BUAD 306 Chapter 7
Quiz
- How do you find the value of a bond, and why do bond prices change? - What is a bond indenture, and what are some of the important features? - What are bond ratings, and why are they important? - How does inflation affect interest rates? - What is the term structure of interest rates? - What factors determine the required return on bonds?
Which bonds have the highest degree of reinvestment rate risk? Which bonds have the highest degree of interest rate risk? Which bonds have the highest degree of default risk? Which bonds have the highest degree of liquidity risk? Which bonds are most vulnerable to inflation?
1. High interest rate bonds and ST bonds 2. Low interest rate bonds and LT bonds (price risk) 3. High interest rate bonds and LT bonds 4. Low interest rate bonds and ST bonds - as an investor if you can trade in your bond faster (more liquid) then you'll receive less yield (less interest) 5. High interest rate bonds (to account for inflation) and LT bonds
Bond Pricing Theorems
- use to compare and come up with base prices for other bonds Bonds of similar risk (and maturity) will be priced to yield about the same return, regardless of the coupon rate - book example page 203 - both have 12 years to maturity but one has 10% coupon while other has 12% coupon - YTM will be 11% for both in this example If you know the price of one bond, you can estimate its YTM and use that to find the price of the second bond This is a useful concept that can be transferred to valuing assets other than bonds
Zero Coupon Bonds*
--> lump sum payment at end (T bills example of zero coupon bond) - Make no period interest payments (coupon rate = 0%) at a price that is much lower than its stated value --> example: bond issues $1000 face value with initial price set to $508.35 --> even though interest is not actually paid, owner of bond must pay taxes on interest accrued each year even though no interest is actually received --> attractive for tax-exempt investors with long-term dollar-denominated liabilities like pension funds because the future dollar value is known with relative certainty - Entire yield to maturity comes from difference between purchase price and par value (face value) - Cannot sell for more than par value - Sometimes called zeroes, deep discount bonds, or original issue discount bonds (OIDs) - Treasury Bills and principal-only Treasury strips are good examples of zeroes
Bond Classifications Security
1. Collateral - secured by financial securities 2. Mortgage - secured by real property, normally land or buildings - When collateral is real estate - Bond backed by real estate is called a mortgage - He holds a mortgage on your house means he holds a bond on your house that's secured by the house asset 3. Debentures - unsecured - Common for large, notable companies → Apple bonds - No chance of not getting bond payments - Will have a higher interest rate - no specific pledge of property/collateral is made - debentures only have claim on property not otherwise pledged (after mortgages and collateral trusts are taken into account) 4. Notes - unsecured debt with original maturity less than 10 years - note: maturity of less than 10 years - bond: longer-term issues
Factors Affecting Bond Yields
1. Default risk premium - remember bond ratings - possibility of default, issuers other than US Treasury may not make all promised payments on bond - lower-rated bonds have higher yields (to account for risk) but it's also not guaranteed that you will get this full yield if issuer defaults esp with junk bonds (Investment-grade debt is considered to have low default risk and is generally more sought-after by investors. Conversely, non-investment grade debt offers higher yields than safer bonds, but it also comes with a significantly higher chance of default.) 2. Taxability premium - remember municipal versus taxable - muni bonds are free from most taxes and have much lower yields than taxable bonds - investors demand extra yield on taxable bond as compensation for unfavorable tax treatment 3. Liquidity premium - bonds that have more frequent trading will generally have lower required returns - callable bond terms - if you want to sell quickly you probably won't get as good of a price as you could otherwise - investors prefer liquid assets vs. illiquid (hard to sell assets while retaining value) - less liquid bonds will have higher yields to account for illiquidity --> increase in liquidity preference must cause market yields on short-term debt to decrease 4. Anything else that affects the risk of cash flows to bondholders will affect the required returns real rate of interest --> compensation investors demand for forgoing the use of their money --> pure time value of money after adjusting for effects of inflation
Other Bond Types
1. Disaster bonds - CAT bonds - CAT bond allows the issuer (the borrower aka the government who pays interest to the investors) to receive funding from the bond only if specific conditions, such as an earthquake or tornado, occur - if certain disaster is triggered, investors pay out/lose all of their money! - generally the higher interest rates than most other fixed-income securities - long-term bonds 2. Income bonds - similar to conventional bonds but coupon payments depend on company income - coupons paid to bondholders only if firm's income is sufficient - not common - lower interest rates possibly 3. Convertible bonds - can be swapped for a fixed number of shares of stock anytime before maturity at the holder's option - relatively common but number decreasing --> You'd rather convert than hold a bond if stock prices yield higher returns than bond - reverse convertible: offers high coupon rate but redemption at maturity can be paid in cash