FI311 Chapter 7 ~ Interest Rates and Bond Valuation

What is another name for face value?

Par value

What does FINRA do?

Provides a daily snapshot from TRACE by reporting the most active issues

What is a "make-whole" call?

Bondholders receive approximately what the bonds are worth if they are called... Because bondholders don't suffer a loss in the event of a call, they are "made whole."

Call Premium

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

Issues with an original maturity or 10 years or more are often called (notes/bonds)

Bonds

Coupon rate

The annual coupon divided by the face value of the bond

What 3 things must the trust company do when it is appointed by the corporation to represent the bondholders?

1. Make sure the terms of the indenture are obeyed 2. Manage the sinking fund 3. Represent the bondholders in default (if the company defaults on its payments to them)

What are the two types of ways that protective covenants can be classified?

1. Negative covenants 2. Positive (or affirmative) covenants

To determine the value of a bond at a particular point in time, what 4 things do you need to know?

1. Periods remaining until maturity 2. The face value 3. The coupon 4. The market interest rate for bonds with similar features

Structured notes

Bonds that are based on stocks, bonds, commodities, or currencies

Clean Price

The price of a bond net of accrued interest; this is the price that is typically quotes

Face Value

The principal amount of a bond that is repaid at the end of the term.

A bond indenture is an important document because it generally includes the following 6 provisions:

1. The basic terms of the bonds 2. The total amount of bonds issued 3. A description of property used as security 4. The repayment arrangements 5. The call provisions 6. Details of the protective covenants

What are the upper and lower rates of a bond sometimes called?

A collar

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's interest.

True/False Treasury issues are NOT exempt from state or federal income taxes.

False Treasury issues ARE exempt from state income takes (but not federal income taxes)

Municipal notes coupons are exempt from ________ income taxes

Federal income taxes

What does FINRA stand for?

Financial Industry Regulatory Authority

What was the largest municipal bankruptcy in US history?

Bankruptcy filed by Detroit

Bond prices and interest rates always move in (opposite/parallel) directions

Bond prices and interest rates always move in opposite directions

Bond value equation

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

Yield to maturity (YTM)

The rate required in the market on a bond

The bond with the (higher/lower) coupon rate coupon rate has a larger cash flow early in its life, so its value is (more/less) sensitive to changes in the discount rate

Bond with the HIGHER coupon rate is LESS sensitive to changes in the discount rate

A large part of corporate borrowing takes the form or low-grade, or "________" bonds

"Junk" bonds

What is the fischer effect equation?

1 + R = (1 +r) x (1 + h) Where "R" is nominal rate, "r" is real rate, and "h" is inflation rate

What 2 things should you always keep in mind when looking at a bond?

1. All other things being equal, the longer the time to maturity, the greater the interest rate risk 2. All other things being equal, the lower the coupon rate, the greater the interest risk

What 3 main things make Treasury notes and bonds different from bonds issued by corporations or municipalities?

1. Credit Risk (possibility of default) ... Investors recognize that issuers other than the Treasury may or may not make all the promised payments on the bond (demand a higher yield as compensation for this risk) 2. Municipal bonds are free from most taxes and have much lower yields than taxable bonds ... Investors demand the extra yield on a taxable bond as compensation for the unfavorable tax treatment 3. Bonds have varying degrees of liquidity ... Investors prefer liquid assets to illiquid ones. Less liquid bonds will have higher yields than more liquid bonds.

From a financial point of view, what are the 3 main differences between debt and equity?

1. Debt is not an ownership interest in the firm. Creditors generally do not have voting power 2. The corporation's payment of interest on debt is considered a cost of doing business and is fully tax deductible. Dividends paid to stockholders are NOT tax deductible. 3. Unpaid debt is a liability of the firm. If it is not paid, the creditors can legally claim the asset of the firm. This action can result in liquidation or reorganization, two of the possible consequences of bankruptcy. Thus, one of the costs of issuing debt is the possibility of financial failure. This possibility does not arise when equity is issued.

What 3 basic components determine the shape of the term structure?

1. The real rate of interest 2. The rate of inflation 3. Interest rate risk

Interest rate risk sensitivity directly depends on 2 things:

1. The time to maturity 2. The coupon rate

Treasury notes and bonds have three important features:

1. They are default-free 2. They are taxable 3. They are highly liquid

What are 2 drawbacks to bearer bonds?

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

What is the coupon rate for a bond with the face value of $1000 and a coupon of $120?

12%

Bonds are rarely issued with maturities longer than _____ years.

30 years

What are "crossover" bonds also called?

5B bonds

Which has more interest rate risk, a 10 year bond or a 20 year bond? Why?

