Finance Chapter 6
Bond coupon
The bonds stated interest rate.
Default
The failure to repay a debt including interest or principal on a loan or security
Bond maturity
The number of years until the face value is paid
Built-in gain
The only way to get the interest rate up to 10 percent is to lower the $1000 price. -For this bond, the investor who purchased it would get $80/per year and have a $115 gain at maturity.
Creditors or lender
The person or firm making the loan (lending money)
Determinants of Bond Yields
The yield on any particular bond is a reflection of a variety of factors, some common to all bonds and some specific to the issue under consideration: -The term structure of interest rates
Put bond
allows the holder to force the issuer to buy back the bond at a stated price reverse of call provisions
Make-whole call
bondholders receive exactly what the bonds are worth if they are called -If bond holders don't suffer a loss in the event of a call they are made whole -to determine the make-whole call price we calculate the present value of the remaining interest and principal payments at a rate specified in the indenture.
Real rates MATH
interest rates or rates of return that have been adjusted for inflation
U.S. Treasury market
largest securities market in the world
Seniority
-Seniority indicates preference in position over other lenders -Some debts are labeled as senior or junior to indicate seniorty.
term structure of interest rates
- represents the relationship between nominal interest rates on default-free, pure discount securities and time to maturity; that is, the pure time value of money -tells us what nominal interest rates are in default-free, pure discount bonds of all maturities.
Bonds (lecture definition)
-A debt investment - an investor loans money to an entity that borrows funds for: -a defined period of time -at a fixed interest rate The borrower promises to pay the face amount on the maturity date and to pay interest each period
Transparency
-A financial market is transparent if it's is possible to easily observe its prices and trading volume -The bond market is almost entirely OTC (over the counter) so it has little to no transparency -Transactions are privately negotiated between parties and there is little or no centralized reporting of transactions
Collateral
-A term that frequently means securities that are pledged as security for payment of debt -The TERM collateral is commonly used to refer to any asset pledged on a debt Ex. Collateral trust bonds often involve a pledge of common stock held by the corporation
Taxes on government bonds
-Because of their tax breaks, the yields on municipal bonds are much lower than taxable bonds -Must compare after tax yields on bonds
Interest-only loans
-Bonds are usually in the form of interest-only loans which pay interest every year but not the principal until maturity
Bonds semi-annual yield
-Bonds interest rates are stayed annually, but bonds interest rates are usually actually SEMI-ANNUAL in the US -Bonds are quoted like APRs, the quoted rate is equal to the actual rate per period multiplied by the number of periods. ex. 16% annual stated rate actually means 8% every six months.
Registered form
-Corporate bonds are usually in registered form -the registrar of a company records who owns each bond and records any changes in ownership -bond payments are made directly to the owner of record.
Terms of a bond
-Corporate bonds have historically had a face value of $1000 meaning if a corporation wanted to borrow $1 million, 1,000 bonds with a face value of $1000 would have to be sold
Why the bond market is so big
-Corporations typically only have one common stock issue but can have a dozen or more note and bond issues outstanding -Federal, state, and local borrowing is enormous
Bonds and interest rates
-Generally when you make an investment you expect it to rise -This is not always true for bonds, which can start collecting negative yield rates. -Time value of bonds can equate to yield rates. -To prevent losses, companies cut back interest rates to improve their economies.
YTM effect on price
-If YTM > coupon rate, bond sells at a discount -If YTM = coupon rate, bond sells at par -If YTM < coupon rate, bond sells at premium
What determines the term structure?
-If investors believe the rate of inflation will be higher in the future, long-term nominal interest rates will tend to be higher than short-term rates. -An upward-sloping structure may be a reflection of anticipated increases in inflation -A downward-sloping structure probably reflects the beliefs that inflation will be falling in the future.
Interest rate risk cont.
-Increases at a decreasing rate. -The value of a bond depends on the present value of its coupons and face amounts -If two bonds with different coupons rates have the same maturity, the value of the one with the lower coupon rate is proportionally more dependent on the face amount to be received at maturity so if the face amount was the same, this bond would amount to less. -The bond with the higher coupon has a larger cash flow early in its life so its value is less sensitive to changes in the discount rate
Long term bonds sensitivity
-Longer-term bonds have greater interest rate sensitivity because a small change in interest rates would not matter if the bond was to be collected in a year, but would matter if it was compounded over 10 years. -In comparing a 1 year bond to a 10 year it would be easy to see that the 10 year has a much greater interest rate risk but the difference would be smaller between a 20 and 30 year bond.
