fin ch 7

credit risk

the possability of default

inflation premium

the prospect of future inflation strongly influences the shape of the term structure. 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, investors demand compensation for this loss in the form of higher nominal rates. This extra compensation is called the inflation premium.

coupon

coupon rate * par/face value how much your paid each month in interest

treasuriey securities are the most

liquid in the world. you can get up-to-the minutes pice info.

If investors believe the rate of inflation will be higher in the future, then long-term nominal interest rates will tend to be

higher than short term rates, thus upwards slopping

why would a firm call a bond

if and only if interest rates have fallen . it helps the company refinance because now they can pay lower coupons when they resell them. the high the coupon at purchase the more likely it will be called.

accured interest

if you sell the bond in the middle of a period you dserve the money for the time you held it for. must be paid at closing

the higher the investors tax bracket the mre liekly they will pick---- bond

municipal

interest rate risk

the risk of a change in the value of a bond resulting from a change in interest rates.

what are the 3 types of bond issuers

1. corporations 2. federal government 3.state/local gov

what 3 factors determine the shape of the term structure

1. real rate of interest- compensation investors demands (time value of money) 2. rate of inflation (inflation premium) 3.interest rate risk

what 3 things effect treasury yeild

1the real rate, 2 expected future inflation, 3the interest rate risk premium

zero coupon bonds

A bond that pays no coupons at all must be offered at a price that is much lower than its stated value.

call provision

A call provision allows the company to repurchase or "call" part or all of the bond issue at stated prices over a specific period. Corporate bonds are usually callable.

syndicated loan

A loan offered by a group of lenders (called a syndicate such as bank of america and goldman sachs) who work together to provide funds for a single borrower. The borrower could be a corporation, a large project, or a sovereignty (such as a government). The loan may involve fixed amounts, a credit line, or a combination of the two

define debt capital

A measurement of a company's financial leverage, calculated as the company's debt divided by its total capital.

sinking fund

A sinking fund 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.( since a lot of bonds mature at once they will have money to pay everyone) The trustee does this by either buying up some of the bonds in the market or calling in a fraction of the outstanding bonds

what are the characteristics of a bond

Bonds are a debt instrument in which a company of government borrows money from investors and according to the conditions of the bond will repay the face value at maturity while making interest payments(coupons) to the bondholders at specified dates.

From a financial point of view, the main differences between debt and equity are the following:

Debt is not an ownership interest in the firm. Creditors generally do not have voting power. 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. Unpaid debt is a liability of the firm. If it is not paid, the creditors can legally claim the assets 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.

default risk premium

Investors recognize that issuers other than the Treasury may or may not make all the promised payments on a bond, so they demand a higher yield as compensation for this risk. This extra compensation is called the default risk premium

the 2 leading bond-rating firms are

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

real rates

Real rates are rates that have been adjusted for inflation.

whats included on a indenture

The basic terms of the bonds. The total amount of bonds issued. A description of property used as security. The repayment arrangements. The call provisions. Details of the protective covenants.

what 2 features do floating rate bonds have

The holder has the right to redeem the note at par on the coupon payment date after some specified amount of time. This is called a put provision, and it is discussed in the following section. The coupon rate has a floor and a ceiling, meaning that the coupon is subject to a minimum and a maximum. In this case, the coupon rate is said to be "capped," and the upper and lower rates are sometimes called the collar.

interest rate risk premium

The longer is the term to maturity, the greater is the interest rate risk, so the interest rate risk premium increases with maturity

how do you determine the coupon for a floating rate bond

The rate that the bonds earn for a particular six-month period is determined by taking 90 percent of the average yield on ordinary five-year Treasury notes over the previous six months.

term structure of interest rates

The relationship between short- and long-term interest rates These rates are, in essence, "pure" interest rates because they involve no risk of default and a single, lump sum future payment. In other words, the term structure tells us the pure time value of money for different lengths of time.

Treasury notes and bonds have three important features

They are default-free, they are taxable, and they are highly liquid

sovereign bonds

are issues by a national government and denominated in the foreign currency. . you have to looks at exchange rates which effect your bond.

debt securities are typically called

bonds.

treasury bills

bought at discount with an original maturiy of one year or less. gain interest based on capital gain. most liquid

accrued interest formula

days since last coupon payment/days in period * coupon rate/2 * Face Value

unsecured bonds

debenture- theres is no specific pledge of property most bonds in the USA are debenture

a bond, is a secured

debt

US treasury securities

debt securities issued by government . no default risk because they control money supply

bond ratings are concerned only with the possibility of

default

whats the main point of a syndicated loan

dominant way for corporation in the U.S to recieve loans from lenders. main purpose is to spread risk among lenders.

how are bonds and revolving credit lines different.

in a bond all the money is recieved upfront

term sturctre is based on

pure discount bonds

default risk

riks that the company will default, which mean they do not pay the interest of principal that is promised in a timely manner

the more risk the higher the

risk premium

sinking funds make bonds less

risky

private placement does NOT have to be registed with

securites and exchange commisson

senority

seniority indicates preference in position over other lenders, and debts are sometimes labeled as senior or junior to indicate seniority.

