Interest Rates and Bond Valuation

Positive covenant

A positive covenant is a "thou shalt" type of covenant. It specifies an action that the company agrees to take or a condition the company must abide by. Here are some examples: 1. The company must maintain its working capital at or above some specified minimum level. 2. The company must periodically furnish audited financial statements to the lender. 3. The firm must maintain any collateral or security in good condition. This is only a partial list of covenants; a particular indenture may feature many different ones.

Important features of treasury notes & bonds

Default-free, taxable, highly liquid

bond coupon

the payment that bondholders receive as interest. Usually paid semi-annually. E.g. of a corporation wants to borrow $1000 for 30 years with an interest rate of 12%. The corporation will pay 0.12 x $1000 = $120 in interest every year for 30 years. At the end of 30 years, the corporation will repay the $1000 In our example, the $120 regular interest payments are called the bond's coupons. Because the coupon is constant and paid every year, the type of bond we are describing is sometimes called a level coupon bond.

coupon payment

(Coupon rate x Face value) / number of coupon payments per year

Differences between debt and equity

1. Debt is not an ownership interest in the firm. Creditors generally do not have voting power. 2. 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. 3. 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.

What do treasury yields depend on?

1. The real-rate 2. Expected future inflation 3. Interest rate risk premium

What determines the shape of the term structure?

1. real rate of interest 2. rate of inflation 3. interest rate risk

Bearer form

A bond issued without record of the owner's name; payment is made to whomever holds the bond Drawbacks to bearer bonds: 1. Difficult to recover if lost or stolen 2. The company doesn't know who owns it bonds, so i can't notify bondholders of important events

Discount bond

A bond that sells below its par value; occurs whenever the going rate of interest is above the coupon rate

Collateral

A general term that frequently means securities (e.g., bonds and stocks) that are pledged as security for payment of debt. E.g., collateral trust bonds often involve a pledge of common stock held by the corporation. However, the term collateral is commonly used to refer to any asset pledged ona debt

Negative covenant

A negative covenant is a "thou shalt not" type of covenant. It limits or prohibits actions that the company might take. Here are some typical examples: 1. The firm must limit the amount of dividends it pays according to some formula. 2. The firm cannot pledge any assets to other lenders. 3. The firm cannot merge with another firm. 4. The firm cannot sell or lease any major assets without approval by the lender. 5. The firm cannot issue additional long-term debt.

Debtor

A person who owes money for borrowing

Creditor or lender

An individual or organization that is owed money or other item of value for lending the loan

Debenture/Secured obligation

An unsecured bond, for which no specific pledge of property is made. A note is the term generally used for such instruments if the maturity of the unsecured bond is less than 10 or so years from when the bond is originally issued. Debenture holders only have a claim on property not otherwise pledged; in other words, the property that remains after mortgages and collateral trusts are taken into account

Gilts/Treasury stock

Bonds issued by the British government

Long-term debt securities

Debt securities with maturities of more than one year

Short-term/unfunded debt securities

Debt securities with maturities of one year or less

Par value bond

If a bond's coupon rate is equal to its YTM, then the bond is selling at par

Premium bond

If a bond's coupon rate is more than its YTM, then the bond is selling at a premium

Seniority

Indicates preference in position over other lenders, and are sometimes labelled as senior or junior to indicate seniority. some debt is subordinated, as in, for example, as subordinated debenture. In the event of default, holders of subordinated debt must give preference to other specified creditors. Usually, this means that the subordinated lenders will be paid off only after the specified creditors have been compensated. However, debt cannot be subordinated to equity.

Bond

Normally an interest-only loan, meaning that the borrower will pay the interest every period, but none of the principal will be repaid until the end of the loan

What are debt securities typically called?

Notes, debentures, or bonds. Strictly speaking, a bond is a secured debt. However, in common usage, the word bond refers to all kinds of secured and unsecured debt. We will, therefore, continue to use the term generically to refer to long-term debt.

How are bonds bought and sold?