Zero coupon bonds (lecture)
-Make no periodic interest payments -YTM is the difference between purchase price and par value -Cannot sell for more than par
How bonds are bought and sold
-Most trading in bonds takes place over the counter or OTC meaning there is no particular place where buying and selling occurs. -Dealers around the country stand ready to buy and sell connected electronically
Criteria for determining value of a bond at a particular point in time
-Number of periods remaining until maturity -Face value -The coupon -The market interest rate for bonds with similar features (YTM)
Bond values and yields
-Over time, interest rates change in the market. -Cash flows from a bond, however, stay the same. -The value of the bond will fluctuate. -When interest rates rise, the present value of a bond's remaining cash flow declines and the bond is worth less -When the interest rates fall, the bond is worth more
More on bond features
-Securities issues by corporations may be classified as equity securities and debt securities.
Short-term vs. long-term debt
-Short term maturities: with maturities of one year or less -Unfunded debt: another name for short-term debt -Long term maturities: With maturities of more than one year
Subordinated
-Some debt is subordinated -In the event of default, holders of subordinated debt must give preference to other specificity creditors. These lenders will be paid off only after the specific creditors have been compensated.
Is it debt or equity?
-Sometimes it is unclear as to whether a security is debt or equity -Corporations try to create debt securities that are really equity to obtain the tax benefits of debt and the bankruptcy benefits of equity. -The maximum amount for owning a debt is ultimately fixed by the amount of the loan, there is no upper limit to the potential reward of owning an equity interest.
Yield to Maturity (YTM)
-The annual rate of return anticipated on a bond if held until the end of its lifetime. -The market required rate of return implied by the current bond price. -Found by trial and error -Bond values and interest rates have inverse relationships Bonds are paid semi annually 16% quoted rate = 8 % every six months n = years x 2
Bond table summary
-The highest rating a firms debt can have is AAA, budged to be the best quality and have the lowest degree of default risk -The lowest rating is D, or debt in default -Low-grade or junk bonds, if they are rated at all they are rated below investment grade -Investment grade bonds are rated at least BBB by S&P or Baa by moody's -Crossover bonds or have different ratings by different agencies -A bonds credit rating can change as the issuers financial strength improves or deteriorates -Credit ratings are important because defaults do occur and when they do investors lose heavily
Nominal vs. interest rates YOUTUBE
-The nominal rate on an investment is the percentage change in the number of dollars you have. -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.
The term structure of interest rates (Figure 6.4)
-The relationship between short and long term interest rates is known as the term structure of interest rates. -The term structure of interest rates tells us what nominal interest rates are on default-free, pure discount bonds of all maturities. -The real rate of interest doesn't determine the shape of the structure but influences the overall level of interest rates. -The prospect of future inflation strongly influences the shape of the term structure
Bond Market Value (Lecture Def)
-The value if the bond is the present value of the remaining cash flows the investor expects to receive
Zero coupon bond interest MATH?
-The way in which yearly interest on a zero coupon bond is calculated is governed by tax law. -Under current tax law, the implicit interest is determined by amortizing their loan. -Some bonds are zero coupons for only parts of their lives
"Pure" discount bonds
-These rates are "pure" 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
Three types of bonds (lecture)
-Treasury -Municipal -Corporate
Trustee
-Usually a trustee (a bank perhaps) is appointed by the corporation to represent the bond holders The trustee must: 1. Make sure the terms of the indenture are obeyed 2. Manage the sinking fund 3. Represent the bond holders in default, that is if the company defaults on its payments to them
Private-issue vs. public-issue debt
-We focus on publicly issues bonds, the main difference is that private debt is directly placed with a lender and not offered to the public. -Because it is a private transaction, the specific terms are up to the parties involved.
Bonds
-When a corporation (or government) wishes to borrow money from the public on a long-term basis, it usually does so by issuing, or selling, DEBT SECURITIES that are generally called bonds. -Straight definition: A certificate issued by a government or private company which promises to pay back the initial amount with interest the money borrowed from the buyer of the certificate.
