Chapter 7

coupon rate

The annual coupon divided by the face value of a bond

face value

The principal amount of a bond that is repaid at the end of the term. Also called par value.

yield to maturity

The rate required in the market on a bond

maturity

The specified date on which the principal amount of a bond is paid

coupon

The stated interest payment made on a bond.

question

also yield to maturity is 12 years

Recall Treasury notes and ____are default-free, they are taxable, and they are highly liquid

bonds

Zero coupon bonds, or zeroes, are...

bonds that make no coupon payments and are thus initially priced at a deep discount; do no pay interest on the life of the bond

Yield curve -

graphical representation of the term structure

The bid-ask spread

is the difference between the bid price and the ask (for dollar amount, multiply by 100)

liquidity premium

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

default risk premium

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

taxability premium

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

indenture

is the written agreement between the corporation (the borrower) and the lender detailing the terms of the debt issue

Treasury bond formulas: dollar price asked for a treasury bond:

(bid/100) * 1000

bond

- A financial security that represents a promise to repay a fixed amount of funds (debt, and I OWE YOU) - 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 generically called bonds.

security for collateral bond, mortgage bond, debenture bond, and notes bond

- Collateral - secured by financial securities - Mortgage - secured by real property, normally land or buildings - Debentures - unsecured w maturity greater than 10 years - Notes - unsecured debt with original maturity less than 10 years

Municipal Securities

- Debt of state and local governments - Varying degrees of default risk, rated similar to corporate debt Today 13% insured vs 57% prior to 1997 - Interest received is tax-exempt at the federal level

Government Bond: •Treasury Securities - Federal government debt $30.1T , 125% of GDP - US Govt. largest holder - 25% held by foreign govts. What are T-bills, T-notes, T-bonds?

- T-bills - pure discount bonds - original < 1 yr - T-notes - coupon debt - original maturity 1-10 yrs - T-bonds - coupon debt - original maturity >10 yrs

For tax purposes, the issuer of a zero coupon bond...

- deducts interest every year even though no interest is actually paid

One reason the bond markets are so big is that the number of bond issues far exceeds the number of stock issues, and there are two reasons for this:

1.A corporation would typically have only one common stock issue outstanding, whereas a large corporation could easily have a dozen or more note and bond issues outstanding 2.Federal, state, and local borrowing is enormous

What determines the shape of the term structure? (3)

1.Real rate of interest 2.Expected future inflation 3.Interest rate risk premium

for bonds, FV is always what?

1000

zero coupon bonds are an attractive investment for whom?

Attractive investment for tax-exempt investors with long-term dollar-denominated liabilities (e.g., pension funds) because the future dollar value is known with relative certainty

cash flow has two components

Cash flows for the bond have an annuity component (the coupons) and a lump sum (the face value paid at maturity)

answer

Company: GM Coupon rate: 7.5%; coupon payment per year = $75 Bond matures in 2033 Current yield = 7.45%; computed as annual coupon divided by current price Bonds traded: 763 Quoted price: 100.641% of face value, so if face value is 1000, the price is $1006.41. It is important to emphasize that bond prices are quoted as a percent of par, just as the coupon is quoted as a percent of par.

•Which bonds will have the higher coupon, all else equal? - Secured debt versus a debenture - Subordinated debenture versus senior debt - A bond with a sinking fund versus one without - A callable bond versus a non-callable bond

Debenture: secured debt is less risky because the income from the security is used to pay it off first Subordinated debenture: will be paid after the senior debt Bond without sinking fund: company has to come up with substantial cash at maturity to retire debt, and this is riskier than systematic retirement of debt through time Callable - bondholders bear the risk of the bond being called early, usually when rates are lower. They don't receive all of the expected coupons and they have to reinvest at lower rates.

Total volume of trading in stock far exceeds that in bonds T/F

F; bonds exceeds stocks

What has a more reinvestment rate risk? low coupon rate bond or high coupon rate bond

High coupon rate bonds have more reinvestment rate risk than low coupon rate bonds

seniority

In general terms, seniority indicates preference in position over other lenders, and debts are sometimes labeled as senior or junior to indicate seniority. Some debt is subordinated, as in, for example, a subordinated debenture.

