Finance Chapter 7 Bonds
which entities use debentures and indentures
debentures - industrial and financial companies indentures - utility and railroad bonds
principal value
stated on the bond certificate
Aa / AA debt
strong capacity to pay interest and repay principal
income bonds
coupon payments depend on company income; paid to bondholders only if the firm's income is sufficient; not very common
individuals involved in lending
creditor/lender and debtor/borrower
coupon payment dates
dd/mm. If more than one, that count determines the number of payments. 12/this number = yields the amount of months in between payments
call premium
difference between call price and stated value of bonds; can change over time - generally become smaller
drawbacks to bearer bonds
difficult to recover if stolen/lost company doesn't know who owns its bonds - can't notify holders of important events
deferred call provision
facilitates call-protection by preventing a company from calling its bonds within a certain specified time period
coupon rate
the interest rate that a bond issuer will pay to a bondholder; annual coupon divided by the face value
municipal notes and bonds
"munis" - state and local government bonds; have varying degrees of default risk; rated much like corporate issuers; almost always callable; exempt from federal income taxes
negative covenant
"thou shalt not" - limits or prohibits actions the company may take; ex. "firm cannot pledge any assets to other lenders" or "firm cannot merge with another firm"
positive covenant
"thou shalt" - specifies an action the company agrees to take or a condition that it must abide by; ex. "the company must maintain its working capital at or above some specified level" or "the firm must maintain any collateral or security in good condition"
zero coupon bonds
"zeroes" - bond that pays no coupons at all; must be offered at a price that is much lower than its stated value
annual coupon
% value describing how much of the face value is awarded to bond-holders annually
investors accept negative yields when
- there is deflation - the amount of cash to be accepted is cumbersome for the investor to receive all at once
medium grade obligations
A & Baa/BBB
generally included provisions in a bond indenture
1. basic terms of the bonds 2. 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
debt v. equity securities
1. debt is not firm ownership. 2. debt is tax deductible, equity is not 3. debt increases chances of financial failure
total debt of US government in early 2018
20 trillion
subordinated debenture
A lower-ranked bond that is not secured by collateral or guarantee; means that subordinated lenders paid off after other specific creditors have been compensated
highest bond class
AAA/Aaa & AA/Aa
investment grade bonds
BBB or higher (S&P) or Baa or higher (Moody's)
Bond Value formula
C * [1 - 1/(1+r)^t]/r + F/(1+r)^t present value of the coupons (pv. of annuity) + present value of the face amount (pv. of single cash flow)
sukuk
Islamic bonds, created due to sharia law's barring of charing/paying interest; structures include partial ownership in a debt or an asset, on which rent is paid before the bond matures; most are bought and held to maturity, making secondary markets extremely illiquid
two leading bond-rating firms
Moody's and S&P
bond markets
OTC
debt securities
Securities issued by corporations and governmental bodies as a form of borrowing.
equity securities
Securities issued by corporations as a form of ownership in the business.
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.
trustee
a creditor representative appointed to represent bondholders
inflation-linked bond
a floating-rate bond with coupons adjusted according to the rate of inflation (principal may be adjusted as well)
sinking fund
account managed by the bond trustee for early bond redemption; created as the debtor pays the creditor off
Baa / BBB debt
adequate capacity to pay interest / repay principal; normally exhibits adequate protection parameters however adverse economic conditions or changing circumstances are more likely to lead to a weakened capacity to pay interest and repay principal for debt in this category than in higher-rated categories
interest rate risk and time to maturity
all else held equal, longer time to maturity means greater interest rate risk; rises in risk diminish as time to maturity grows
interest rate risk and coupon rate
all else held equal, lower coupon rates mean greater interest rate risk; lower coupon rate = greater dependency on face value, which is more sensitive to interest rate changes due to its end-of-bond-life yield
warrant
bond feature that gives the buyer right to purchase shares of stock in the company at a fixed price (valuable if stock price climbs); typically issued at a low coupon rate
coupons
bond interest payments
make-whole call price calculation
calculate present value of the remaining interest and principal payments at a rate specified in the indenture - call price is higher when interest rates are lower and vice versa
trading volume of bonds
far greater than that of stocks - more bond isuances
collateral