Over the counter/electronically

Long-term debt securities

Promises made by the issuing firm to pay principal when due and to make timely interest payments on the unpaid balance

Mortgage securities

Secured by a mortgage on the real property of the borrower. The property involved is usually real estate e.g. land or buildings. The legal document that describes the mortgage is called a mortgage trust indenture or trust deed. A "blanket" mortgage pledges all the real property owned by the company

Debt

Something that must be repaid; it's the result of borrowing money. When corporations borrow, they generally promise to make regularly scheduled interest payments and to repay the original amount borrowed i.e. the principal.

Is It Debt or Equity?

Sometimes it is not clear if a particular security is debt or equity. Suppose a corporation issues a perpetual bond with interest payable solely from corporate income if, and only if, earned. Whether or not this is really a debt is hard to say and is primarily a legal and semantic issue. Courts and taxing authorities would have the final say. Corporations are very adept at creating exotic, hybrid securities that have many features of equity but are treated as debt. Obviously, the distinction between debt and equity is very important for tax purposes. So, one reason that corporations try to create a debt security that is really equity is to obtain the tax benefits of debt and the bankruptcy benefits of equity. As a general rule, equity represents an ownership interest, and it is a residual claim. This means that equity holders are paid after debt holders. As a result, the risks and benefits associated with owning debt and equity are different. To give one example, note that the maximum reward for owning a debt security is ultimately fixed by the amount of the loan, whereas there is no upper limit to the potential reward from owning an equity interest.

Taxable versus municipal bonds

Suppose taxable bonds are currently yielding 8 percent, while at the same time, munis of comparable risk and maturity are yielding 6 percent. Which is more attractive to an investor in a 40 percent tax bracket? What is the break-even tax rate? How do you interpret this rate? For an investor in a 40 percent tax bracket, a taxable bond yields 8 x (1 — .40) = 4.8 percent after taxes, so the muni is much more attractive. The break-even tax rate is the tax rate at which an investor would be indifferent between a taxable and a nontaxable issue. If we let t* stand for the break-even tax rate, then we can solve for it as follows: .08x (1- r) = .06 1 - = .06/.08 = .75 t' = .25, or 25% Thus, an investor in a 25 percent tax bracket would make 6 percent after taxes from either bond.

Example to understand clean vs dirty price

Suppose you buy a bond with a 12 percent annual coupon, payable semiannually. You actually pay $1,080 for this bond, so $1,080 is the dirty, or invoice, price. Further, on the day you buy it, the next coupon is due in four months, so you are between coupon dates. Notice that the next coupon will be $60. The accrued interest on a bond is calculated by taking the fraction of the coupon period that has passed, in this case two months out of six, and multiplying this fraction by the next coupon, $60. So, the accrued interest in this example is 2/6 x $60 = $20. The bond's quoted price (i.e., its clean price) would be $1,080 - 20 = $1,060.

Relationship between bond price and yield to maturity (ytm)

The higher a bond's price, the lower its yield.

What's the main difference between public-issue and private-issue debt?

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

Maturity of a long-term debt instrument

The length of time the debt remains outstanding with some unpaid balance

inflation premium

The portion of a nominal interest rate that represents compensation for expected future inflation

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.

Bond face value/par value

The principal amount of a bond that will be repaid at the end of the term ($1000 for our previous example)

Corporate bonds are usually in registered form, this means...

The registrar of a company records who owns each bond, and bond payments are made directly to the owner of record

Trade Reporting and Compliance Engine (TRACE)

Under new regulations, corporate bond dealers are now required to report trade information through TRACE

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

Upward sloping. When this occurs, it is usually because rates increase at first, but then begin to decline as we look at longer and longer-term rates

zero coupon bonds/zeroes

a bond that makes no coupon payments, and thus is initially priced at a deep discount

current yield

a bond's annual coupon divided by its price

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

Call provision

agreement giving the issuer the option to repurchase a bond at a specific price prior to maturity

Put bond

allows the holder to force the issuer to buy back the bond at a stated price

Principal value

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

Sinking fund

an account managed by the bond trustee for early bond redemption. The company makes annual payments to the 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 in the market or calling in a fraction of the outstanding bonds. This second option is discussed in the next section. There are many different kinds of sinking fund arrangements, and the details would be spelled out in the indenture. For example: 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.