at par value or paid in shares of stock --> risky if stock declines by the time maturity comes around where shares are worth less than par value - higher coupon rates than normal bond 4. Put bonds - Allows bond holder to force issuer (borrower) to buy back bond at the stated price --> real life has higher interest rates - Opposite of callable bonds --> You can put them back on the corporation → put money back - put bond is a bond that allows the bondholder to force the issuer to repurchase the security at specified dates before maturity - company with bonds outstanding that allows the holder of this bond to force this company to buy back 100% face value of bond if certain risk events happen (credit rating falls lower than investment BBB investment) - A put option gives the bond holder the ability to receive the principal of the bond whenever they want before maturity for whatever reason. If the bond holder feels that the prospects of the company are weakening, which could lower its ability to pay off its debts, they can simply force the issuerer to repurchase their bond through the put provision. It also could be a situation in which interest rates have risen since the bond was intially purchased, and the bond holder feels that they can get a better return now in other investments. - Investors are wiling to accept a lower yield on a put bond than the yield on a straight bond because of the value added by the put option. Likewise, the price of a put bond is always higher than the price of a straight bond. --> willing to pay more because you have the freedom to put it back on them in case of an event There are many other types of provisions that can be added to a bond and many bonds have several provisions - it is important to recognize how these provisions affect required returns (discount rate R, not real rate of return r)
Differences Between Debt/Equity → MC Questions on exam Debt
1. Not an ownership interest 2. Creditors do not have voting rights 3. Interest is considered a cost of doing business and is tax deductible --> Interest is tax deductible (you can tax interest payments) --> dividends paid to stockholders at not tax deductible --> Corporations didn't pay income taxes for years → double taxation on capital slows economic growth 4. Creditors have legal recourse if interest or principal payments are missed - liability of a firm for unpaid debt 5. Excess debt can lead to financial distress and bankruptcy - liquidation or reorganization possible consequences of bankruptcy if unpaid debt (liability) → you get a tax break in our economy for more debt than equity --> Deduce interest paid on debt before getting taxed (lower tax bill) Firms have huge incentives to pay Dividends to get capital out of hands from managers and into hands of investors (to reinvest back into company or somewhere else) You don't file for bankruptcy for too much equity, you file for too much debt Tax code favors additional debt
Differences Between Debt/Equity → MC Questions on exam Equity
1. Ownership interest - if the company goes bankrupt it is your bankruptcy 2. Common stockholders vote for the board of directors and other issues (such as mergers) 3. Dividends are not considered a cost of doing business and are not tax deductible --> Dividends are NOT tax deductible Not a cost of doing business so what are they? --> What you pay to use your capital in the form of equity 4. Dividends are not a liability of the firm, and stockholders have no legal recourse if dividends are not paid 5. An all equity firm can not go bankrupt merely due to debt since it has no debt → but it can go out of business!
Term Structure of Interest Rates
1. Term structure is the relationship between time to maturity and yields, all else equal - short-term and long-term interest rates will be different - generally short-term are higher - term structure of interest rates is relationship between ST and LT rates - tells us what nominal interest rates (no inflation) are default free/pure discount bonds of all maturities - these rates are "pure" interest rates because they involve no risk of default and a single, lump-sum future payment - structure: tells us pure time value of money for different lengths of time 2. It is important to recognize that we pull out the effect of default risk, different coupons, etc. 3. Yield curve - graphical representation of the term structure → very important -Normal - upward-sloping; long-term yields are higher than short-term yields -Inverted - downward-sloping; long-term yields are lower than short-term yields https://www.treasury.gov/resource-center/data-chart-center/interest-rates/Pages/TextView.aspx?data=yield EC: When was the last yield curve inversion? From 1 month (1.6%) to 10 year (1.46%) yield curve is inverted (you get paid less per year to hold debt that's 10 years long than you get paid for debt that's 1 month long) → sign of recession (on test) - Significant piece of the average adult's taxes are payroll taxes - A good solution: lower government spending to lower the amount they need to tax us! - Government is spending less during times we were fighting wars in the past than we are now
Treasury Quotations
8 Nov 21 136:29 136.30 5 4.36 Maturity date: 8 Nov 21 Bid price: 136:29 - selling for this --> :29 → 30 seconds of a dollar --> Yield on treasury security is currently up 9/32 (up 9 of 32 seconds of a dollar) Ask price: 136:30 How much did the price change from the previous day? - 5% --> the ask price increased by 5% from previous day Yield to Maturity (based on ask price): 4.36% - interest rate fallen - YTM is < coupon of 8% --> premium Coupon rate - 8% What is the bid price? What does this mean? How much someone wants/willing to pay What is the yield based on the ask price?
