Bonds, Loans, and Interest Rates

Why would a company use bank debt rather than high-yield bonds?

Bank debt is secured by the assets of the company and therefore normally commands lower interest rates. The trade off is that it will typically amortize and may have maintenance covenants.

What causes a treasury note to rise?

If the stock market is extremely volatile, and investors are fearful of losing money, they will desire risk free securities, which are government bonds. The increase in demand for these securities will drive the price up, and therefore the yield will fall.

Bullet bonds

Pay the entire sum of the principal at maturity.

Cost of carry

Refers to the costs incurred as a result of an investment position. This can include financial costs, such as interest costs on bonds, interest expense on margin accounts, and interest on loans used to purchase a security. They can also include economic costs, such as the opportunity costs associated with taking the initial position.

Volatility risk

Risk associated with fixed-income securities that have embedded options, such as call options, prepayment options, or put options. Changes in interest rate volatility affect the value of these options.

Exchange rate risk

Risk from uncertainty about the value of foreign currency cash flows to an investor in terms of home country currency.

Sovereign Risk

Risk of changes in governmental attitudes and policies toward the repayment and servicing of debt.

What is Macaulay duration?

The Macaulay duration is the weighted average term to maturity of the cash flows from a bond. The weight of each cash flow is determined by dividing the present value of the cash flow by the price. Macaulay duration is frequently used by portfolio managers who use an immunization strategy. Determined by the present value of a bond's cash flows, weighted by length of time to receipt, and divided by the bond's current market value. This formula is an approximation, since it assumed a linear relationship between bond prices and yields, even though the relationship is convex. Thus, it is less reliable for larger changes in yield.

R-Squared

The R-squared measures the percentage of a security's historical price movements that could be explained by movements in a benchmark index. When using beta to determine the degree of systemic risk, a security with a high R-squared value, in relation to its benchmark, would increase the accuracy of the beta measurement. R-squared values range from 0 to 100. According to Morningstar, a mutual fund with a score between 85-100 has a performance record closely correlated with the index. A fund rated 70 or less typically does not perform like the index. Mutual fund investors should avoid mutual funds with high R-squared ratios which are generally criticized by analysts for being closet index funds.

Market timing

The act of moving in and out of the market or switching between the asset classes based on using predictive methods such as technical indicators or economic data. Because it is extremely difficult to predict the stock market, especially mutual fund investors, tend to underperform investors who remain invested.

Alpha

The active return on an investment, gauged against a benchmark or market index which is considered to represent the market's movement as a whole. Alpha is usually used in conjunction with beta, which measures volatility or risk.

What is the difference between senior secured debt or "bank debt" and bonds?

The first difference is that bank debt is secured by the assets of the company and bonds many times are not, so the interest rate on bank debt is typically lower. Second, bank debt tends to have floating interest rates based on LIBOR plus a spread, whereas bonds normally pay at a fixed rate. Third, bank debt may carry financial maintenance covenants that require the company to maintain certain leverage levels, interest coverage levels, etc., while bonds do not. Fourth, bank debt is normally amortized at a certain percentage per year. The fifth and final difference is that bank debt tends to be pre-payable at any time, whereas bonds tend to have call protection for some years after issuance, ensuring that bonds remain outstanding. In smaller transactions, the deal may be uni-tranche (all bank debt), but in large transactions the capital structure could include first-lien bank debt, second-lien bank debt, AND bonds.

If the price of the bond goes down, what happens to the yield?

The price and yield of a bond move inversely to one another. Therefore, when the price of a bond goes up the yield goes down.

Quick ratio

(Current assets - inventory)/ current liabilities This is similar to the current ratio but is more conservative since it assumes a company could not instantly liquidate inventory to pay debt coming due.

What factors affect a bond's duration?

- A bond's price (price moves up, duration down) - Coupon ( If we have two bonds that are identical with the exception on their coupon rates, the bond with the higher coupon rate will pay back its original costs faster than the bond with a lower yield. The higher the coupon rate, the lower the duration, and the lower the interest rate risk.) - Maturity (longer maturity, duration) - Yield to maturity (the higher a bond's yield to maturity, the shorter its duration, because the present value of the distant cash flows (which have the heaviest weighting) become overshadowed by the value of the nearer payments) - A sinking fund lowers duration. The extra cash flows in the early years are greater than those without a sinking fund.

How are convertible bonds accounted for in calculating enterprise value?

