chapter 7

an issuer can handle a sinking duns in either of two ways

1) it can call in for redemption at par value. the bonds are numbered serially and those called for redemption would be determined by a lottery administrated by a trustee. 2) the company can buy the required number of bonds on the open market

mortgage bond

a bond backed by fixed assets. first mortgage bonds are senior in priority to claims of second mortgage bonds. under a mortgage bond the corporation pledges specific assets as security for the bond.

a bond is more likely to be called...

a bond is more likely to be called it its price is above par value- because the price above par means that the going market interest rate (ytm) is less than the coupon rate. a company is more likely to calll its bonds if they are able to replace their current high coupon debt with less expensive finanancing

indexed (purchasing power) bonds

a bond that has interest payments based on an inflation index so as to protect the holder from inflation. the interest rate is based on inflation index such as consumer price index so the interest paid rises automatically when inflation rate rises, thus protecting bondholders against inflation. US treasury is the main issuer of indexed bonds.

new vs outstanding

a bond that has just been issued is called a newly issued bond. once it has been issued it is called an outstanding bond. newly issued bonds are generally sell at prices very close to par but the prices of outstanding bonds can vary widely from par. execpt for floating rate bonds, a coupon payments are constant.

discount bond

a bond that sells below its par value occurs whenever the going rate of interest is above the coupon rate. whenever the going rate of interest rises above the coupon rate,a fixed rate bond's price will fall below par value

income bond

a bonds that pays interest only if it is earned. which pays interest only if the issuer had earned enough money to pay the interest. This income bonds cannot bankrupt a company but from an investors standpoint they are riskier than normal bonds.

indenture

a formal agreement between the issuer and the bondholders. these indentures are generally open ended meaning that new bonds can be issued from time to time under the same indenture.

debenture

a long term bond that is not secured by a mortgage on specific property. an unsecured bond and as such it provides no specific collateral as security for obligation. therefore debentures holders are general creditors whose claims are protected by property not otherwise pledged the use of a debenture depend on the nature of the firms asset on the general credit strength

call provision

a provision in a bond contract that gives the issuer the right to redeem the bonds under specified terms prior to the normal maturity date. the call provision generally states that the issuer must pay the bondholders and amount greater than the par value if they are called. the additional sum which is called a call premium is often equal to one years interest

sinking fund provisions

a provision in a bond contract that requires the issuer to retire a portion of the bond issue each year, faciliates the orderly retirement of a bond issue. sinking fund provisions require the issuer to buy back a specified percentage of the issue each year. a failure to meet the sinking duns requirement constitutes a default. sinking fund is a mandatory payment

maturity date

a specified date on which the par value of a bond must be repaid.

convertible bonds

bonds that are exchangable at the option of the holder for the issuing firms common stock. bonds that are exchangeable into shares of common stock at a fixed price at the option of the bondholder. offer investors the chance for capital gains if the stock prices rises, but that feature enables the issuign company a set a lower coupon rate than on nonconvertible bonds.

zero coupon bonds

bonds that pay no annual interest but are sold at a discount below par, thus compensating investors in the form of capital appreciation

floating rate bonds

bonds whose interest rate flunctuates with shifts in the general level of interest rates. this is when the rate is set and then will flunctuate over time for example some can be converted at the holders option into a fixed rate debt, and some floaters have high upper limits caps, and lower limits (floors) on how high or low the rate can go

original issue discount bond

any bond that originally offered at a price below its par value

provisions in the bond contract..

are set so that the call premium declines over time as the bonds approach maturity. most bonds are often not callable until several years after issue, this is known as a deferred call, and such bonds are said to have call protection. Companies will only call bonds when interest rates decline

subordinated debentures

bonds having a claim on assets only after the senior debt has been paid in full in the event of liquidation in the event of liquidation holders of subordinated debentures receive nothing until all senior debt has been paid

corporate bonds

bonds issued by corporations

foreign bonds

bonds issued by foreign governments or by foreign corporations

municipal bonds

bonds issued by state and local governments

treasury bonds

bonds issued by the federal government sometimes referred to as government bonds

investment grade bonds

bonds rated triple b or higher many banks and other institutional investors are permitted by law to hold only investment grade bonds

fixed rate bonds

bonds whose interest rate is fixed for their entire life

putable bonds

bonds with provisions that allow investors to sell them back to the company prior to maturity at a prearranged price. whereas callable bonds give the issuer the right to retire the debt prior to maturity putable bonds allow investors to require the company to pay in advance. if interest rates rise, investors will put the bonds back to the company and reinvest in higher coupon bonds.