Current Treasury Yield Curve
Blue line: in 2007 → yield curve was kinked or inverted (on year ago from 2008) → sign of a recession Housing prices immediately dropped by ⅓ in good neighborhoods No prices in bad neighborhoods/nobody wanted to buy there Green line: today in 2008 → no longer in recession, yield curve is normal Treasury yield curve: U.S. Treasury provides plot of Treasury yields relative to maturity Treasury yield curve and term structure of interest rates almost the same thing - difference: term structure based on pure discount bonds while yield curve based on coupon bond yields - depends on real rate, expected future inflation, and interest rate risk premium
Bond Coupon Face value or Par value Coupon Rate Yield to Maturity Current Yield
Bond Coupon - interest payments you pay back Face value or Par value - amount that will be repaid at the end of a loan (not the adjusted market discount/premium value) par value bond: a bond that sells for its par value (typically $1000 for corporate bonds) - if yield to maturity market rate increases, bond's PV will decrease (sell at discount) - bond sells for less than face value - Assumed to be $1,000 in U.S. - Bonds all have the same initial price (1,000) - If you're looking to invest more than $1,000 just buy multiple bonds (if you need 10,000 buy 10 bonds) Coupon Rate - annual coupon / by face value - Discount bond to account inflation - Brings $1,000 face value bonds to market value so that their prices/offering are still competitive - You want to be paid back for the difference in exchange for the risk you're taking if the interest rates go up - Bonds can be adjusted to $0 but bonds almost never go to $0 because the bankruptcy core will force the company into liquidation (seize assets) = Amount of Coupon Payment / Face Value of Bond Yield to Maturity - interest rate required in the market on a bond - a bond's yield Current Yield - bond's annual coupon / price
Bond prices: Relationship Between Coupon and Yield
Bond prices: most direct proof that finance "works" Federal government adjust interest rates on bonds to account for fluctuations in economic activity •If YTM = coupon rate, then par value = bond price •If YTM > coupon rate, then par value > bond price -Why? The discount provides yield above coupon rate -Price below par value, called a discount bond •If YTM < coupon rate, then par value < bond price -Why? Higher coupon rate causes value above par -Price above par value, called a premium bond
Bond Ratings - Investment Quality
Bond ratings are concerned only with the possibility of default Price of a highly rated bond can still be quite volatile as bond ratings don't account for fluctuations in interest rate High grade - Moody's Aaa and S&P AAA → capacity to pay extremely strong - Moody's Aa and S&P AA → capacity to pay very strong Medium grade - Moody's A and S&P A → capacity to pay strong, but more susceptible to changes in circumstances - Moody's Baa and S&P BBB → capacity to pay adequate, adverse conditions will have more impact on the firm's ability to pay https://www.standardandpoors.com/en_US/web/guest/article/-/view/sourceId/504352 Ratings only applicable in U.S. (not international) Theres no ratios in these descriptions (all qualitative descriptions) For how long is a rating "good" or valid → it's good until it's changed 1 year, 5 years, 10 years? Credit ratings changed bond ratings during recessions → if the next day something bad happens in the news and S&P reads it, ratings will immediately be changed But not all people will be notified of these rating changes
Clean vs. Dirty Prices - know but don't need to calculate on test