general term that frequently means securities pledged as security for payment of debt; commonly used to refer to any pledged asset on a debt
municipal bonds' face values
generally are $5,000
note definition issues
generally interchangeable with "bond" but can specifically refer to issues with an original maturity of 10 years or less
AAA / Aaa debt
highest rated debt; capacity to pay interest and principal is extremely strong
D grade debt
in default; payment of interest and/or repayment of principal is in arrears
bond value fluctuations
interest rates rise: bond's present value falls interest rates fall: bond's present value rises
Republic National Bank
issuer of bonds with the longest time to maturity ever recorded, 1000 years
bond market transparency
little to none - transactions are private with little/no centralized reporting
term structure descriptions
long-term rates higher than short term: upward sloping (most common in modernity) short term higher than long term: downward sloping rates increase at first but then decline as rates' terms become longer: humped
names for debt securities
notes, debentures, bonds
public issue debt
offered to the public (v. privately placed, offered to one person)
most US treasury issues
ordinary coupon bonds; have no default risk because Treasury can always come up with money to make payments; exempt from state income takes (but not federal income taxes)
crossover / 5B bonds
rated triple-B by one agency and double-B by another, causing a "split rating"
fisher effect
relationship between nominal rates, real rates, and inflation can be written as: 1 + R = (1 + r) * (1 + h) R = nominal rate r = real rate h = inflation rate
reverse convertible
relatively new; offers a high coupon rate but redemption at maturity can be paid in cash at par value or paid in shares of stock
A debt
strong capacity to pay interest and repay principal although somewhat more susceptible to adverse effects of changes in circumstances and economic conditions than debt in high-rated categories
commonality of AAA ratings
uncommon; only BellSouth 100+ year bonds, Microsoft, and Johnson & Johnson bonds have this grade
debenture
unsecured bond, for which no specific pledge of property is made; also called a "note" if maturity of the unsecured bond is under 10 years holders have claim only on property not otherwise pledged
bellwether bond
very last ordinary bond listed in an OTC exchange
bond asked price
what a dealer is willing to take for it
date of issue
when a bond is sold
maturity
the date at which a bond matures (debt is entirely collected)
face value
the denomination of the 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 interest payments received by sending coupons directly to the company for payment
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 interest payments are received via the company tearing off coupons from bond certificate and sending them to the company registrar (the paying agent)
default risk premium
the higher yield demanded by investors in realizing that the bond-issuer may not make all promised payments on a bond
shape of term structure determined by
1. real rate of interest (little actual influence; mostly influences the overall level of interest rates) 2. rate of inflation (strong influence; investors demand compensation for inflation loss in the form of higher nominal rates - inflation premium) 3. interest rate risk (demanding higher nominal rates for bearing longer-term bonds w/ higher interest rate risk - interest rate risk premium) (increases at a decreasing rate as does interest rate risk)
most bonds have maturities smaller than
30 years
treasury bonds
all make semiannual payments and have a minimum face value of $1,000
call provision
allows a company to repurchase or "call" part or all of the bond issue at stated prices over a specific period; corporate bonds are usually callable call price generally above bond's stated value (par value)
put bond
allows holder to force the issuer to buy back the bond at a stated price
debt ratings
assessment of the creditworthiness of the corporate issuer, concerned only with the possibility of default; can change as issuer's financial strength improves or deteriorates
discount bond
bond which sells for less than the face value return promised
premium bond
bond which sells for more than the face value return promised
current yield
bond's annual coupon divided by its price; lower for discounted bonds because gain on face value is ignored - reverse for premium bonds
make-whole call
bondholders receive approximately what the bonds are worth if they are called; because bondholders don't suffer a loss in the event of a call, they are "made whole"
structured notes
bonds based on stocks, bonds, commodities, or currencies
"sleeping beauty" bonds
bonds issued by Walt Disney in 1990s which mature in 100 years
treasury notes and bonds
bonds sold by the government when they are looking to raise money for more than one year; have original maturities ranging from 2 to 30 years; default-free, taxable, and highly liquid
fallen angels
bonds that drop into junk territory (from BBB- to BB+)
to compare taxable versus municipal bonds