What has more of a price risk, low coupon rate bonds or high coupon rate bonds?

Low coupon rate bonds have more price risk than high coupon rate bonds

•On the ______, for example, it is possible to see the price and quantity for every single transaction •In the _______, it is often not possible to observe either, resulting in a lack of transparency

New York Stock Exchange; bond market

Previous day's asked price

Previous day's asked price = Today's asked price - Change

What has a more reinvestment rate risk? short term bonds or long term bonds

Short-term bonds have more reinvestment rate risk than long-term bonds

term structure of interest rate

Term structure is the relationship between time to maturity and yields, all else equal - •It is important to recognize that we pull out the effect of default risk, different coupons, etc.

answer

The 4% value is the 6-month interest rate. YTM is an annual rate.

In 2002, transparency in the corporate bond market began to improve, as new regulations required dealers to report trade information through the _____ •_____ bond quotes are available online

Trade Reporting and Compliance Engine (TRACE); TRACE

Treasury yield curve is a plot of the yields on ____ and ____

Treasury notes and bonds relative to maturity

current yield

a bond's annual coupon payment divided by its price (on chart under coupon column, multiply it by 100 and then divide it by price)

A bond's yield is calculated assuming...

all promised payments will be made

Inverted yield curve-

downward-sloping; long-term yields are lower than short-term yields

The number of years until the face value is paid is called the bond's time to ____

maturity

For tax purposes, the owner of a zero coupon bond...

must pay taxes on interest accrued every year, even though no interest is actually received

Most trading in bonds takes place...

over the counter, or OTC

If YTM < coupon rate, then par value ____ bond price

par value < bond price - Why? Higher coupon rate causes value above par - Price above par value, called a premium bond

If YTM = coupon rate, then par value ____ bond price

par value = bond price

If YTM > coupon rate, then par value ____ bond price

par value > bond price - Why? The discount provides yield above coupon rate - Price below par value, called a discount bond

answer pt 1

present value for annuity cash flows + basic present value equation

The coupon rate depends on the ______ of the bond when issued

risk characteristics

A financial market is ______ if it is possible to easily observe its prices and trading volume

transparent;

Normal yield curve-

upward-sloping; long-term yields are higher than short-term yields

question

what is the bond value equation based off this formula sheet?

yield to maturity question (semi annual)

what is the yield to maturity

Can change in interest rates cause change in price for a bond (price risk)?

yes

What has more risk, long-term bonds or short-term bonds?

§Long-term bonds have more price risk than short-term bonds

indenture generally includes the following 6 provisions

•Basic terms of the bonds •Total amount of bonds issued •Description of property used as security •Repayment arrangements •Call provisions •Details of the protective covenants

•Each day, representative prices for outstanding Treasury issues are reported •Bid price: ____ •Asked price: _____ •Bid-ask spread : ______ •Treasury prices are quoted as a percentage of ____ •If the bid price is 132.23 and the face value is $1,000, the quote represents $1,322.30 •Change in the asked price from the previous day, measured as a percentage of face value, is also quoted

•Each day, representative prices for outstanding Treasury issues are reported •Bid price is the price a dealer is willing to pay for a security •Asked price is the price a dealer is willing to take for a security •Bid-ask spread is difference between the bid price and asked price •Treasury prices are quoted as a percentage of face value •If the bid price is 132.23 and the face value is $1,000, the quote represents $1,322.30 •Change in the asked price from the previous day, measured as a percentage of face value, is also quoted

Usually, a trustee (e.g., a bank) is appointed by the corporation to represent the bondholders and the trustee must do what 3 things

•Make sure the terms of the indenture are obeyed •Manage the sinking fund •Represent the bondholders in default

Treasuries depend on the three components that underlie the term structure:

•Real rate •Expected future inflation •Interest rate risk premium

inflation premium

•is the portion of a nominal interest rate that represents compensation for expected future inflation •Upward-sloping term structure may reflect anticipated increases in inflation, while a downward-sloping term structure probably reflects the belief that inflation will be falling in the future

interest rate risk

•premium is the compensation investors demand for bearing interest rate risk •Interest rate risk premium increases with maturity, but it increases at a decreasing rate