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?