floating rate bond

the coupon payments are adjustable. The adjustments are tied to an interest rate index such as the Treasury bill interest rate or the 30-year Treasury bond rate.

formula for fisher effect

(1+R)=(1+r)(1+h)

liquidity premium

, there are an enormous number of bond issues, most of which do not trade regularly. As a result, if you wanted to sell quickly, you would probably not get as good a price as you could otherwise. Investors prefer liquid assets to illiquid ones, so they demand a liquidity premium on top of all the other premiums we have discussed. As a result, all else being the same, less liquid bonds will have higher yields than more liquid bonds.

liquidity risk

in order to sell the bond you hav to sell at a discount if you need the cash right away

Bonds DO NOT represent

ownership in the company

IMMEDIETLY after the coupon payment is made, the clean price

= dirty price

as a general rule, equity represents

an ownership interest, and it is a residual claim. equity holders paid after debt holders

collateral

are bonds secured by any of the firms assets

nominal rates

are called "nominal" because they have not been adjusted for inflation

treasury bonds

are coupon bearing debt instruments with a maturity greater than 10 years.

treasury notes

are coupon-bearing debt instruments with a maturty between 1 and 10 years

The real rate on an investment is the percentage change in how much you can

buy with your dollars—in other words, the percentage change in your buying power.

convertible bond

can be swapped for a fixed number of shares of stock anytime before maturity at the holder's option. Convertibles are relatively common, but the number has been decreasing in recent years.

yeild curve is based on

coupon bond yeilds

term loan

is a loan that appears much like a traditional bond, but instead it is a loan from a bank with a specified repayment schedule. the company pays interest on the borrowed amount- the interest rate is gerenally a floating interest rate. . used by small bussiness for small money

revolving credit line

is like a credit card for a company- they are approved to borrow up to some limit and they can acess the money when and as needed. So for example, a company might be approved for a revovling credit line of 1 Million and use is as needed

dirty price

is the present value of ALL future cash flows. it INCLUDES accrued interest

clean price

is the present value of all future cash flows to which you are entitled.

indenture

is the written agreement between the corporation (the borrower) and its creditors. It is sometimes referred to as the deed of trust. Usually, a trustee (a bank, perhaps) is appointed by the corporation to represent the bondholders. The trust company must (1) make sure the terms of the indenture are obeyed, (2) manage the sinking fund (described in the following pages), and (3) represent the bondholders in default—that is, if the company defaults on its payments to them

The nominal rate on an investment is the percentage change in the

number of dollars you have.

a senior debenture has a higher---- than a subordiate debenture meaning

senority in case of a bankruptcy, a subordinate debenture is paid last

the word spread indicated

that we are comparing them on 2 different investments and finding the difference- we attibute the diference to the different risk factors for the 2 bonds, including crdit risk when analyzing bonds

the maximum reward for a debt is------ while the maxium portenital reward for equity is -----

the amount of the loan limitless

The main difference between public-issue and privately placed debt is that

the latter is directly placed with a lender and not offered to the public. Because this is a private transaction, the specific terms are up to the parties involved.

call risk

the risk that the bond can be called by the company. most likely when interest rates have fallen because company will want to refinance.

debenture

unsecured. these are based on the firms good name only. since they are riskier they pay higher interest rates

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

upward slopping and vice versa

the clean price is used in---- the dirty price is used in-----

usa europe

private placement

with private placement a relatively small number of select invetors, usually insitutions such as mutal funds, and large banks, insurance comapnies or pension funds purchase the compaies bonds.

call protected

a company might be prohibited from calling its bonds for the first 10 years. This is a deferred call provision. During this period of prohibition, the bond is said to be call-protected.

whats the base rate

US treasury bond , since these securities are considered risk free

example of floating rate bond

adjustable mortage

the clean price is the prices of what-------- while the dirty price is----

clean price is what you are receiving dirty price is the check you have to write

security type bonds

collateral- backed by C/S mortgage securities(deed)- secured by real property

public bond market

is primarily an over-the-counter market. the dealers are connected electonically.

municipal bond

issued by state or local gov intrest recieved is tax EXEMPT rates similarly to corproate debt(aaa, aa,etc) so not taxed

whats the advantage to a convertible bond

its attractive to investores because it allows them to earn a return in the early years (bond coupon payment), it gives them first position if the firm goes bankrupt, but it also gives them the upside if the company becomes successful. common for startups

taxability premium

ivestors demand the extra yield on a taxable bond as compensation for the unfavorable tax treatment. This extra compensation is the taxability premium.

An important thing to recognize about a bond's yield is that it is calculated assuming that all the promised payments will be

made. if the issuer defaults, your actual yield will be lower—probably much lower this is important for junk bonds .... they are promised yeilds not guarenteed

With revolving credit how do companys make payments

the comany is expected to make payments for interest AND to substantially pay off the principal from time to time. they cannot simpy wait until maturity to do so.

whats a benefit of a revolving credit line

the company only borrows when they need the money . They can borrow the money right when they need it- this is valuable since bond issuance usually takes quite a bit of time

credit risk spread

the difference between the yield on a corporate spread and a risk free bond

par value

usually 1000. this is the amount you get at maturity