A 20 year bond would have a much greater interest risk because the value of a bond depends on the present value of its coupons and the present value of the face amount

Zero coupon bonds

A bond that makes no coupon payments and is thus initially priced at a deep discount

Call-protected bond

A bond that, during a certain period, cannot be redeemed by the issuer

Current yield

A bond's annual coupon divided by its price

Deferred call provision

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

Treasury Yield Curve

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

Which ratings indicate very good quality debt and are much more common than AAA?

AA or Aa

Put Bond

Allows the holder to force the issuer to buy back the bond at a stated price

Sinking fund

An account managed by the bond trustee for early bond redemption

Call provision

An agreement giving the corporation the option to repurchase a bond at a specified 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

Convertible Bond

Can be swapped for a fixed number of shares of stock anytime before maturity of the holder's option

Which type of bonds are usually "callable"

Corporate bonds

Who issues bonds?

Corporations or government

Floating-rate bonds

Coupon payments are adjustable

What is another word for bond?

Debt securities

Debt securities are classified according to the ___________ and ___________ used to protect the bondholder

Debt securities are classified according to the collateral and mortgages used to protect the bondholder

How do you calculate the effect of inflation on present value calculations?

Discount nominal cash flows at a nominal rate or discount real cash flows at a real rate

Treasury prices are quoted as a percentage of _________ _________.

Face Value

What are floating-rate bonds sometimes also referred to as?

Floaters

Warrant

Gives the buyer of the bond the right to purchase shares of stock in the company at a fixed price

Do government or corporate bonds frequently have much larger face, or par, values?

Government

Amortize

Gradually write off the initial cost of (an asset)

Put Provision

Holder has the right to redeem the note at par on the coupon payment date after some specified amount of time

Creditworthiness

How likely the firm is to default and the protection creditors have in the event of a default

As time passes, ________ ________ change in the marketplace, but the ______ ________s from a bond stay the same.

Interest Rates in the market place change as time passes Cash flows from a bond stay the same

Nominal Rates

Interest Rates or rates of return that have not been adjusted for inflation Percentage change in the number of dollars you have

Interest rate increases at a(n) (increasing/decreasing) rate

Interest rate increases at a decreasing rate

Real Rates

Interest rates or rates of return that have been adjusted for inflation Percentage change in how much you can buy with your dollars---in other words, the percentage change in your buying power

What is the major differences between Western financial practices and shariah?

Islamic law does not permit charging or paying riba, or interest... Anyone following shariah cannot buy or issue conventional bonds

Negative Covenant

Limits or prohibits actions the company might take Ex: limit amount of dividends it pays according to some formula, the firm cannot pledge any assets to other lenders, the firm cannot merge with another firm, etc

Present value of the face amount will be much more volatile with a (longer/shorter)-term bond

Longer-term bond

How many year(s) is a long-term debt security?

Maturities of more than one year

Interest rate risk premium increases with __________.

Maturity

What are the two leading bond-rating firms?

Moody's and Standard & Poor's (S&P)

What type of note is very attractive to high-income, high-tax bracket investors?

Municipal notes

Most trading bonds take place..

OTC (over the counter)

Reverse Convertible

Offers a high coupon rate, but the redemption at maturity can be paid in cash at par value or paid in shares of stock

How many year(s) is a short-term debt security?

One year or less

Public bonds issued in the United States by industrial and financial companies are typically ______. However, most utility and railroad bonds are secured by a pledge of _________.

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.

Death Bond

Purchase life insurance policies from individuals who are expected to die within the next ten years. They sell bonds that are paid off from the life insurance proceeds received when the policyholders pass away.

Nominal rate equation

R = r + h + (r x h) But usually nominal rate is just computed approximately by doing the real rate plus the inflation rate or: R = r + h

When happens when a term structure has been "humped"

Rates increase at first, but then begin to decline as we look at longer and longer term rates

Income Bonds

Similar to conventional bonds, except the coupon payments depend on company income

Positive Covenant

Specifies an action the company agrees to take or a condition the company must abide by. Ex: Company must maintain its working capital at or above some specified minimum level, company must periodically furnish audited financial statements to the lender, etc

Inflation-linked bond

Such bonds have coupons that are adjusted according to the rate of inflation (the principle amount may be adjusted as well)

The Treasury yield curve and the term structure of interest rates are almost the same thing. The only difference is that the term structure is based on _______ ________ bonds, whereas the yield curve is based on ________ _________ yields.

Term structure is based on pure discount bonds The yield curve is based on coupon bond yields.

When interest rates rise, the bond is worth (more / less)

The bond is worth LESS because the remaining cash flows decline

What does a "interest-only loan" mean?

The borrower will pay the interest every period, but none of the principal will be repaid until the end of the loan

Interest rate risk premium

The compensation investors demand for bearing interest rate risk

What does it mean for a coupon rate to have a floor and a ceiling?

The coupon is subject to a minimum and a maximum

What are debt ratings an assessment of?

The creditworthiness of the corporate issuer

For a premium bond, the current yield is (higher/lower) than the yield to maturity

The current yield is higher than the yield to maturity

What is the indenture sometimes referred to as?

