Interest Rate and Bond Valuation - Chapter 6

discount bond

A bond sells for less than face value.

current yield

A bond's coupon payment divided by its closing price.

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.

deferred call provision

Bond call provision prohibiting the company from redeeming the bond prior to a certain date.

real rates

Interest rates or rates of return that have been adjusted for inflation.

nominal rates

Interest rates or rates of return that have not been adjusted for inflation.

trust company

Must (1) make sure the terms of the indenture are obeyed, (2) manage the sinking fund (described in the following pages), and (3) represent the bondholders in default, that is, if the company defaults on its payments to them.

maturity

Specified date on which the principal amount of a bond is paid.

call premium

The amount by which the call price exceeds the par value of the bond.

face value or par value

The amount that will be repaid at the end of the loan. A bond that sells for its par value is called a par value bond.

coupon rate

The annual coupon divided by the face value of a bond.

interest rate risk premium

The compensation investors demand for bearing interest rate risk.

liquidity premium

The portion of a nominal interest rate or bond yield that represents compensation for lack of liquidity.

default risk premium

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

coupon

The stated interest payment made on a bond. Because the coupon is constant and paid every year, the type of bond we are describing is sometimes called a level coupon bond.

debenture

Unsecured debt, usually with a maturity of 10 years or more.

Mortgage securities

are secured by a mortgage on the real property of the borrower. The property involved is usually real estate, for example, land or buildings. The legal document that describes the mortgage is called a mortgage trust indenture or trust deed. A "blanket" mortgage pledges all the real property owned by the company.

Collateral

is a general term that frequently means securities (for example, bonds and stocks) that are pledged as security for payment of debt. For example, collateral trust bonds often involve a pledge of common stock held by the corporation. However, the term collateral is commonly used to refer to any asset pledged on a debt.

the main differences between debt and equity

1. Debt is not an ownership interest in the firm. Creditors generally do not have voting power. 2. 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. 3. 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.

bearer form

A bond issued without record of the owner's name; payment is made to whomever holds the bond. There are two drawbacks to bearer bonds. First, they are difficult to recover if they are lost or stolen. Second, because the company does not know who owns its bonds, it cannot notify bondholders of important events.

zero coupon bond

A bond that makes no coupon payments, and thus is initially priced at a deep discount.

call provision

Agreement giving the issuer the option to repurchase a bond at a specific price prior to maturity.

sinking fund

An account managed by the bond trustee for early bond redemption.

bond

Is normally an interest-only loan, meaning that the borrower will pay the interest every period, but none of the principal will be repaid until the end of the loan. For example, suppose a corporation wants to borrow $1,000 for 30 years. The interest rate on similar debt issued by similar corporations is 12 percent. They will thus pay .12 × $1,000 = $120 in interest every year for 30 years. At the end of 30 years, they will repay the $1,000.

bond yields represent the combined effect of no fewer than six things

The first is the real rate of interest. On top of the real rate are five premiums representing compensation for (1) expected future inflation, (2) interest rate risk, (3) default risk, (4) taxability, and (5) lack of liquidity. As a result, determining the appropriate yield on a bond requires careful analysis of each of these effects.

yield to maturity (YTM)

The interest rate required in the market on a bond. This rate is sometimes called the bond's yield for short.

taxability premium

The portion of a nominal interest rate or bond yield that represents compensation for unfavorable tax status.

inflation premium

The portion of a nominal interest rate that represents compensation for expected future inflation.

registered form

The registrar of a company records who owns each bond, and bond payments are made directly to the owner of record.

Fisher effect

The relationship among nominal returns, real returns, and inflation.

term structure of interest rates

The relationship between nominal interest rates on default-free, pure discount securities and time to maturity; that is, the pure time value of money. To be a little more precise, the term structure of interest rates tells us what nominal interest rates are on default-free, pure discount bonds of all maturities. These rates are, in essence, "pure" interest rates because they involve no risk of default and a single, lump-sum future payment. In other words, the term structure tells us the pure time value of money for different lengths of time.

Interest Rate Risk

The risk that arises for bond owners from fluctuating interest rates. 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: the time to maturity and the coupon rate. Keep in mind: 1. All other things being 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.

indenture

The written agreement between the corporation and the lender detailing the terms of the debt issue. It is sometimes referred to as the deed of trust.

note

Unsecured debt, usually with a maturity of under 10 years.