If the convertible bonds are "in the money" meaning the conversion price is below the current market price, then you account for the bonds as additional dilution to the Equity Value. However, if the bonds are out of the money, then you would account for them as debt at their face value.

What is the order of credit preference in the event of a company bankruptcy?

The first creditors to get paid in the event of liquidation are the senior debt holders—usually banks and senior bondholders. They likely have some of the firm's assets as collateral. Next come those holding subordinated debt, followed by preferred stockholders. Common stockholders have the last claim on assets in the event of liquidation or bankruptcy.

What is a Eurodollar bond?

A Eurodollar bond is one issued by a foreign company but in U.S. Dollars rather than the home currency.

What is a perpetual bond?

A perpetual bond is a bond that simply pays a coupon payment indefinitely (or until the company goes into default) and never returns a principal amount.

Beta

Calculated using regression analysis. Represents the tendency of a security's returns to respond to swings in the market. A security's beta is calculated by dividing the covariance of the security's returns and the benchmark's returns by the variance of the benchmark's returns over a specified period. A security's beta should only be used when a security has a high R-squared value in relation to the benchmark.

Call Risk

Risk of investor's principal being returned when interest rates fall, and as a result reinvesting at a lower rate.

How do you determine the discount rate of a bond?

The discount rate is determined by the company's default risk. Some of the factors that influence the discount rate include a company's credit rating, the volatility of their cash flows, the interest rate on comparable U.S. Bonds, the amount of current debt outstanding, leverage and interest coverage.

What is the difference between a corporate bond and a consumer loan?

The main difference between a corporate bond and a consumer loan is the market that it is traded on. A bond issuance is usually for a larger amount of capital, is sold in the public market and can be traded. A loan is issued by a bank, and is not traded on a public market.

If you believe interest rates will fall, which should you buy: a 10-year coupon bond or a 10-year zero-coupon bond?

The price of a zero-coupon bond is more sensitive to fluctuations in interest rates, and the price moves in the opposite direction of interest rates. So, when interest rates fall, the price of the zero-coupon bond will rise more than the price of the coupon bond. Therefore, if you believe interest rates will fall, you should purchase the zero-coupon bond.

Sharpe Ratio

This measures the risk-adjusted performance, calculated by subtracting the risk-free rate from the rate of return for an investment and dividing the result by the investment's standard deviation of its return. Sharpe ratio tells investors whether an investment's returns are due to wise investment decisions or the result of excess risk. Useful because one portfolio may be doing better than its peers, but that's only good if those higher returns don't come with too much additional risk. The higher an investment's Sharpe Ratio, the better its risk adjusted performance.

Leverage ratio

Total debt/ EBITDA This ratio allows an investor to evaluate how many years of cash flow it would take for a company to retire its debt.

Tracking Error

Tracking error is the divergence between the price behavior of a position or a portfolio and the price behavior of a benchmark. This is often in the context of a hedge or mutual fund that did not work as effectively as intended, creating an unexpected profit or loss instead. Tracking error is reported as a standard deviation percentage difference, which reports the difference between the return an investor receives and that of the benchmark he was attempting to imitate.

What is negative convexity?

Typically, when interest rates decrease, a bond's price increases. For bonds that have negative convexity, prices decrease as interest rates fall. For example, with a callable bond, as interest rates fall, the incentive for the issuer to call the bond at par increases; therefore, its price will not rise as quickly as the price of a non-callable bond. The price of a callable bond might actually drop as the likelihood that the bond will be called increases. This is why the shape of a callable bond's curve of price with respect to yield is concave or negatively convex.

If the stock market falls, what would you expect to happen to bond prices and yields?

When the stock market falls, investors flee to safer securities, like bonds. This increases the demand for those securities and therefore raises their price. Since prices and yields move inversely, if bond prices rise, their yields will fall. In that case, the government may lower interest rates in an attempt to stimulate the economy.

What is the difference between a corporate bond and a corporate loan?

While both loans and bonds are forms of debt, there are several differences between them. One difference is that a loan will be syndicated by a bank who leads the deal and then sells pieces of the loan to other investors such as loan funds and CLOs. A bond will be underwritten by a bank that will go on a road show to sell the issue to other financial institutions like mutual funds. Another difference is that a bank loan is a private security in which investors may have access to private, more detailed information about the company's operations, which then prohibits them from investing in public bonds or stocks. Bondholders have access only to public information and are therefore not restricted. Yet another difference is that bank loans are usually secured by all assets of the company, while bonds may or may not be secured. Bonds are also lower in the capital structure and will be repaid in bankruptcy after loans are, so all else equal, bonds will have a higher interest rate.

