Fundamentals of Business Finance Chapter 7
Current Yield
=a bonds annual coupon/bond price or present value not face value
Formula for bond value:
=cash flows(1-(1/(1+r)^t))/r+ FV/(1+R)^T
Medium Grade
A: capacity to pay is strong, but more susceptible to changes; Baa and BBB is capacity to pay is adequate, adverse conditions will have more impact on the firms ability to pay.
High Grade bonds
AAA capacity to pay is extremely strong; AA
Low Grade
Ba and B, BB and B for s&p; considered possible that the capacity to pay will degenerate.
Bearer Form Bond
Bond is issued without record of the owner's name; payment is made to whomever holds the bond
Moody's & S&P
Bond rating firms that measure the creditworthiness of the issuer
Classifications of debt securities:
Collateral, mortgage, debenture, and notes
Bonds are usually what type of loan?
Interest-only loan
Very Low Grade Bonds
Moody's C and below, S&P C and below; these are income bonds with no interest being paid or in default with principal and interest in arrears.
Sinking Fund
an account managed by the bond trustee for early redemption requires a repurchase of a certain number of bonds each year
Debenture
an unsecured debt, usually with a maturity of 10 years or more; no specific pledge of property is made
Note
an unsecured debt, with maturity of 10 years or less;
Floating Rate Bonds
coupon rate floats depending on some index value ; adjustable rate mortgages, and inflation linked treasuries. coupons may have a cap or collar rate
Municipal Securities
debt of state and local government; varying degrees of default risk and the interest received is tax-exempt at the federal level.
Federal Government Bond Types
include T-bills, T-notes, and T-bonds, as well as municipal bonds
Seniority
indicates preference in position over other lenders; or who gets the right to the money first.
Real Rates
interest rates of return that have been adjusted for inflation
Price Risks with bonds
long term bonds have more price risk than short term bonds; low coupon rate bonds have more price risk than high coupon rate bonds
Debt Features
no ownership interest in the firm, creditors do not have voting rights, interest is considered a cost, creditors have legal recourse if interest payments are missed, and excess debt can also lead to bankruptcy. Debt can be a positive if it is used correctly.
Deferred Call Provision
prohibits company from redeeming a bond prior to a certain date.
T-Bills
pure discount bonds with original maturity of less than 1 year
What are the two terms of bonds?
registered form and bearer form
Mortgage
securities secured by a mortgage on the real property of the borrower
Coupon Rate
the annual coupon/face value of the bond
The indenture
the contract between the company and the lender detailing the terms of the debt issue
Coupons
the stated interest payment made on a bond
Call Protected
a bond that cannot be redeemed by the issuer for a certain period.
Zero Coupon Bonds
a bond that makes no coupon payments and is thus initially priced at a deep discount
Call Provision
an agreement giving the corporation the option to repurchase a bond at a specified price prior to maturity.
Bond Ratings
an assessment of creditworthiness of the corporate issuer and how likely firms are to default on debt and to protect creditors
Collateral
any asset pledged as payment of a debt
What is included in the indenture?
basic terms of the bond, total amount of bonds issued, a description of property used as security, sinking fund provisions, call provisions, and details of protective covenants.
T-Notes
coupon debt with original maturity between 1-10 years
T-Bonds
coupon debt with original maturity of greater than 10 years
Nominal Rates
interest rates of return that have not been adjusted for inflation
Definition of a bond:
issuing or selling debt securities by the government and or corporations.
Protective Covenants
limiting certain actions that might be taken during the term of the loan.
Bid Price
th eprice a dealer is willing to pay for a security
Call Premium
the amount by which the call price exceeds the par value of the bond.
Ask 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 the full or invoice price.
Clean Price
the price of abond net of accrued interest; this is the price quoted
Face Value of a bond
the principal amount of a bond that is repaid at the end of the term and is called the par value.
Yield to Maturity
the rate required in the market on bonds
Registered Form Bond
the registrar of the company records ownership of each bond; payment is made directly to the owner of record.
Term Structure interest rates
the relationship between nominal interest rates on default-free pure discount securities and time to maturity; pure TVM
The fischer-Effect
the relationship between real rates, nominal rates, and inflation; 1+R=(1+r)*(1+h), R is the nominal, h is the inflation, r is the real
Maturity
the specified date on which the principal amount of a bond is paid.
Reinvestment Rate Risk of bonds
uncertainty concerning rates which cash flows can be reinvested. Short term has greater reinvestment risk than long term bonds; high coupon rate bonds have a higher risk than low coupon rate bonds.
Discount bond
when a bond sells for less than its face value; less than 1,000. the YTM>coupon rate and the par value>bond price
Premium Bond
when a bond sells for more than its face value; more than 1,000. the YTM<coupon rate and the par value<bond price
Relationship between the interest rate and Present value:
when interest rates rise, the present value of the bonds cash flow decline and is worth less. when interest rates decline the bond is worth more
Relationship between current yield and yield to maturity
with a discount bond; the current yield<YTM With a premium bond; the current yield>YTM