ch 6 - interest rates and bond valuation

equity

debt cannot be subordinated to

subordinated debt

debt with an inferior claim (relative to senior debt) to venture assets

Treasury Bonds

default-free, taxable, highly liquid

treasury yields

depend on the three components that underlie the term structure: the real rate, expected future inflation, and the interest rate risk premium

call protected

during the period of deferred call provision, the bond is said to be

interest rate risk

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

make-whole call provision

the bondholder receives exactly what the bond is worth if it is called

greater

the longer the time to maturity, the __________ the interest rate risk

corporate

$1000 is the usual par value of these bonds

Fisher effect

1 + nominal rate = (1 + real rate) x (1 + inflation rate)

bond value

= C x [1-1/(1+r)^t]/r + F/(1+r)^t

Treasury Bonds

Bonds issued by the federal government when they want to borrow money for over 1 year. no default risk, and are exempt from state (but not federal) income taxes

convertible bonds

Bonds that can be converted into common stock at the bondholder's option

medium grade

S&P A, BBB; Moody A, Baa

inflation-linked bond

Type of floating-rate bond that has coupons that are adjusted according to the rate of inflation

zero coupon bond

a bond that pays no coupons at all , must be offered at a price much lower than its stated value. interest rate (YTM) is the difference between purchase price and the par value

premium bond

a bond that sells for more than its face value

discount bond

a bond that sells less than face value

coupon rate

annual coupon/face value

bond

long-term debt is called a

inflation premium

A premium equal to expected inflation that investors add to the real risk-free rate of return

crossover/5b bonds

BBB or Baa by one rating and BB or Ba by another; aka a "split rating)

aftertax yield

Determined for an investment by the formula: Investment yield (1 - Tax bracket).

high grade

S&P AAA, AA; Moody's Aaa, Aa

low grade

S&P BB, B; Moody Ba, B

Very Low Grade

S&P CCC, CC, C, D; Moody's Caa, Ca, C

default risk premium

The additional return required by investors to compensate them for the risk of default. It is calculated as the difference in rates between a U.S. Treasury bond and a corporate bond of the same maturity and marketability

Put Provision

The holder has the right to redeem the bond at par on the coupon payment date after some specified amount of time (characteristic of a floating rate bond)

mortgage trust indenture/ trust deed

The legal document that describes the mortgage

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.

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

30

a corporate bond typically has a maturity of how many years when it is originally issued?

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

treasury yield curve

a plot of the yields on treasury notes and bonds relative to maturity

face/par value

amount repaid at the end of the loan

sinking fund

an account managed by the bond trustee for the purpose of repaying bonds. the company makes annual payments to the trustee, who then uses the funds to retire a portion of debt by either buying up some of the bonds in the market or calling in a fraction of the outstanding bonds

OTC

bond market is almost entirely ______, so there has little or no transparency (transactions are privately negotiated between parties)

collateral

general term that frequently means securities (bonds and stocks) that are pledges as security for payment of debt (commonly referred to any asset pledged on a debt).

Investment Quality Bond Ratings

high and medium grade: S&P's AAA, AA, AA, BBB Moody's Aaa, Aa, A, Baa

indenture

includes: basic terms of the bonds, total amount of bonds issued, description of the property used as security, the repayment arrangements, the call provisions, the details of the protective covenants

yes

is the corporation's payment of interest on debt tax deductible?

Negative Covenant

limits or prohibits actions that the company might take

municipal bonds (munis)

long-term bonds issued by state and local governments. have varying degrees of default risk, rated much like corporate issues, almost always callable. their coupons ARE exempt from federal (and sometimes state) income taxes

maturity

number of years until the face value is paid

Trustee

often a bank, appointed by the corporation to represent the bondholders. purpose is to make sure the terms of the indenture are obeyed, manage the sinking fund, and represent the bondholders in default

creditor/ lender

person or firm making the loan

nominal rates

rates not adjusted for inflation

real rates

rates that have been adjusted for inflation

term structure

reflects the combined effect of the real rate of interest, the inflation premium, and the interest rate risk premium

above

the call price is generally above or below the bond's stated value?