Debt ratings

an assessment of the creditworthiness of the corporate issuer. The creditworthiness used by a leading bond-rating firm, Moody's & S&P, are based on how likely the firm is to default and the protection creditors have in the event of a default It's important to recognise that bond ratings are only concerned with the possibility of default.

Deferred call provision

bond call provision prohibiting the company from redeeming the bond prior to a certain date

Call protected

bond during period in which it cannot be redeemed by the issuer

Structured notes

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

Floating-rate bonds (floaters)

bonds whose 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. 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. Suppose a coupon rate adjustment is made on June 1. The adjustment might be based on the simple average of Treasury bond yields during the previous three months. In addition, the majority of floaters have the following features: Official information on U.S. inflation-indexed bonds is at www.treasurydirect.gov. 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, and it is discussed in the following section. 2. 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. A particularly interesting type of floating-rate bond is an inflation-linked bond. Such bonds have coupons that are adjusted according to the rate of inflation (the principal amount may be adjusted as well). The U.S. Treasury began issuing such bonds in January of 1997. The issues are sometimes called "TIPS," or Treasury Inflation-Protected Securities. Other countries, including Canada, Israel, and Britain, have issued similar securities.

Convertible bond

can be swapped for a fixed number of shares of stock anytime before maturity at the holder's option

What causes bond price movements?

changes in interest rates, and passage in time

Securities issued by corporations may be classified roughly as...

equity securities and debt securities

Real rates

interest rates or rates of return that have been adjusted for inflation

Nominal rates

interest rates or rates of return that have not been adjusted for inflation

Bond's time to maturity

number of years until the face value is paid

zero coupon bond price

par value/((1 + YTM)/no. payments per year)^total no. payments e.g. there are zero coupon bonds outstanding that have a YTM of 6.33 percent and mature in 13 years. The bonds have a par value of $10,000. If we assume semiannual compounding, what is the price of the bonds? PV = 10,000/((1 + 0.0633/2)^26 = $4,447.93

Two major forms of long-term debt

public issue and private issue

call premium

the amount by which the call price exceeds the par value of a bond. generally, the call price > bond's stated value.

coupon rate

the annual coupon divided by the face value of a bond ($120/$1000 = 0.12 = 12% for our previous example)

interest rate risk premium

the compensation investors demand for bearing interest rate risk

bid-ask spread

the difference between the bid price and the asked price

liquidity premium

the portion of a nominal interest rate or bond yield that represents compensation for lack of liquidity

Default risk premium

the portion of a nominal interest rate or bond yield that represents compensation for the possibility of default

taxability premium

the portion of a nominal interest rate or bond yield that represents compensation for unfavorable tax status

bid price

the price a dealer is willing to pay for a security

asked prices

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's Yield to Maturity (YTM)

the rate required in the market on a bond

Fisher effect

the relationship among nominal returns, real returns, and inflation R = nominal rate r = real rate R ≈ r + h

Term structure of interest rates

the relationship between nominal interest rates on default-free, pure discount securities and time to maturity; that is, the pure time value of money i.e. the pure time value of money for different lengths of time

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. The sensitivity directly depends on two things: the time to maturity and the coupon rate. As we will see momentarily, you should keep the following in mind when looking at a bond: 1. All other things being equal, the longer the time to maturity, the greater the interest rate risk 2. All other things being equal, the lower the coupon rate, the greater the interest rate risk

Indenture

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); (3) represent the bondholders in default, that is, if the company defaults on its payments to them. The bond indenture is a legal document. It can run several hundred pages and generally makes for very tedious reading. It is an important document, however, because it generally includes the following provisions: 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.