Clean price: quoted price (independent of the interest accrued) Dirty price: price actually paid = quoted price + accrued interest (from selling or buying in between interest payment periods) Example: Consider a T-bond with a 4% semiannual yield and a clean price of $1,282.50: -Number of days since last coupon = 61 → will include for the new party the accrued 61 days of interest payments -Number of days in the coupon period = 184 -Accrued interest = (61/184)(.04*1000) = $13.26 -Dirty price = $1,282.50 + $13.26 = $1,295.76 → So, you would actually pay $ 1,295.76 for the bond
The Bond Indenture
Contract between company and bondholders that includes: 1. The basic terms of bonds 2. Total amount of bonds issued 3. Description of property used as security, if applicable 4. Sinking fund provisions Money set aside to pay bondholders back 5. Call provisions - You call the bonds in - Why? --> Might be beneficial to company to pay off their bonds early because you can refinance them at new, lower interest rates (interest rates are at an all time low) - Generally a waiting period for when to call a bond in 6. Details of protective covenants - limits certain actions a company might otherwise wish to take during the term of the loan - Protect the bondholders from what shareholders might want to do - Dividends can't exceed 20% of NI - Current ratio is always above 2 --> If you violate one of these covenants then the bond is subject to renegotiation - protects price of a bond
Bond Characteristics and Required Returns → MC on exam
Coupon rate depends on the risk characteristics of the bond when issued Which bonds have the higher coupon, all else equal? 1. Secured debt vs. debenture - Unsecured debts have higher interest rates 2. Subordinated debenture versus senior debt - Back of line interest is higher - Front of line has taken much less risk at lower interest rate to ensure that they get paid in worse case of bankruptcy - Everyone behind is in a riskier state so they'll charge a higher price for this risk (higher coupon rate) 3. Bond with sinking fund vs. one without - Higher sinking fund is more secure and therefore a lower coupon rate (less risky so lower interest rate needed) - sinking fun: account managed by bond trustee for purpose of repaying bonds 4. Callable bond vs. non-callable bond - Callable bonds can have higher coupon rates (to account for the chance they're called/payed back early and no more interest can be collected) - Bond isn't callable for 5 years at 12% prevents bond from being reissued at lower interest rate - secures interest payments to whoever issued the bond
Floating Rate Bonds
Coupon rate floats depending on some index value - coupon payments are adjustable (not just constant 10%) Examples - adjustable rate mortgages and inflation-linked Treasuries There is less price risk with floating rate bonds --> The coupon floats, so it is less likely to differ substantially from the yield-to-maturity Coupons may have a "collar" - the rate cannot go above a specified "ceiling" or below a specified "floor" --> Collars → you pay no more than 10% and they collect no less than 2% → interest rate is capped at =>2% and <= 10%
Current Yield vs. Yield to Maturity
Current Yield = annual coupon / price - ex: $80 / 955.14 (book pg. 202) - coupon rate of 8% vs. 9% YTM (lower PV - discount) - = 8.38% current yield < 9% YTM - Discount bond: current yield is lower because it only considers coupon portion of your return and doesn't consider the built-in gain from the price discount - Premium bond: current yield will be higher than YTM because ignores built-in loss of premium between now and maturity Yield to maturity = current yield + capital gains yield
Fisher Effect
Defines relationship between real rates, nominal rates, and inflation If real return and expected inflation are relatively high, there is a significant difference between the actual Fisher Effect and the approximation.
