Interest Rates and Bond Valuation

maturity date

date when principal is due and issuer is to repay par value to bond holder.

Real Rates

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

Asked Price

The price a dealer is willing to take for a security.

Level Coupon Bond

A bond that pays a coupon that is constant every year.

Par Value Bond

A bond that sells for its par value.

Call-protected Bond

A bond that, during a certain period, cannot be redeemed by the issuer. The time in which the bond cannot be called - call is deferred.

Deferred Call Provision

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

Collateral

A general term that frequently means securities (for example bonds and stocks) that are pledged as security for payment of debt.

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.

Put Bond

Forces issuer to buy back the bond at a stated price.

Put Provision

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

Subordinated Debt

In the event of debt, holders of these must give preference to other specified creditors. Will only be paid after the seniors.

Income bond

Pays interest ONLY when interest is earned. Coupon payments depend on a company's income.

Original Issue Discount Bond (OID)

Priced to sell for less than $1000 when issued.

Yield to call

Rate of return an investor will receive if bond is called prior to maturity.

Clean Price

The Price of a bond net of accrued interest; this is the price that is typically quoted.

Call Premium

The amount by which the call price exceeds the par value of a bond. The amount that must be paid to the bond holder if the call feature is excersized.

Fisher Effect

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

Seasoned/Outstanding Issue

When bonds are sold by one investor to another investor. This is considered a secondary market transaction.

New Issue

When the issuer sells its bonds to the public and receives the proceeds. This is considered a primary market transaction.

Negative Covenant

"Thou shalt not" covenants. Limits or prohibits actions the company might take. Ex: Firm must limit the amount of dividends it pays according to a formula, firm cannot pledge any assets to other lenders, firm cannot merge with another firm, firm cannot sell or lease any major assets without approval by the lender, and firm cannot issue additional long-term debt.

Positive Covenant

"Thou shalt" covenants. Specifies an action that the company agrees to take or a condition the company must abide by. Ex: company must maintain its working capital at or above some specified minimum level, company must periodically furnish audited financial statements to the lender, and firm must maintain any collateral or security in good condition.

Current Yield

A bond's annual coupon divided by its price. Coupon payment/market price. Doesn't consider built in gain from price discount nor built in loss from premium bond.

Treasury Yield Curve

A plot of the yields in treasury notes and bonds relative to maturity.

Blanket mortage

Agreement that pledges all the real property of the company as securities.

Sinking Fund

An account managed by the bond trustee for early bond redemption. Safety feature for the investor. Firm either sets aside money to retire or a percentage of outstanding bonds are retired each year. Some sinking funds start about 10 years after the initial issuance, and some establish equal paymkents over the life of the bonds.

Call Provision

An agreement giving the corporation/issuer the option to repurchase a bond at a specified price prior to maturity. Allows issuer to retire bonds before maturity. This is advantageous to the issuer if rates drop and financing can therefore be done at a lower cost. Issuer may have to pay a premium to bond holders.

Notes

An unsecured debt with an original maturity of 10 years or less.

Debenture

An unsecured debt, usually with a maturity of 10 years or more. Not backed by an asset, just the reputation/creditworthiness of the issuer. May be senior or subordinate.

Secured Bond

Backed by a specific asset

Mortgage Bond

Backed by real estate of the borrower. Agreement is called the mortgage trust indenture, or trust deed.

Creditor

Bondholder. Anyone who owns a bond.

Structured Notes

Bonds that are based on stocks, bonds, commodities, or currencies. Follows the return and growth of the market. If it declines it returns the principal, if it improves it will return a portion of the index return.

Fallen Angels

Bonds that drop into junk bonds territory in ratings.

Indexed Bond

Coupon is indexed to inflation.

coupon payment

Coupon rate times the face value. Generally paid in semi-annual installments.

Bonds

Debt securities that a corporation or government sells when it wants to borrow money from the public on a long term basis. Has an original maturity of over 10 years. Issuer/borroweragrees to pay bondholder/creditor interest payments and principal on specific dates in the future. Bond value = C x [1-1/(1+r)^t]/r + F/(1+r)^t = Present value of the coupons + present value of the face amount.