What is the difference between yield to maturity and yield to worst?

Yield to maturity assumes the debt holder will maintain the investment through its maturity date, collecting all interest payments and being repaid in full when it matures. Yield to worst is the lowest potential yield an investor can earn on a debt investment short of default by the issuer. This means that if a bond is callable, or has other provisions, an investor could earn less than yield to maturity should the company exercise a prepayment option to get out of the bond early.

Current ratio

current assets/current liabilities A lower number (just above 1) means the company is managing inventory efficiently. Lower than that could imply inability to pay debts.

Types of risk

1) Interest rate risk 2) Yield curve risk 3) Call risk 4) Prepayment risk 5) Reinvestment risk 6) Credit risk 7) Liquidity risk 8) Exchange-rate risk 9) Inflation risk 10) Volatility risk 11) Event risk 12) Sovereign risk

What is a callable bond?

A callable bond allows the issuer of the bond to redeem the bond prior to its maturity date, thus ending coupon payments. However, a premium is usually paid by the issuer to redeem the bond early.

Why would a company issue debt rather than equity?

A company will normally prefer to issue debt because it is cheaper than issuing equity. In addition, interest payments are tax deductible and therefore provide tax shields. However, a company has to have a steady cash flow to make coupon payments, whereas that is not necessary when issuing equity. A company may also try to raise debt if it feels its stock is particularly undervalued such that an equity offering would not raise the capital needed.

What is a convertible bond?

A convertible bond can be "converted" into equity during the bond's lifetime. Therefore, the bond can be converted before maturity should the bondholder decide that equity in the company is worth more than the bond. Issuing convertible bonds is one way to minimize negative investor interpretation of its corporate action, since issuing stock is interpreted as the stock price being somewhat overvalued. This instrument allows investors to protect their principal on the downside, but participate on the upside.

ROCO

A corporate credit tool that helps systematically translate our fundamental analyst views from PRISM into a score and overall investment target. Accomplished by utilizing analyst range of outcome data from PRISM< specifically forward, upside, an downside ratings. Performed at the user tranche level. Fully reprice bond to fair value spreads associated with analyst views. ROCO ranks all tranches in the capital structure.

What are covenants?

A covenant is a requirement included in the legal documents governing a bond or loan. The company must comply with these requirements during the life of the bond or loan in order to avoid a default.

What is lien?

A legal right granted by the owner of property, by a law or otherwise acquired by a creditor. Serves to guarantee an underlying obligation, such as repayment of a loan. If the underlying obligation is not satisfied, the creditor may be able to seize the asset that is the subject of the lien.

What is a put bond?

A put bond is essentially the opposite of a callable bond. A put bond gives the owner of bond the right to force the issuer to buy back the security (usually at face value) prior to maturity.

Delta

A ratio comparing the change in the price of an asset, usually a marketable security, to the corresponding change in the price of its derivative.

Sinking Fund

A sinking fund is a means of repaying funds borrowed through a bond issue through periodic payments to a trustee who retires part of the issue by purchasing the bonds in the open market. Rather than the issuer repaying the entire principal of a bond issue on the maturity date, another company buys back a portion of the issue annually and usually at a fixed par value or at the current market value of the bonds, whichever is less.

What is riskier, a 30 year coupon bond or 30 year zero bond?

A zero-coupon bond will yield $0 until its date of maturity, while a coupon bond will pay out some cash every year. This makes the coupon bond less risky since even if the company defaults prior to the bond's maturity date, you will have received some payments with the coupon bond.

What is amortization?

Amortization is a feature that may be built into a loan requiring the borrowing company to pay off the loan over its term rather than paying the entire face value at maturity. Each payment period, the company pays its lenders the interest payment and a portion of the loan's face value. Since the pay down of face value reduces the amount outstanding, interest payments will grow successively smaller. In the below example, the company borrows $1,000 at a 10% interest rate with a $100/year amortization schedule and a 5 year maturity.

What is the difference between investment grade and a "junk" bond?

