates, we say that the term structure is ____ sloping; and when short-term rates are higher than long-term rates, we say the term structure is ___ sloping
Upward (most common in modern times) Downward
A ____ gives the buyer of a bond the right to purchase shares of stock at a fixed price. Such a right would be very valuable if the stock price climbed substantially. Because of the value of this feature, bonds that have these features are often issued at a very low coupon rate
Warrants
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When bonds pay less than the going rate, investors are willing to lend only something less than $1,000 (face value) promised repayment. Because the bond sells for less than face value, it is said to be a discount bond
The interest rate required in the market on a bond
Yield to Maturity (YTM)
A bond that makes no coupon payments and is thus initially priced at a deep discount
Zero coupon bonds