Finance Chapter 7

Yield to maturity shouldn't be confused with current yield

, which is simply a bond's annual coupon divided by its price. The above current yield is 80/955.14 = 8.38 percent.

interest rate risk

1. All other things 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.

coco and nono

Coco bonds (do make coupons) and nono bonds (don't) are contingent convertible, putable, callable, subordinated bonds. Must do it.

What is the relationship between the current yield and YTM for premium bonds? For discount bonds? For bonds selling at par value?

Current yield is defined as the annual coupon payment divided by the current bond price. For premium bonds, the current yield exceeds the YTM, for discount bonds the current yield is less than the YTM, and for bonds selling at par value, the current yield is equal to the YTM. In all cases, the current yield plus the expected one-period capital gains yield of the bond must be equal to the required return.

Explain why some bonds sell at a premium over par value while other bonds sell at a discount. What do you know about the relationship between the coupon rate and the YTM for premium bonds? What about for discount bonds? For bonds selling at par value>

If the coupon rate is higher than the required return on a bond, the bond will sell at a premium, since it provides periodic income in the form of coupon payments in excess of that required by investors on other similar bonds. If the coupon rate is lower than the required return on a bond, the bond will sell at a discount since it provides insufficient coupon payments compared to that required by investors on other similar bonds. For premium bonds, the coupon rate exceeds the YTM; for discount bonds, the YTM exceeds the coupon rate, and for bonds selling at par, the YTM is equal to the coupon rate.

i. See page 221.

READ THAT FIRST PARAGRAPH AGAIN

short term debt

Short term (less than one year) is sometimes referred to as unfunded debt.

What all is included in the Indenture

Terms of a bond Security Seniroity Repayment The Call Provision Protective Covenant

What is the relationship between the price of a bond and it's YTM

The bond price is the present value of the cash flows from a bond. The YTM is the interest rate used in valuing the cash flows from a bond.

put provision

The holder has the right to redeem the note at par on the coupon payment date after some specified amount of time

maturity of a long term debt

The maturity of a long-term debt instrument is the length of time the debt remains out-standing with some unpaid balance.

1. Protective Covenant

a. 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. i. Negative covenenant - 'thou shall not' - limits or prohibits actions the company might take ii. Positive covenant - 'thou shall' specifies an action the company agrees to take or a condition the company must abide by.

1. The Call Provision

a. Allows the company to repurchase or 'call' part or all of the bond issue at stated prices over a specific period. Corp bonds usually callable. b. Generally above the bonds stated value. The difference between the call price and the stated value is the call premium. c. Deferred - when you have to wait a set amount of time. d. "Make-whole" - bondholders receive approximately what the bonds are worth if they are called. To determine this price, we calculate the present value fo the remaining interest payments and principal payments at a rate specified in the indenture. e. The call price is higher when interest rates are lower and vice versa

Bond Ratings

a. Two leading bond-rating firms are Moody's and Standard & Poor's. b. Ratings concerned only with the possibility of default. c. See graph on page 211 before exam d. Fallon angels - bonds that fall from Baa3 to Baa1. When it's lowered from investment grade to junk bond status.

Put Bond

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

bellwether bond

bond yield is the one reported in the news

Convertible bond

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

TIPS (treasury inflation protected bonds)

have coupons that are adjusted with inflation

fischer effect

i. 1+R=(1+r)x(1+h)

Sukuk

i. Assets that comply with shariah, or Islamic law and cultural traditions, has grown dramatically. Islamic law does not permit charging or paying riba, or interest. ii. While we have noted that traditional bonds can be relatively illiquid, most sukuk are bought and held to maturity. As a result, secondary markets in sukuk are extremely illiquid.

a. Main differences between debt and equity

i. Debt is not an ownership in the firm. Creditors generally do not have voting power. ii. The corporation's payment of interest on debt is considered a cost of doing business and is fully tax detectable. Dividends paid to stockholders are not tax deductible. iii. 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. i. As a general rule, equity represents an ownership interest, and it is a residual claim. Equity holders are paid after debt holders, but debt holders have a cap on what they can make, while equity does not.

Coupon Rate

i. The annual coupon divided by the face value is called the coupon rate, in this case its 120/1000 so 12 percent.

a. Floating Rate Bonds

i. The 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. ii. In most cases, coupon adjusts with a lag to some base rate. Majority of floaters have the following features 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 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. Government Bonds

i. US treasury issues have no default risk, and are exempt from state incoming taxes (though not federal income taxes). ii. State and local gov also borrow money by sellig notes and bnods. These are called municipal notes and bonds, or just 'munis'. Unlike treasury issues, munis have varying degres of default risk and are rated much like corporate bonds. Almost always callable. Coupons are exempt from federal income taxes (though not necessarily state income taxes) which make them attractive to high-income, high-tax bracket investors. Yields are much lower. iii. See example 7.4

Warrant

i. gives the buyer of a bond the right to purchase shares of stock in the company at a fixed price. Such a right would be valuable if the stock price climbed substantially. Because of the value of this feature, bonds with warrants are often issued at a very low coupon rate.

Income Bonds

i. similar to conventional bonds, except that coupon payments depend on company income. Specificially coupons are paid to bondholders only if the firm's income is sufficient. Not common.

a debenture

is an unsecured debt

Death bond

life insurance policies from individuals who are expected to die within 10 years. They then sell bonds that are paid off from the life insurance proceeds received when the policyholders pass away. A major risk is that if medical treatment advances quickly, it will raise the life expectancy of the policyholders.

Treasury bonds all

make semiannual payments of 1000

Reverse convertible `

new type of structured note. One type generally offers a high coupon rate, but the redemption at maturity can be paid in cash at par value or paid in shares of stock.

number of bonds sold far exceeds

number of stocks sold

blanket mortgage

pledges all real property owned by the company

Terms of a bond

registered vs bearer form registered has the name drawbacks of bearer form is that they can be difficult to recover if lost or stolen and the company can't easily notify them of changes in policy

i. So, a bond with 10 years maturity, annual coupon of 80 dollar. Similar bonds have a yield to maturity of 8 percent. 1. First, at the going rate of 8 percent, for 10 years a. PV = 1000/1.0810 = 463.19 2. Second, the bond offers 80 dollars per year for 10 years; the present value of this annuity stream is a. 80 x (1-1/1.0810)/.08 b. 80 x 6.7101 = 536.81 3. Add these two together to get 1000 dollars, the total bond value. 4. See book for when it's 9 years at 10 percent rate, or try to figure it out. Answer is 884.82 5. Because it sells for less than face value, considered a discount bond

you use the coupon rate (pmt) of original!!!