Corporate Finance Chapter 7
Provisions of the Indenture:
The basic terms of the bonds. The total amount of bonds issued. A description of property used as security. The repayment arrangements. The call provisions. Details of the protective covenants.
Bond ratings are only concerned with what?
The possibility of default.
The shape of the term structure is determined by the three components that impact nominal rates
The real rate of interest The rate of inflation The interest rate risk premium
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.
The reason bond markets are so large is that the number of bond issuers
far exceeds the number of stock issuers.
The price including accrued interest is called the
full or dirty price
1 + R = (1 + r) x (1 + h)
h is the rate of inflation r is the real interest rate R is the nominal interest rate
With bearer bonds, the bond certificate is the
evidence of ownership.
Suppose that the price of an 8% Treasury bond is quoted at $1327.50 Number of days since last coupon: 61 days Number of days in coupon period: 184 days What is the clean price?
$1327.50
What is the fisher effect?
1 + R = (1 + r) x (1 + h) or r = R - h / (1 + h)
How much interest rate risk a bond has depends on how sensitive its price is to interest rate changes. This sensitivity directly depends on two things:
1. The time to maturity 2. The coupon rate 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.
Usually all bonds have a protective call provision for about
10 years.
Suppose that the price of an 8% Treasury bond is quoted at $1327.50 Number of days since last coupon: 61 days Number of days in coupon period: 184 days What is the dirty price?
= $1327.50 + (0.04 x 1000) x (61/184) = $1340.76
Present Value of the Coupons (an annuity basically) + Present Value of the Face Amount (A lump sum)
= Bond Valuation
Bond Ratings:
AAA AA A BBB BB B CCC CC C
The price a dealer is willing to take for a security.
Asked Price
The price a dealer is willing to pay for a security.
Bid
The difference between the bid price and the asked price.
Bid-ask spread
Pledges all the real property owned by the company.
Blanket Mortgages
Section 7.1
Bonds and Bond Valuation
The amount by which the call price exceeds the par value.
Call Premium
the price paid the bond holder when the bond is called, generally a price above the par value
Call Price
A bond that, during a certain period, cannot be redeemed by the issuer.
Call Protected Bond
An agreement giving the corporation the option to repurchase a bond at a specified price prior to maturity.
Call Provision
Permits the issuer to buy back the issue at a given price over a given time frame
Call Provision
The difference between the call price and the par value of the bond is the
Call premium
The price of a bond net of accrued interest; this is the price that is typically quoted.
Clean Price
A general term that frequently means securities (for example, bonds and stocks) that are pledged as security for payment of debt.
Collateral
The term is used here to refer to any asset pledged on a debt.
Collateral
The stated interest payment made on a bond.
Coupon
The rate of interest that will be paid by the borrower When multiplied by the face value gives the dollar amount of interest annually
Coupon Interest Rate
The annual coupon divided by the face value of a bond.
Coupon Rate
An unsecured debt, usually with a maturity of 10 years or more.
Debenture
Unsecured and only have a claim on any unpledged assets of the issuer in the event of default
Debenture Bonds
Security used by corporations to borrow money from the public (retail investors)
Debt
From a financial point of view, the main differences between debt and equity are the following:
Debt is not an ownership interest in the firm. Creditors generally do not have voting power. 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. 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.
The portion of a nominal interest rate or bond yield that represents compensation for the possibility of default.
Default Risk Premium
A call provision prohibiting the company from redeeming a bond prior to a certain date.
Deferred Call Provision
The price of a bond including accrued interest, also known as the full or invoice price. This is the price the buyer actually pays.
Dirty Price
The principal amount of a bond that is repaid at the end of the term. Also called par value.
Face Value
the amount that will be repaid at the end of the loan
Face Value (or Par Value)
The relationship between nominal returns, real returns, and inflation.
Fisher Effect
• Coupon rate changes depending on the value of a chosen index • Examples - adjustable rate mortgages and inflation-linked Treasuries • There is less price risk with floating rate bonds. • The coupon floats, so it is less likely to differ substantially from the yield to maturity. • Coupons may have a "collar" - the rate cannot go above a specified "ceiling" or below a specified "floor."
Floating Rate Bond
The coupon payments are adjustable.
Floating Rate Bonds
Treasury Securities • Federal government debt • No default risk • Interest received is tax-exempt at the state level • Types of treasuries 1. T-bills - pure discount bonds with original maturity less than one year 2. T-notes - coupon debt with original maturity between one and ten years 3. T-bonds - coupon debt with original maturity greater than ten years • Municipal Securities • Debt of state and local governments • Varying degrees of default risk, rated similar to corporate debt • Interest received is tax-exempt at the federal level
Government Bonds
The written agreement between the corporation and the lender detailing the terms of the debt issue.
Indenture (or deed of trust)
The portion of a nominal interest rate that represents compensation for expected future inflation.
Inflation Premium
Section 7.6
Inflation and Interest Rates
Bonds are (blank) loans and there is no amortization over the life of the bond Since each interest payment is the same, the interest payments represent an annuity
Interest Only
The compensation investors demand for bearing interest rate risk.
Interest Rate Risk Premium
The risk that arises for bond owners from fluctuating interest rates is called
Interest Rate Risk.
Chapter 7
Interest Rates and Bond Valuation
The risk for bond holders that results from changes in interest rates is called
Interest rate risk
The portion of a nominal interest rate or bond yield that represents compensation for lack of liquidity.
Liquidity Premium
The specified date on which the principal amount of a bond is paid.
Maturity
The date when the face value must be repaid in full.
Maturity Date
Section 7.2
More about Bond Features
Secured by a mortgage on real property of the issuer.
Mortgage Bonds
Secured by a mortgage on the real property of the borrower. The property involved is usually real estate—for example, land or buildings.