Relationship between payout Debt/Equity
Example If bonds are going way down in a company → when a company is going into bankruptcy - If you buy 80% of bonds when the company goes bankrupt you're the new owner - Equity holders don't get anything → they will pay off debt to creditors first (bond holders aka you) when a company goes bankrupt Some corporations try to create a debt security that is really equity to obtain the tax benefits of debt and the bankruptcy benefits of equity (debt tax benefits - interest deducted before taxed but equity means no bankruptcy possible as it is not a liability)
Ethics Issue
In 1996, allegations were made against Moody's that it was issuing ratings on bonds it had not been hired to rate, in order to pressure issuers to pay for their service. The government conducted an inquiry, but charges of antitrust violations were dropped. Even though no legal action was taken, does an ethical issue exist? → Yes A "pure public good" → not being paid to do it, not required to believe them, "just a report" and therefore they're not guilty in court Bristow shocked that charges were dropped Many financial companies avoided bankruptcy through government aid (to avoid domino effect of crashing economy) WeWork avoided bankruptcy through additional funding of investors Bristow: can't make money if you're buying assets for more than what you're making on them Buying office complexes and renting them out to companies who can't afford them (losing money, negative profit)
Interest Rate Risk Price Risk Reinvestment Rate Risk
Interest rates are currently historic low prices!! (2.1% vs. 14% in the past) Low interest rates will lead to a price risk --> Bond value will increase Price Risk - Change in price due to changes in interest rates - Long-term bonds have more price risk than short-term bonds --> The longer the bond the greater the price risk (longer until maturity date/payout) - Low coupon rate bonds have more price risk than high coupon rate bonds (less return) - higher coupon has larger cash flow early in its life so its value is less sensitive to changes in the discount rate - bond with lower coupon is more dependent on face amount to be received at maturity --> If coupon payments get really small then most of your money is more and more in the future (get paid less each coupon payment) --> Zero coupon rates = maximum amount of price risk ($0 no coupon payments) Reinvestment Rate Risk - if interest rates decline to 10% the reinvestment risk is that you may not have other good investment options to make up for the difference (what if the only place you can invest your money is only 2% now?) → some retirees have no place to put their money as interest rates have declined - Uncertainty concerning rates at which cash flows can be reinvested - Short-term bonds have more reinvestment rate risk than long-term bonds --> if you'll get entire amount of bond back in 1 year the entire reinvestment rate risk is right in front of you (figure out what to do with this money now) --> return of principal is the risk - inverted yield curve: short rates are above long rates -High coupon rate bonds have more reinvestment rate risk than low coupon rate bonds If interest rates rise your portfolio of bonds will decline in value! - You get reimbursed/get your money back through coupon rate adjustment but you get this back in 20 years or much later - When interest rates change, bond prices change - Bond price risk: if interest rates go up your bond price can plummet Graph: The longer the maturity date the steeper this curve (more time to maturity)
Bond Markets
Primarily over-the-counter transactions with dealers connected electronically - No physical location - No exchange on floor or on stock system (NASDAQ) - Bonds are purchased put in a drawer and forgotten about (for retirement) Extremely large number of bond issues, but generally low daily volume in single issues → Bonds with huge daily volume are generally government bonds! - government way more than private issues - Some of these securities are listed on NYSE Makes getting up-to-date prices difficult, particularly on small company or municipal issues - although total volume of trading bonds far exceeds that in stocks, only a small fraction of total bond issues that exist actually trade on a given day --> not much liquidity in bond market --> huge number of issues: people buy bonds and hold them (don't like to trade them) - trading: buying/selling between other people - this fact along with lack of transparency in bond market due to mainly over the counter OTC (transactions privately negotiated between parties with no centralized reporting of transaction unlike NYSE) makes getting up to date prices on individual bonds difficult/impossible Treasury securities are an exception - People hold treasuries for the benefits of high liquidity (no default risk so people trade more and are more willing to trade daily) - traded often --> people trade frequently results in higher liquidity North Koreans hold U.S. treasuries
Inflation and Interest Rates
Real rate of interest - change in purchasing power - What you get paid nominally - inflation - The real improvement in your life/purchasing power Nominal rate of interest - quoted rate of interest, change in actual number of dollars - not adjusted for inflation - The ex ante (from before in Latin, future events or potential return in finance) nominal rate of interest includes our desired real rate of return + an adjustment for expected inflation
Bond Classifications Registered vs. Bearer
Registered vs. Bearer Forms Bearer: whoever owns the bond holds the bond themselves - ownership is not recorded other than the one certificate - company doesn't know who owns the bonds so it can't notify bondholders of important events Registered: serial number on it, a way to track your bond through your account and get them reissued - Much more secured
Bond Classifications Seniority