interest rate risk premium

the compensation investors demand for bearing interest rate risk. the longer the term to maturity, the greater is the interest rate risk, so this increases with maturity

real rate of interest

the compensation investors demand for forgoing the use of their money (pure time value of money after adjusting for the effects of inflation)

debtor/borrower

the corporation borrowing the money

public issue, private issue

two major forms of long-term debt

floating rate bonds

the coupon payments are adjustable, the adjustments are tied to an interest rate index. examples include adjustable rate mortgages and inflation-linked Treasuries. there is less price risk, the coupon is less likely to differ substantially from the YTM, coupons may have a "collar" - the rate cannot go above a specified ceiling for below a specified floor

bid-ask spread

the difference between the bid price and the asked price (the dealer's profit)

call premium

the difference between the call price and the stated value

liquidity premium

the extra expected return demanded by investors as compensation for the greater risk of longer-term bonds

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. these are difficult to recover if lost/stolen, and the company cannot notify bondholders of important events. much less common form of bonds

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

Yield to Maturity (YTM)

the interest rate required in the market on a bond

long-term debt

maturity > 1 year

greater

all things being equal, the lower the coupon rate, the __________ the interest rate risk

call provision

allows the company to repurchase or "call" part or all of the bonds issue at stated prices over a specific period.

put bond

allows the holder to force the issuer to buy the bond back at a stated price (opposite of the call provision)

principal value

amount that the issuer agrees to repay the bondholders at the maturity date

debt ratings

an assessment of the creditworthiness (how likely the firm is to default and the protection creditors have in the event of a default) of the corporate issuer

Debenture

an unsecured bond, for which no specific pledge of property is made; holders only have a claim on the property that remains after mortgages and collateral trusts are taken into account

no

are dividends paid to stockholders tax deductible?

lower

because of the enormous tax breaks they receive, the yields on munis are much _______ than the yields on taxable bonds

par value bond

bond that sells for its par value

Structured Notes

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

level coupon bond

coupon is constant and paid every year

Senority

indicates preference in position over other lenders

low-quality, speculative, and/or "junk" bond ratings

low grade, very low grade

short-term (unfunded) debt

maturity < 1 year

bond

normally an interest-only loan (the borrower will pay interest every period, but none of the principal will be repaid until the end of the loan)

"blanket" mortgage

pledges all the real property owned by the company

Equity

represents an ownership interest, and it is a residual claim (holders are paid after debt holders)

mortgage securities

secured by a mortgage on the real property of the borrower. the property involved is usually real estate

debt

something that must be repaid

positive covenant

specifies an action that the company agrees to take or a condition the company must abide by

US Treasury market

the largest securities market in the world

real rate

the percentage change in how much you can buy with your dollars (the percentage change in your buying power)

nominal rate

the percentage change in the number of dollars you have the actual percentage change in the dollar value of an investment adjusted for inflation

taxability premium

the portion of a nominal interest rate or bond yield that represents compensation for unfavorable tax status (municipal vs taxable)

bid price

the price a dealer is willing to pay for a security

ask price

the price a dealer is willing to take for a security

clean price

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

bond coupons

the regular interest payments in which the borrower (corporation or government) promises to make

term structure of interest rates

the relationship between short and long term interest rates (what nominal interest rates are on default-free, pure-discount bonds of all maturities) AKA the pure time value of money for different lengths of time

Break-even tax rate

the tax rate at which an investor would be indifferent between a taxable and a nontaxable issue

indenture

the written agreement between the corporation and the lender detailing the terms of the debt issue. aka deed of trust.

OTC

there is no place where buying and selling occurs, dealers around the country/world stand ready to buy and sell

TRACE

transparency of the bond market is improving under new regulations through

bonds

when a corporation (or gov) wishes to borrow money from the public on a long-term basis, it usually does so by issuing, or selling, debt securities called

more

when interest rates fall, the bond is worth

less

when interest rates rise, the bond is worth

upward sloping term structure

when long term rates are higher than short term rates (most common), a reflection of anticipated increases in inflation

downward sloping term structure

when short term rates are higher than long term rates, reflects the belief that inflation will be falling in the future

one without

which bond will have a higher coupon: a bond with a sinking fund vs one without?

Callable Bond

which bond will have a higher coupon: a callable bond vs a non-callable bond?

Debenture

which bond will have a higher coupon: secured debt vs debenture?

subordinated debenture

which bond will have a higher coupon: subordinated debenture vs senior debt?

riskier

which bonds will have a higher coupon - the more or less riskier one?