Inflation Linked bond

Have coupons adjusted to the rate of inflation and the principal amount may be adjusted as well.

Seniority

Indicates preference in position over the other lenders, and debts are sometimes labeled as senior or junior to indicate this.

Floating rate bond

Interest fluctuates based upon the rise or fall in yield on another "benchmark" security. The coupon payments are adjustable and the adjustments are tied to an interest rate index. Has the put provision. The coupon rate has a floor and a ceiling with upper and lower rates called the collar.

Nominal Rates

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

Warrants

Long term option to buy a certain number of shares at a given price - have expiration date, but long-term - can be separated from the bond and sold separately or turned in for shares (exercised) without giving up the bond. The right to purchase certain stock at a fixed price.

Premium Bond

Sells abovepar - occurs when current market interest rate is less than coupon - sells for more because new bonds are paying less - therefore the market price adjusts so that both a seasoned issue and new bonds are of equivalent value (have same rate of return). With premium bonds, Coupon > Current Yield > YTM.

Discount Bond

Sells below par when market interest rate is above coupon rate - price falls so that the value (rate of return) of a seasoned issue is equivalent to a new issue bond. With discount bonds, Coupon < Current Yield < YTM.

Unfunded Debt

Short term debt with maturities of one year or less.

Municiple Notes and Bonds

State and local government issued bonds and notes. They have varying degrees of default risk and are rated much like corporate issues. They are almost always callable. Coupons are exempt from federal income taxes.

Coupon Rate

The annual coupon divided by the face value of a bond. If interest rates rise then then the present value of the bonds decrease, because investors are only willing to lend so much if the coupon rate is less than the going rate. Annual interest rate set at the time of the bond's issue and paid for the life of the bond. Normally = current market rate so bond sells at par.

Interest Rate Risk Premium

The compensation investors demand for bearing interest rate risk.

Bid-ask Spread

The difference between the bid price and the asked price.

Bearer Form

The form of bond issue in which the bond is issued without the record of the owner's name; payment is made to whomever holds the bond.

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 the record.

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.

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.

Bid Price

The price a dealer is willing to pay for a security.

Dirty Price

The price of the bond including accrued interest, also known as the full or invoice price. This is the price the buyer actually pays.

Par Value

The principal amount of a bond that is repaid at the end of the term. Also Called Face Value. Printed on the face of the document. Amount repaid at maturity. Typically $1000. Also called the principal value.

Yield to maturity

The rate of return an investor will receive on a bond if it is held to maturity and if the interest payments are re-invested at the YTM. the IRR of a bond - the interest rate that makes the PV of all payments equal to the price of the bond. The "expected" return. The rate required in the market on a bond.

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.

Interest Rate Risk

The risk that arises for bond owners from fluctuating interest rates, this depends on the time to maturity and the coupon rate. All things equal, the longer the time to maturity and the lower the coupon rate the greater the interest rate risk.

Maturity

The specified date on which the principal amount of a bond is paid. A corporate bond will frequently have a maturity of 30 years. Bond's terms. The time from the present until the principal is to be returned to the bondholder.

Coupon

The stated interest payment made on a bond. A level coupon bond has a coupon that is constant and paid every year.

Zero Coupon Bond

The ultimate OID bond. Pays no interest. Investor makes return on difference between what is paid and what is received at maturity. Although no annual interest is paid to bondholders, they receive "phantom" income annually that is taxable each year. At maturity, therefore, there is no capital gain as ordinary income tax has been paid over the life of the bond. A bond that makes no coupon payments and is thus initially priced at a deep discount.

Indenture

The written agreement between the corporation and the lender detailing the terms of the debt issue. Sometimes referred to as the deed of trust. Includes the basic terms of the bond, the total amount of bonds issued, a description of property used as security, the repayment arangements, the call provisions, and details of the protective covenants.

Convertible Bond

can be exchanged for a specific number of shares of common stock. If stock prices go over par value, then conversion option has value. Can be swapped for a number of stocks before maturity.

junk bonds (high yield Securities)

issued by companies that might be risky (risk could be for a number of different reasons). Rated "below investment grade" - BB/Ba