Finance Chapter 7

When interest rates rise, a bond's value, like any other present value

declines

Bond rating

- Firms pay to have their debt rated - the debt rating are an assessment of the creditworthiness of the corporate issuer - based on how likely the firm is to default and what protection creditors have in the even of a default - Only concern credit risk - Do not address interest rate risk; the risk of a change in the value of a bod from a change in interest rates

Stripped bond or zero-coupon bond

A bond that pays no coupons must be offered at a price that is much lower that is stated value - start as normal coupon bonds. Investment dealers engage in bond stripping when they sell the principal and coupons separately

Canada yield curve

A plot of the yield on Government of Canada notes and bonds relative to maturity

Real Rates

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

Sinking fund

Account managed by the bond trustee for early bond redemption

Call provision

Agreement giving the corporation the option to repurchase the bond at a specified price before maturity

Deferred call

Amount by which the call price exceeds the par value of the bond

Retractable bond or put bond

Bond that may be sold back to the issuer at a prespecified price before maturity - Allow the holder to force the issuer to buy the bond back at a stated price. - As long as the issuer remains solvent, the put feature sets a floor price for the bond; just the reverse of the call provision

Canada plus call

Call provision that compensates bond investors for interest differential, making it unattractive for an issuer to call a bond

notes, debentures, or bonds

Debt securities

high-yield bonds

Junk bonds - they yield an interest rate 3 to 5 percentage points higher than that of AAA-rated debt - their niche has been filled in part by preferred shares and, to a lesser extent, income bonds

Protective covenant

Part of the indenture limiting certain transactions that can be taken during the term of the loan, usually to protect the lender's interest

Bond Value

Present value of the coupons + Present value of the face amount

Maturity

Specified date at which the principal amount of a bond is paid.

face value or par value

The amount repaid at the end of the loan

Coupon rate

The annual coupon divided by the face value of a bond

Yield to maturity (YTM)

The market interest rate that equates a bond's present value of interest payments and principal repayments with its price

term structure of interest rates

The relationship between nominal interest rates on default-free, pure discount securities and tie to maturity; that is the pure time value of money

Interest rate risk

The risk that arises for bond owners from fluctuating interest rates - How much interest risk a bond has depend on how sensitive its price is to interest rate changes - depends on 2 things: the time to maturity and the coupon rate 1. the longer the time to maturity, the greater the interest rate risk 2. the lower the coupon rate, the great the interest rate risk

Call premium

amount by which the call price exceeds the par value of the bond

Call protected

bond during period in which it cannot be redeemed by the issuer

Debenture

an unsecured bond, where no specific pledge of property is made - only have to claim on property not otherwise pledge; the property that remains after mortgages and collateral trusts are taken into account

Asset-backed bonds

backed by a diverse pool of illiquid assets such as accounts receivable collections, credit card debt, or mortgages - If an issuing company defaults on it bond debt repayments, bondholders become legally entitled to cash flows generated from these illiquid (not easily converted into cash) pools of assets

when interest rates fall..

bond values rise

convertible bond

can be swapped for a fixed number of shares of stock any time before maturity at the holder's option. Are debt/equity mix that allow the holder to profit if the issuer's stock price rises

Coupons

constant and paid every year, the type of bond we are describing is sometime called a level coupon bond

Collateral

general term that, strictly speaking, means securities (bonds and stocks) pledged as security for payment of debt - involve a pledge of common stock held by the corporation

Real return bonds

have coupons and principal indeed to inflation to provide a stated real return

Nominal rates

interest rates or rates of return that have not been adjusted for inflation

Seniority

preference in position over other lenders, and debts are sometimes labelled as "senior" or "junior" to indicate seniority

Registered form

registrar of company records ownership of each bond; payment is made directly to the owner of record - the company has a registrar who records the ownership of each bond and records any changes in ownership

Mortgage securities

secured by a mortgage on the real property of the borrower

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

When interest rates are above the bond's coupon rate

the bond sells at a discount

Bearer form

the certificate is the basic evidence of ownership, and the corporation pays the bearer 2 drawbacks 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

Interest rate risk premium

the compensation investors demand for bearing interest rate risk

floating-rate bonds

the coupon payments are adjustable.

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

inflation premium

the portion of nominal interest rate that represents compensation for expected future inflation

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.

Dirty price

the price of a bond including increase interest, also known as the 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 - if you buy a bond between coupon payment dates, the price you pay is usually more than the price you are quoted.

Fisher effect

the relationship between nominal return, real return, and inflation

Indenture

the written agreement between the corporation and its creditors - sometimes referred to as the deed of trust

Interest rates below the bond's coupon rate cause the bond

to sell at a premium

note

used for such a instruments if the maturity of the unsecured bond is less than ten or so years when it is originally issued

Financial engineering

when financial managers or their investment bankers design new securities or financial processes - reduce and controls risk and minimizes taxes - seeks to reduce financing costs of issuing and servicing debt as well as costs of complying with rules laid down by regulatory authorities