The deed of trust

Bid-ask spread

The difference between the bid price and the asked price

The coupons you receive on a Treasury note or bond are taxed only at the _______ level.

The federal level

Bearer form

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

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 the highest rating a firm's debt can have? What is such debt judged to be?

The highest rating a firm's debt can have is AAA or Aaa, and such debt is judged to be the best quality and to have the lowest degree of risk.

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 expected future inflation

Bid Price

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 the FULL or INVOICE price. This is the price the buyer actually pays

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 These rates are, in essence, "pure" interest rates because they involve no risk of default and a single, lump sum future payment

Fischer effect

The relationship between nominal returns, real returns, and inflation Because investors are ultimately concerned with what they can buy with their money, they require compensation for inflation

When interest rates rise, what happens to the present value of the bond's remaining cash flows?

The remaining cash flows decline

Interest Rate Risk

The risk that arrises for bond owners from fluctuating interest rates

Bond maturity

The specified date on which the principal amount of a bond is paid

Bond coupon

The stated interest payment made on that bond

If interest rates in the market place change, the value of the bond will (fluctuate / stay the same)

The value of the bond will fluctuate

The par value of a bond is almost always the same as the _______ value.

face value

Bonds that drop into junk territory are called ...

fallen angels

What does TIPS stand for?

Treasury Inflation-Protected Securities

Treasury bonds all make (annual/semi-annual) payments and have a face value of $______.

Treasury bonds all make SEMI-ANNUAL payments and have a face value of $1,000

When the government wishes to borrow money for more than one year, it sells what to the public?

Treasury notes and bonds

True/False A bond's credit rating can change as the issuer's financial strength improves or deteriorates

True

True/False U.S. Treasury issues, unlike any other bonds, have no default risk because the Treasury can always come up with the money to make the payments

True

What is short term debt also sometimes referred to as?

Unfunded debt

Bonds with warrants are often issued at a very (high/low) coupon rate

Very low coupon rate

Why are bonds issued?

When a corporation or government wishes to borrow money from the public on a LONG TERM basis

When real rates are high, all interest rates will tend to be (higher/lower)

When real rates are high, all interest rates will tend to be higher, and visa versa

Municipal notes and bonds

When state and local governments borrow money by selling notes and bonds

Indenture

Written agreement between the corporation and the lender detailing the terms of the debt issue

What does it mean when you hear that long-term interest rates rose?

Yield on the bond went up (and its price went down)

Trading volume in bonds on a typical day is many, many times (larger/smaller) than the trading volume in stocks

larger... (and by trading volume, we simply mean the amount of money that changes hands)

Longe-term bonds have greater interest rate sensitivity because...

a large portion of a bond's value comes from the face amount

A ____________ mortgage pledges all the real property owned by the company

blanket mortage

The put feature is the reverse of the ______ ____________.

call provision

The person/firm making the loan is called the..

creditor or lender

The corporation borrowing the money is called the..

debtor or borrower

When short-term rates are higher than long-term rates, we say that the term structure is ____________ sloping

downward sloping

Securities issued by corporations may by classified roughly as...

equity securities and debt securities

The value of a floating-rate bond depends on...

exactly how the coupon payments are defined

The longer the term to maturity, the (greater/lesser) the interest rate risk

greater

All else being the same, less liquid bonds will have (higher/lower) yields than more liquid bonds.

higher yield

How much interest rate risk a bond has depends on...

how sensitive its price is to interest rate changes

Yield to maturity is also sometimes called the _______________ ______________ _____________

implicit discount rate

;The only difference between a note and a bond is the original _______

maturity

Mortgage securities are secured by a...

mortgage on the real property of the borrower

The legal document that describes the mortgage is called a...

mortgage trust indenture, or trust deed

Because of the enormous tax break they receive, the yields on municipal bonds are much ______ than the yields on taxable bonds

much lower

For tax purposes, the issuer of a zero coupon bond deducts interest every year even though...

no interest is actually paid (and must pay taxes on interest accrued every year, even though no interest is actually received)

Financial rates (such as interest rates, discount rates, and rates of return) are almost always quoted in ___________ terms.

nominal terms

Issues with an original maturity of 10 years or less are often called (notes/bonds)

notes

What are three other names for debt securities?

notes, debentures, or bonds

As a general rule, equity represents an __________ interest, and it is a residual claim

ownership interest

Collateral is a general term that frequently means securities that are pledged as security for...

payment of debt

In general terms, seniority indicates ..

preference in position over other lenders, and debts

For an income bond, coupons are paid to bondholders only if...

the firm's income is sufficient

One reason that corporations try to create a debt security that is really equity is to obtain...

the tax benefits of debt and the bankruptcy benefits of equity

When long-term rates are higher than short-term rates, we say that the term structure is ____________ sloping

upward sloping