An investment grade bond is one that has a good credit rating (AAA to BBB, Aaa to Baa) and a low risk of default and therefore pays a low interest rate. These are usually low-risk, fundamentally sound companies, which produce steady, reliable cash flows significantly greater than their interest requirements. A "junk bond" is a bond that has a poor credit rating (BB to D, Ba to C) and a relatively high risk of bankruptcy and is therefore required to pay investors a higher interest rate. These companies usually are characterized as having less consistent cash flows, or they may be in relatively more volatile industries.

Standard Deviation

Dispersion of data from the mean. Standard deviation is applied to the annual rate of return of an investment to measure its volatility. High volatility, high standard deviation. With mutual funds, the standard deviation tells us how much the return on a fund is deviating from its historical performance.

What is duration?

Duration is a measure of the sensitivity of the price -- the value of principal -- of a fixed-income investment to a change in interest rates. Duration is expressed as a number of years. Bond prices are said to have an inverse relationship with interest rates. Therefore, rising interest rates indicate bond prices are likely to fall, while declining interest rates indicate bond prices are likely to rise. As a general rule, for every 1% increase or decrease in interest rates, a bond's price will change approximately 1% in the opposite direction for every year of duration.

Interest Coverage Ratio

EBITDA/interest expense This is similar to the current ratio but is more conservative since it assumes a company could not instantly liquidate inventory to pay debt coming due.

What is face value?

Face value or par value of a bond is the amount the bond issuer must pay back at the time of maturity. Bonds are usually issued with a $1,000 face value.

What is a floating interest rate?

Floating rate interest is typically seen on bank loans when a bank makes a loan to a company at a rate that will move with interest rates. The loan's rate typically is LIBOR plus a certain spread based on the default risk of the borrower.

What will happen to the price of a bond if the Fed raises interest rates?

If interest rates rise, newly issued bonds offer higher yields to keep pace. This makes existing bonds with lower coupon payments less attractive, and their price must fall to raise the yield enough to compete with the new bonds.

If you believe interests rates will fall, and are looking to make money due to the capital appreciation on bonds, should you buy them or short sell them?

If you believe interest rates are going to fall bond prices should rise. If you are looking to make money on the capital appreciation of the bonds, you should be looking to buy the bonds. Since price moves inversely to interest rates, if you believe interests rates will fall, bond prices will rise, and therefore you should buy bonds.

How could inflation hurt creditors?

Inflation can severely injure creditors. Creditors assign interest rates based on the risk of default as well as the expected inflation rate. Creditors lending at 7% with inflation expected at 2%, are expecting to make 5%. But if inflation actually increases to 4%, they are only making 3%.

Spline (Interpolation method)

Interpolation is a statistical method by which related known values are used to estimate an unknown price or potential yield of a security. Interpolation is a method of estimating an unknown price or yield of a security. This is achieved by using other related known values that are located in sequence with the unknown value. In the mathematical field of numerical analysis, Spline interpolation is a form of interpolation where the interpolant is a special type of piecewise polynomial called a spline. Splines are often used to fill in the gaps for various metrics in fixed income, such as historical spreads and prices.

What is PIK interest?

PIK interest is interest that is Paid In Kind. This means that rather than making a cash interest payment, the bond or loan will increase in face value each period by the PIK interest rate. Because of compounding, the company will be required to pay more overall, but the cash outflow will be at maturity rather than annually, semi annually, or quarterly.

What is convexity?

Rate of change of its duration, and it's measured as the second derivative of the bond's price with respect to its yield. Most mortgage bonds are negatively convex, and callable bonds exhibit negative convexity at lower yields.

Credit risk

Risk of issuer's creditworthiness deteriorating, increasing required return and decreasing the security's value. 3 types of credit risk: (1) Default Risk (2) Credit Spread Risk (Difference between a bond's yield and comparable risk free bond's yield. All else equal the riskier the bondthe higher the spread) (3) Downgrade Risk (Risk bond will be reclassified as a riskier sec by a major rating agency, thus leading to price decline)

Reinvestment risk

Risk of reinvesting principal and interest cash flows at lower rates reducing investor returns.

Liquidity risk

Risk of security having to be sold for less than market value due to lack of liquidity.

Prepayment risk

Similar to Call Risk, risk of prepayment when interest rates fall, requiring investor to reinvest at a lower rate.

How would you value a zero-coupon perpetual bond?

Since a zero-coupon bond doesn't have any interest payments, and a perpetual bond has no par value, the value of a zero-coupon perpetual bond is zero because it will pay out nothing.