Actual term structure
-When long-term rates are higher than short-term rates, we say that the term structure is upward sloping and when the short-term rates are higher we say it is downward sloping. -The structure can also be "humped" which occurs because rates increase at first but then begin to decline as we look at longer and longer-term rates -The most common shape is upward sloping but the degree of steepness has varied a bit
Bearer form
-a bond issued without record of the owner's name; payment is made to whomever holds the bond -the certificate of ownership is the basic evidence of ownership and the corporation will "pay the bearer" Two drawbacks of bearer form: -Difficult to recover if lost or stolen. -Company does not know who owns the bonds and cannot notify them of important events.
Zero coupon bonds
-a bond that makes no coupon payments and is thus initially priced at a deep discount -Even though no interest payments are made, zero coupon bonds use semiannual periods to be consistent with coupon bond calculations -For tax purposes, the owner deducts interest every year even though it is not paid, the owner must also pay taxes on the interest accrued every year even though there is not interest.
deferred call provision
-a call provision prohibiting the company from redeeming a bond prior to a certain date -call provisions are usually not operative during the first part of a bond's life
Call provision
-agreement giving the company the option to repurchase or "call" part or all of a bond at a stated price prior to maturity -corporate bonds are usually callable -Are not usually operative during the first part of a bonds life
Sinking fund
-an account managed by the bond trustee for the purpose of repaying the bonds -The company makes annual payments to a trustee, who then uses the funds to retire a portion of the debt. -The trustee does this by either buying up some of the bonds of the market or calling in a fraction of the outstanding bonds
Debt ratings
-an assessment of the creditworthiness of the corporate issuer -firns frequently pay to have their debt rated. -the two leading bond-rating firms are Moody's and Standard and Poor's -their definitions of creditworthiness are based on how likely the firm is to default and the protection creditors have in the case of a default
Debenture
-an unsecured bond; no assets are specifically pledged to guarantee repayment -currently, almost all public bonds issued in the US by industrial and financial companies are debentures
Mortgage securities
-are secured by a mortgage on the real property of the borrower. -The legal document that described the mortgage is called a mortgage trust indenture or trust deed -A "blanket" mortgage pledges all the real property owned by the company
Bond ratings
-concerned only with the possibility of default -the price of a highly rated bond can still be volatile -contrasted from information supplied by the corporation
clean price vs. dirty price
-if you buy a bond between coupon dates the price you pay is usually more than the price you are quoted because of accrued interest Clean (stated) price: the price of a bond net of accrued interest (accrued interest is deducted); this is the price that is typically quoted Dirty (real) price: The price of a bond including accrued interest, this is what you actually pay Accrued interest on a bond is calculated by taking the fraction of the coupon period that has passed and multiplying this fraction by the next coupon
Other dimensions of debt
-security -call features -sinking funds -ratings -protective covenants
Interest rate risk premium
-the compensation investors demand for bearing interest rate risk -long-term binds have much greater risk of loss resulting from changes in interest rates than shorter term bonds. -Investors recognize this risk and demand extra compensation
Inflation premium
-the compensation investors demand for forgoing the use of their money. -investors thinking about loaning money for various lengths of time indy and that future inflation erodes the value of dollars that will be returned. -Pure time value of money after adjusting for the effects of inflation.
floating rate bonds
-the coupon payments are adjustable, -the adjustments are tied to an interest rate index such as the treasury bill interest or the 30-year treasury bond rate. -the value of a floating-rate bond depends on exactly how the coupon payment adjustments are defined. -In most cases the coupon adjusts with a lag to some base rate
Interest rate risk
-the risk that arises for bond owners from fluctuating interest rates. -how much interest rate risk a bond has depends on how sensitive its price is to interest rate changes. -Depends on two things: the time to maturity and the coupon rate
Indenture (deed of trust)
-the written agreement between the corporation and the lender detailing the terms of the debt issue. Also referred to as the deed of trust Provisions included in indenture: 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
Main differences between debt and equity
1. Debt is not an ownership interest in the firm. Creditors generally do not have voting powers. 2. The corporations payment of interest on debt is considered a cost of doing business and is fully tax deductible. Dividends paid to stock owners are not deductible 3. Unpaid debt is a liability if the firm. If it is not paid, creditors can legally claim the assets of the firm.
Different types of sinking fund arrangements
1. Some sinking funds start about 10 years after the initial issuance 2. Some sinking funds establish equal payments over the life of the bond 3. Some high quality bond issues establish payments to the sinking fund that are insufficient to redeem the entire issue. As a consequence there is the possibility of a large balloon payment at maturity.