although sinking funds are designated to protect investors...

by ensuring that the bonds are retired in an orderly fashion. these funds work to the determinant of bondholders if the bonds coupon rate is higher than the market rate. a sinking fund called at par would require a long term investor to give up a bond which is an disadvantage.

note that price risk relates to current market value of bond portfolio while reinvestment risk relates to the income the portfolio produces

ex: if you hold a long term bond you will face significant price risk because the value of your portfolio will decline if interest rates rise, but you will not face much reinvestment risk because your income will be stable. on the other hand: if u hold short term bonds you will not be exposed to much price risk but you will be exposed to reinvestment risk .

price risk is higher on bonds that...

have long maturities. this follows because the longer the maturity, the longer before the bond will be paid off and the bondholder can replace it.

junk bonds

high risk, high yield bonds. double b and lower bonds are specultative they have significant probability of going into default

bond

long term debt instrument

warrants

long term options to buy a stated number of shares or common stock at a specified price. similar to convertibles but instead of giving the investors an option to exchange the bonds for stock warrants give the holder the option to buy a stock for a stated price threby providing a capital gain if stock rises. because of this factor bonds issued with warrants carry lower coupon rates than otherwise.

because interest rates can and do rise..

rising rates causes losses to bondholders, people or firms who invest in bonds are exposed to risk from increasing interest rates.

refunding operation

suppose a company sold bonds when interest rates were relatively high. provided the issue is callable, the company could sell a new issue of low-yielding securities if and when interest rates drop, use the proceeds of the new issue to retire the high-rate issue and thus reduce its interest expense. this process is called refunding operation thus the call privilage is valuable to a firm but detrimental to long-term investors who will need to reinvest funds they receive at the new and lower rates

sinking funds, if interest rates have falled since the bonds is issued the firm will..

the bond will sell for more than its par value in this case the firm will use its call option,

when a coupon bond is issued...

the coupon is generally set at a level that causes the bond's market price to equal its par value

a bonds total return is equal to..

the current yield plus the capital gains yield. in the absence of a default risk and assuming market equillibrium the total return is also equal to YTM and the market interest rate

par value

the face value of a bond represents the amount of money the firm borrows and promises to repay on maturity date

for bonds with similar coupons, this differential interest rate sensitivity always holds true----

the longer the bonds maturity, the more its prices changes in response to a given change in interest rates. Thus even if the risk of default on two bonds is exactly the same the one with the longer maturity is typically exposed to more risk from a rise in interest rates

original maturity

the number of years to maturity at the time a bond is issued

investment horizon

the period of time an investor plans to hold a particular investment. which type of risk is more relevant to a given investor depends on how long the investors plan to hold the bonds ex: investors with shorter investment horizons should view long-term bonds as being more risky than short term bonds

yield to maturity

the rate of return earned of a bond that is held to maturity. generally the rate when discussed by investors when and the rate reported on wall street journal

yield to call

the rate of return earned on a bond when it is called before its maturity date if the current interest rates are well below an outstanding bonds coupon rates, a callable bond is likely to be called and investors will estimate its mist likely rate of return as YTC

price (interest rate) risk

the risk of a decline in a bonds price due to an increase in interest rates. interest rates flunctuate over time, and when they rise the value of outstanding bonds decline.

reinvestment risk

the risk that a decline in interest rates will lead to a decline in income from a bond portfolio. reinvestment is high on callable bonds and it also high on short term bonds because the shorter the bonds maturity the fewer the years before the relatively high old coupon bonds will be replaced with the new low coupon issues. thus retirees whose primary holdings ar short term bonds or other securities will hurt badly by a decline in rates, but holders of noncallable long term bonds will continue to enjoy the old high rates

coupon payment

the specified number of dollars of interest paid each year it is set at the time the bond is issued and remains in force during the bonds life. typically at the time a bond is issued its coupon payment is set at an level that will induce investors to buy the bond at or near its par value

coupon interest rate

the stated annual interest rate on a bond this is when the annual coupon payment is divided by the par value the result is this rate

duration

the weighted average of the time it takes to receive each of the bonds cash flows. to account for the effects related to both a bonds maturity and coupon, many analysts focus on measurable called duration. a bonds duration is the weghted average of the time it takes to receive each of the bonds cash flows.

premium bond

whenever the going interest rate falls below the coupon rate a fixed rate bond's price will rise above its par value