Tenor

The amount of time left for the repayment of a loan or until a financial contract expires. Mostly used for non-standardized content, such as foreign exchange and interest rate swaps, while the term maturity is usually used to express the same concept for government bonds and corporate bonds. Tenor can also be used to refer to the payment frequency on an interest rate swap.

What is the coupon payment?`

The coupon payment is the amount a company pays its loan and bondholders, usually on an annual, semi-annual or quarterly basis. It is the coupon rate, or interest rate times the face value of the bond. For example, the coupon payment on an annual 10% bond with a $1,000 face value would be $100.

What is the default premium?

The default premium is the difference between the yield on a corporate bond and the yield on a government bond with the same time to maturity to compensate the investor for the default risk of the corporation, compared with the "risk-free" comparable government security.

What is the default risk?

The default risk is the risk of a given company not being able to make its interest payments or pay back the principal amount of their debt. All else equal, the higher a company's default risk, the higher the interest rate a lender will require it to pay.

What are some ways to determine the extent to which a company poses credit risk?

The easiest way to determine a company's credit risk is to look at its credit rating, available from Standard & Poor's, Moody's and Fitch. If you wanted to perform your own analysis, some metrics to look at would be the Current Ratio, Quick Ratio, Interest Coverage Ratio, and Leverage Ratio.

Interest rate risk

The effect of changes in the prevailing market rate of interest on bond values. Inverse relationship between interest rates and bond prices. i.e., When rate goes up, bond prices fall.

What are bond ratings?

The lower the grade, the more speculative the stock, and all else equal, the higher the yield. A bond rating is a grade given to a bond based on its risk of defaulting. This rating is issued by an independent firm and updated over the life of the bond. The most trusted rating agencies are S&P, Moody, and Fitch, and their ratings range from AAA to C or even D. The top rating of AAA goes to highly rated "investment grade" bonds with a low default risk; the C rated bond is "non-investment grade" or "junk," and a rating of D means the bond is already in default and not making payments.

Yield curve risk

The possibility of changes in the shape of the yield curve. Relation between bond yields and maturity. Non-parallel shift. Any investor holding interest-rate bearing securities is exposed to yield curve risk. To hedge against this risk, investors can build portfolios with the expectation that if interest rates change, their portfolios will react in a certain way. Since changes in the yield curve are based on bond risk premiums and expectations of future interest rates, an investor that is able to predict shifts in the yield curve will be able to benefit from corresponding changes in bond prices.

How do you price a bond?

The price of a bond is the net present value of all future cash flows (coupon payments and par value) expected from the bond using the current interest rate. For the example below, assume the current interest rate is 7% on comparable bonds. The bond you are looking to invest in has a $100 face value and pays 10% annual interest. Since the bond you are investing in pays a higher coupon than bonds of comparable companies, you will be required to pay a premium for that higher interest rate, hence the $112.30 price, which brings the yield on the bond down to levels in line with comparables.

What is the yield to maturity on a bond?

The yield to maturity (YTM) is the rate of return on a bond if it is purchased today for its current price, held through its maturity date and is paid off in full at maturity. Normally, the yield to maturity is expressed as an annual rate. The calculation of YTM includes the current market price, the face value, the coupon payments, and the time to maturity. If the coupon yield of a bond (coupon/face) is lower than its current yield (coupon/price) it is selling at a discount. If the coupon yield of a bond (coupon/face) is higher than its current yield (coupon/price) it is selling at a premium.

Why might two bonds with the same maturity and same coupon, from the same issuer, be trading at different prices?

There are a couple of explanations for the observed price difference. A bond that is putable or convertible would demand a premium, and a callable bond would trade at a discount.

What steps can the Fed take to influence the economy?

o Open market operations are The Fed buying and selling securities (government bonds) to change the money supply. Buying government securities increases the money supply and stimulates expansion; selling securities shrinks the money supply and slows the economy. Raise or lower interest rates o The discount rate is the interest rate The Fed charges banks on short-term loans. o The federal funds rate is the rate banks charge each other on short-term loans. o When The Fed lowers these rates, it signals an expansionary monetary policy. Manipulate the reserve requirements o The reserve requirement is the amount of cash a bank must keep on hand to cover its deposits (money not loaned out). When this requirement is lowered, more cash can be loaned and pumped into the economy, so lowering the reserve requirement is expansionary policy.