Additional features of floating-rate bonds
1. 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. 2. The coupon rate has a floor and a ceiling meaning that the coupon is subject to a maximum and minimum. The coupon rate is said to be "capped" and the lower rates are sometimes called the collar
Discount bond
A bond that sells below its par value; occurs whenever the going rate of interest is above the coupon rate.
Par value bond
A bond that sells for its par value
Inflation-linked bond
A bond with coupons that are adjusted according to the rate of inflation. The principal amount may also be adjusted for inflation.
Note
A term used for debentures if the maturity of the unsecured debt is less than 10 years
Textbook definition of bond value
Bond value = Present value of the coupons + Present value of the face amount.
Scructured notes
Bonds based on stock, bonds, commodities, or currencies.
Repayment
Bonds can be repaid at maturity, at which time the bondholder will receive the stated or face value of the bond; or they may be repaid in part or in the entirety before maturity.
Call premium
Call price - Stated value -The difference between the call price and the stated (par) value -generally, the call price is above the bond's par value -usually declines over time
Coupon rate
Coupon rate = coupon price / bond face value WE USE COUPON RATE TO CALCULATE PAYMENTS the coupon rate is actually the annual coupon divided by the face value of a bond. Is the PMT part of the TVM. -Ex. Coupon price is $120, and the par value is $1000. To find the coupon rate we divide $120 by $1000 to get 12 percent. Enter $120 into PMT.
Effective annual rate
EAR = (1 + .08)^2 - 1 = 16.64 the interest rate expressed as if it were compounded once per year ex. 8% compounded semi-annually would be 16.64%
Treasury Securities (Lecture)
Federal government debt: -Treasury bills (T-Bills) -pure discount bonds -Original maturity of one year or less -Treasury notes -Coupon debt -Original maturity greater than ten years
interest rate risk criteria
Keep the following in mind: -All other things being equal, the longer the time to maturity, the greater the interest rate risk -All other things being equal, the lower the coupon rate, the greater the interest rate risk
YTM
MATH
Calculating bond value
MATH GUIDE
Xanath co. example
Math shows that it has a $1000 face value at 8 percent. -The market yield rose to 10% and it sells for $885. -The company must sell the bond for less than its $1000 rate because as an interest-only loan, it keeps its 8 percent coupon rate. -The buyer of the DISCOUNT BOND will revive an additional $115 at maturity to make up for the original value.
Us Treasury coupon bonds
Most US Treasury issues are ordinary coupon bonds. These bonds -Have no default -Are exempt from state income taxes, only taxed on federal level
Municipal notes or bonds "munis"
Municipal notes and bonds "munis": Money borrowed by state and local governments by selling notes and bonds -Have varying degrees of default risk, almost always callable. -Their coupons are exempt to federal income taxes (and state taxes sometimes) making them attractive to high income investors
bond face value/par value
The amount paid at the end of the loan
Trade Reporting and Compliance Engine (TRACE)
System used to report corporate bond transactions in the secondary market
Fisher effect
Tells us the relationship between nominal returns, real returns, and inflation 1 + R = (1 + r) x (1 + h) r = real rate on investment h = compensation for decrease in the value of money originally invested third component is usually dropped so R ~~ r + h
Bonds INVERSE relationship with interest rates
When interest rates rise, a bonds value will decline. When interest rates fall, a bond's value will increase.
Treasury notes and bonds
When the government wishes to borrow money for more than one year, it sells treasury notes and bonds to the public (does so every month) -Treasury notes: have original maturities ranging from 2 to 10 years -Treasury bonds: have longer maturities, extending as far as 30 years
Premium bond
a bond that sells above its par value; occurs whenever the going rate of interest is below the coupon rate.
Call protected
a bond that, during a certain period, cannot be redeemed by the issuer
protective convenant
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 -A negative covenant limits or prohibits the actions the company might take -A positive covenant specifies an action that the company agrees to take or condition it must abide by.
convertible bonds
can be swapped for a fixed number of shares of stock anytime before maturity at the holder's option
level coupon bond
coupon is constant and paid every year
Nominal rates YOUTUBE
rates that have not been adjusted for inflation
Debtor or borrower
the corporation borrowing the money
Bid-ask spread
the difference between the bid price and the asked price. represents the deals profit
Bid price
the price a dealer is willing to pay for a security. Are quoted by a percentage of face value
Asked price
the price a dealer is willing to take for a security. Are quoted as a percentage of face value