Seniority During bankruptcy: - Creditors line up based on seniority - Most senior debt lines up first and is satisfied in total before the next person in line is paid out (senior debt) - Person in back of line probably have the highest interest rates (junior debt) and lower prices on bonds - Entrepreneurs are paid at the end of the line Junior: if you're getting paid out (collecting face amount of your bond) after the seniors, you're willing to pay less/loan less for your bond now (lowering price of bond) for a higher risk --> the higher risk is why you receive a high interest payment (possibly) Senior: if you're getting paid out before juniors, you're willing to pay more/loan more for your bond now (raising price of the bond) for a lower risk in collecting face amount of bond during liquidity --> the lower risk is why you receive a lower interest payment (possibly) Debt holders get paid first then preferred shareholders and then common shareholders get paid last! - debt can't be subordinated (less important) to equity Toys"R"Us → shareholders lost 100% of their investments while debt holders got paid out through sale of assets/liquidation of company
Government Bonds Treasury Securities Municipal Securities
Treasury Securities - Federal government debt 1. T-bill - pure discount bonds with original maturity <= 1 year Discount Loan: you receive entire principal without any interest payments (pay all interest in lump sum at the end) --> considered 0 risk (will get only interest difference when buying from market - if buying when issued you'll get the full principal + interest back) - Treasury bills are excellent examples of pure discount loans. The principal amount is repaid at some future date, without any periodic interest payments. 2. T-notes - coupon debt with original maturity 1 year < x < 10 years 3. T - bonds - coupon debt with original maturity >10 years Treasury bonds... 1. Have no default risk because the Treasury can always come up with the money to make payments 2. Exempt from state income taxes (but not federal income taxes) Municipal Securities (munis) - Debt of state and local governments - Varying degrees of default risk, rated similar to corporate debt - Interest received is tax-exempt at the federal level --> makes munis very attractive to high-income, high-tax bracket investors ---> Invest in municipal securities to avoid interest taxes! --> because of huge tax break, yields on munis are much lower than yields on taxable bonds - Almost always callable - interest on debt is tax deductible - if you increase your interest by issuing debt, you'll have much less overall tax! - but if you have any business interruption you'll end up going bankrupt (too much interest expense that you're contractually obligated to pay) - all equity - no tax deduction - more likely to survive business interruption Should you like municipal debt? → depends on your tax rate (example slide 27) - Debt by non-governmental entities (sewer treatment district) - States can still go bankrupt https://www.governing.com/gov-data/municipal-cities-counties-bankruptcies-and-defaults.html New York went bankrupt → got more sophisticated and earn a little more income on portfolio but they lost it all Bankruptcy either leads to... 1. Reorganization filing (let them keep operating because they can pay this debt) 2. Liquidation filing (business model isn't working and they recommend selling all assets/paying off credit)
Graphical Relationship Between Price and YTM
When Par Value of bond was $1,000 the coupon rate was 8% If at any point the interest rate returns to 8% the bond will have a an adjusted value of $1,000 (even if the bond is almost at its maturity date) As the coupon payments go by the bond gets closer to its maturity
Bond Ratings - Speculative
Which is riskier? Equity or junk bonds? - Junk bonds: low-grade bond, rated below investment grade by major rating agencies (below BBB by S&P) - Junk bonds are much less risky than equity in the same firm - Junk bonds still stand at front of line versus shareholders/equity are at end of line Low Grade - Moody's Ba and B - S&P BB and B - Considered possible that the capacity to pay will degenerate Very Low Grade - Moody's C (and below) and S&P C (and below) --> Income bonds with no interest being paid --> Or in default with principal and interest in arrears (money that is owed and should have been paid earlier) Example: bond that yields 47% - Small coupon payments are suddenly 47% of bonds value - Bond will get paid based on priority order in liquidation → this bond is VERY risky due to such high interest payments required
A project has a required return of 14% and cash flows every year for seven years. Which of the following is inconsistent with the other four? a. The payback period is 7 full years b. The project has conventional cash flows. c. NPV=$0 d. IRR = 14% e. The present value of the future cash flows is equal to the initial outlay
a. The payback period is 7 full years
If the required return on a bond does not change from one year to the next, then ________ over the same period. (Ignore changes in default risk.) a. the price of a perpetuity will fall b. the price of a premium bond will fall c. the price of a discount bond will fall d. the price of a par bond will fall e. the price of any bond will fall
b. the price of a premium bond will fall if required return doesn't change, there's less risk as a result, the price of your bond will move towards face/par value price of premium will fall towards 1000, price of discount will raise towards 1000
An increase in which of the following factors must cause the market yields on short term debt to decrease? (Hint: I'm not asking about entire yield curve slope, just the low maturity YTMs.) a. Interest Rate Risk b. Re-Investment Rate Risk c. Liquidity Preference d. Investor's dislike of risk e. Inflation
c. Liquidity Preference - more liquid, yield lower --> if you sell quickly you probably won't get as good of a price as you would otherwise a. interest rate/reinvestment rate risk increases --> yield more e. inflation increases --> yield more
One redeeming characteristic of IRR compared to NPV is that: a. IRR is insensitive to project independence. b. IRR can lead to multiple rates of return, which makes project selection a simpler exercise. c. Project profitability can be expressed independent of the project's scale. d. IRR is can be solved for by a calculator. e. The IRS sometimes accepts IRR evidence in tax hearings
c. Project profitability can be expressed independent of the project's scale.