Mortgage Securities
Are bonds amortized?
No. The lump sum of the face value is due on the maturity date.
The rate observed in the market
Nominal Interest Rate Rate of return not adjusted for inflation
Interest rates or rates of return that have not been adjusted for inflation.
Nominal Rates The nominal rate on an investment is the percentage change in the number of dollars you have
Generally used for such instruments if the maturity of the unsecured bond is less than 10 or so years when the bond is originally issued.
Note
Face value is also referred to as
Par Value
What are the two types of covenants?
Positive - specifies an action that the issuer agrees to take & Negative - limits actions of the issuer
When the coupon rate is higher then the discount rate the bond is said to sell at a (premium or discount?)
Premium
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.
Protective Covenant
limits the actions that may be taken by the issuer. Usually found in the indenture document.
Protective Covenant
The nominal interest rate adjusted for the rate of inflation
Real Interest Rate
Interest rates or rates of return that have been adjusted for inflation.
Real Rates 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.
When bonds trade, the new owner must become registered with the issuer. Interest payments and the single payment of face value at maturity are made to the
Registered Owner
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.
Registered form
In the event of default, subordinated lenders give preference to
Secured lenders Default is the failure to make indicated payments in a timely manner Default may also be due to failure to maintain compliance with various terms specified in the bond indenture
Indicates the preference in position over other lenders
Seniority • Debts labeled as senior have a preferred position to debts that are junior in the event of liquidation or bankruptcy • By its nature, a debenture is subordinated to debt with designated collateral
An account managed by the bond trustee for early bond redemption.
Sinking Fund
An account managed by the trustee for the purpose of repaying the bonds
Sinking Fund
The portion of a nominal interest rate or bond yield that represents compensation for unfavorable tax status
Taxability Premium
The relationship between nominal interest rates on default-free, pure discount securities and time to maturity; that is, the pure time value of money.
Term Structure of Interest Rates
Who is the largest borrower in the world?
The U.S. goverment.
A plot of the yields on Treasury notes and bonds relative to maturity.
Treasury Yield Curve
Bonds are normally an interest only loan. True or False?
True
Corporate Bonds are usually callable. T or F?
True
The longer the time to maturity and the lower the coupon rate, the greater the risk of the bond. T or F?
True
Sinking funds are typically paid to the
Trustee.
• Consider the following bond • 10% annual coupon rate • 15 years to maturity • Par value of $1,000 • Current price of $928.09. What is the rate of return or what is the yield-to-maturity?
YTM (or r) = 11.00 %
Suppose you plan to purchase a bond with 22 years to maturity, a coupon rate of 8 percent and a current market price of $960.17. The bond makes semiannual payments. What is the YTM?
YTM = 8.40 %
The rate required in the market on a bond.
Yield to Maturity (YTM)
The rate of return implied by the current bond price.
Yield-to-Maturity (YTM)
If you buy a bond at this price and hold it to maturity, what return will you earn?
You would earn the YTM (or Required Rate of Return)
• Make no periodic interest payments (coupon rate = 0%) • The entire yield to maturity comes from the difference between the purchase price and the par value • Cannot sell for more than par value • Sometimes called zeroes, deep discount bonds, or original issue discount bonds (OIDs) • Treasury Bills and principal-only Treasury STRIPS (or "strips") are good examples of zeroes
Zero Coupon Bond
A bond that makes no coupon payments and is thus initially priced at a deep discount. Also referred to as a Deep Discount Bond
Zero Coupon Bonds
When inflation increases, investors demand
a higher (nominal) rate for lending money!
Groucho and Harpo Co. issued 30-year zero-coupon bonds 6 years ago. A zero-coupon bond does not make any intermediate payments; it simply pays the holder the face value at maturity ($1,000). What is the current price of the bonds if the YTM for these bonds is 7.4%? Assume annual compounding. a. $ 180.26 b. $ 421.95 c. $ 656.38 d. $ 800.00 e. $1,000.00
a. $180.26
L&H Inc. issued 11-year bonds 2 years ago at a coupon rate of 7.6%. The bonds make semi-annual payments. What is the current price of the bonds if the YTM for these bonds is 9.1%? a. $ 869.54 b. $ 897.10 c. $ 909.16 d. $1,000.00 e. $1,369.41
c. 909.16
The price without the accrued interest is the
clean price
Bonds may be classified by various types of
collateral.
A bond sells at par, at a discount, or at a premium based on the relationship between the
coupon rate and discount rate.
The person or firm making the loan is called the
creditor or lendor
The corporation borrowing the money is called the
debtor or borrower
If the coupon rate < the discount rate, the bond sells at a
discount (less than par value)
Because the bond sells for less than face value, it is said to be a
discount bond.
A financial market is transparent if it is possible to
easily observe its prices and trading volume.
Because the coupon is constant and paid every year, the type of bond we are describing is sometimes called a
level coupon bond.
When unsecured debt issues carry a maturity of less than 10 years, they are generally referred to as
notes.
The following are now flashcards for Sapnoti's Powerpoints
on Chapter 7
Bon prices and interest rates always move in
opposite directions. Ex. When interest rates fall, bond values rise.
If the coupon rate = the discount rate, the bond sells at
par (equal to par value)
A bond that sells for its par value is called a
par value bond.
If the coupon rate > the discount rate, the bond sells at a
premium (more than par value)
Corporate bonds are usually in
registered form.
When bonds are registered, the name of the owner of the bond and their contact information are recorded by the
registrar.
The series of rates observed in the market on bonds over all maturities
term structure of interest rates
Interest payments are made to the individual presenting coupons of the bond. Face value payments are made when
the bond certificate is presented.
Interest rate risk depends on
time to maturity and coupon rate