c * (1 - t) = m c = corporate bond yield rate t = tax rate m = municipal bond yield rate
convertible bond
can be swapped for a fixed number of shares of stock anytime before maturity at the holder's option; relatively common
catastrophe bonds
cat bonds - cover disasters; if one such disaster happens, investors lose some or all of their money
company requirements when issuing bonds
companies must make sure indenture terms are obeyed, manage the sinking fund and represent the bondholders in default (if the company defaults on its payments to them)
death bond
companies purchase life insurance policies from individuals expected to die in next 10 years then issue bonds paid off from the life insurance proceeds received when the policyholders pass away
CoCo and NoNo bonds
contingent convertible, putable, callable subordinated bonds; CoCo = coupon payment, NoNo = zero coupon
level coupon bond
coupon is constant and paid every year
floating rate bonds
coupon payments are adjustable and are tied to an interest rate index such as the Treasury bill interest rate or the 30-year Treasury bond rate value depends on exactly how the coupon payment adjustments are defined holder has the right to redeem the note at par on the coupon payment date after some specified amount of time - a "put" provision coupon rate has a floor and a ceiling (minimum and maximum) - rate is "capped"; upper/lower bounds called the "collar"
real rates
interest rates / discount rates that have been adjusted for inflation - percentage change in how much you can buy with your dollars - in other words, the percentage change in your buying power
nominal rates
interest rates or rates of return that have not been adjusted for inflation - the percentage change in the number of dollars you have
junk bonds
low-grade corporate bonds rated below investment grade by major rating agencies
Ba, B, Caa, Ca, C / BB, B, CCC, C, C grade debt
low-quality, speculative and/or "Junk" bonds; large uncertainties or major risk exposures to adverse conditions; issues rated C by Moody's are typically in default
NCAA
no coupon at all - defaulting on bond payments
bond
normally an interest-only loan, meaning that the borrower will pay interest every period, but none of the principal will be repaid until the end of the loan
protective covenant
part of the indenture or loan agreement that limits certain actions a company might otherwise wish to take during the term of the loan; classified into negative and positive (affirmative) covenants
privately placed debt
placed directly with a lender (v. public issue, offered to the public)
blanket mortgage
pledges all the real property owned by a company
seniority
preference in position over other lenders; debts are sometimes labeled as senior/junior to indicate seniority; can also be subordinated
long-form debt types
public issue & privately placed
term structure of interest rates
relationship between short- and long-term interest rates; tells us what nominal interest rates are on default-free, pure discount bonds of all maturities; pure interest rates because they involve no risk of default and a single, lump sum future payment; tells us the pure time value of money for different lengths of time
bond bid-ask spread
represent's dealer's profits
bond bid
represents what a dealer is willing to pay for a security
mortgage securities
secured by mortgage on the real property of the borrower; the property involved is usually real estate; legal document that describes the mortgage = "mortgage trust indenture" or "trust deed"
unfunded debt
short term debt (debt maturing within a year)
treasury bond yield curve
similarly depends on term structure's components (real interest rate, rate of inflation, interest rate risk) but based on coupon bond yields
bond price reporting
since 2002, must be reported via TRACE, the Trade Reporting and Compliance Engine
bond definition issues
specifically - a secured debt generally - all secured and unsecured debt sometimes refers specifically to debt issuances with 11+ years to maturity
maturity
the length of time a debt instrument's debt remains outstanding with some unpaid balance
liquidity premium
the portion of a nominal interest rate or bond yield that represents compensation for lack of liquidity; less liquidity = higher yield rate
taxability premium
the portion of a nominal interest rate or bond yield that represents compensation for unfavorable tax status; thus, taxable (corporate) bonds have higher interest rates
clean price
the price of a bond net of accrued interest; this is the price that is typically quoted
face/par value
the principal amount of a bond that is repaid at the end of the term
yield to maturity
the rate required in the market on a bond
interest rate risk
the risk that arises for bond owners from fluctuating interest rates; quantity depends on how sensitive its price is to interest rate changes, dependent on time to maturity and coupon rate
amount of issue
the sum monetary value of bonds issued
finding a yield on a bond
trial and error - only way
security
whether or not the bonds are secured by specific assets
indenture
written agreement between a corporation (borrower) and its creditors, also called a "deed of trust"