Which of the following indenture clauses will decrease the price of a bond? a. The bond is convertible. b. The bond is protected by collateral. c. The bond is junior rather than senior debt. d. The bond indenture contains protective covenants. e. The bond indenture sets up a sinking fund.
c. The bond is junior rather than senior debt. junior debt: paid out after seniors, pay less/loan less for bond to account for this higher risk d: indentures protects price of a bond e: sinking fund makes bond less risky (willing to loan at higher price), lower interest rate on bond possibly a. The bond is convertible. - raises prices because a great deal where you can convert to equity (if you want this freedom you'll pay more for the bond)
You currently hold a convertible bond (convertible into stock) from IBM Corp. Which of the following is good news for you? a. The return on IBM's debt goes up. b. IBM's stock price goes down. c. Inflation goes up. d. IBM's debt rating is changed from B to A e. IBM's profits go down.
d. IBM's debt rating is changed from B to A - makes stock more valuable If debt return goes up = NI / debt (debt decreases) --> still good for company but not necessary going towards shareholders = NI / debt (NI increases) --> good for you since company has more NI to pay dividends
Downward Sloping Yield Curve
if you expect interest rates to fall → Inverted Recession causes prices to fall Don't believe there will be as much inflation in the future due to a recession Interest rate risk premium still increases over time but at a decreasing rate --> inflation rate falling makes a overall downward sloping effect - shape of structure depends on real rate of interest (compensation investors demand for forgoing the use of their money) and rate of inflation (compensation investors demand for loss due to inflation in form of higher nominal rates), and interest rate risk (long-term bonds have greater risk than short-term, investors demand compensation in form of higher rates for bearing greater risk)
Upward Sloping Yield Curve
if you expect interest rates to raise → Normal Interest rate risk premium should be large for 30 year bond (more risk over longer term) Interest rate risk premium still increases over time but at a decreasing rate --> inflation rate rising makes an overall combined upward sloping effect - shape of structure depends on real rate of interest (compensation investors demand for forgoing the use of their money) and rate of inflation (compensation investors demand for loss due to inflation in form of higher nominal rates), and interest rate risk (long-term bonds have greater risk than short-term, investors demand compensation in form of higher rates for bearing greater risk)
Why does a yield curve invert?
inversely related: if prices go up, yield goes down - if you will receive more money in interest, you'll yield less overall invert - people get nervous about current return on bonds if people think we're going into a recession, lock in duration --> lock in current interest rate on bonds if you predict interest rates will drop - maintain same interest rate for 30 years at higher interest - as demand for LT bonds go up, LT bond price goes up - if price goes up, yield goes down causing yield curve on long-term side to decline lower than ST bonds - the more you're paying to get this yield, the less the overall yield becomes
PV of Cash Flows as Rates Change
•Bond Value = PV of coupons + PV of par •Bond Value = PV of annuity + PV of lump sum •As interest rates increase, present values decrease •So, as interest rates increase, bond prices decrease (discount) and vice versa If interest rates increase... - Federal Reserve promised 4 interest rate increases but cut interest rates 3 times - Company suffers some kind of set back (product pulled for example) will cause their bonds to be "riskier" and investors will then offer less for the bonds (meaning the interest rate has changed) We define the price of the bond in terms of the interest rate (neither of these actions come "first" - happen at the same time) - If the interest rate changes that indicates bonds have changed - If the bond changes that indicates the interest rates have changed
Computing YTM
•Yield to Maturity (YTM) is the rate implied by the current bond price •Finding the YTM requires trial and error if you do not have a financial calculator and is similar to the process for finding r with an annuity •If you have a financial calculator, enter N, PV, PMT, and FV, remembering the sign convention (PMT and FV need to have the same sign, PV the opposite sign)