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1

Bond definition & components (2)

(BKM - 14)

type of debt security where the borrower (issuer/seller) compensates the lender (holder/buyer) for use of the cash

components:
1. coupon payments - periodic interest payments
2. par value - face value of the bond

2

Zero-coupon bonds & pricing

(BKM - 14)

bonds that do not pay any coupons

usually sold at a price < par value with price converging to par value over time

3

Bond coupon payment

(BKM - 14)

coupon payment = coupon rate * par value

4

Ask vs. bid price for bonds

(BKM - 14)

ask = price you can buy a bond from a dealer
bid = price you can sell a bond to a dealer

generally ask price > bid price

5

Bond sale price

(BKM - 14)

Bond sale price = stated price (aka flat price) + accrued interest

6

Accrued interest definition & formula

(BKM - 14)

pro-rated portion of coupon for bonds sold between coupon payments

accrued interest = (annual coupon payment / # payments) * (# of days since last coupon payment / # days b/w coupon payments)

7

Unique bond features (10)

(BKM - 14)

1. callable bonds
2. puttable bonds
3. convertible bonds
4. floating-rate bonds
5. inverse floating-rate bonds
6. international bonds
7. asset-backed bonds
8. catastrophe bonds
9. indexed bonds
10. preferred stock

8

Callable bonds and relative riskiness

(BKM - 14)

optional bond feature where the issuer can re-purchase the bond for a specified call price before maturity

riskier for investors, so they typically have higher coupons and higher promised yields to compensate

9

When is it optimal to call callable bonds?

(BKM - 14)

desirable to call when interest rates are low (b/c it allows the bond to be refinanced at a lower interest/coupon rate)

10

Convertible bonds and relative riskiness

(BKM - 14)

bond feature where the bond is exchangeable for a specified number of shares of common stock

lower risk (lower coupons and promised yields) because of the potential future benefit

11

When is it desirable to convert convertible bonds?

(BKM - 14)

convert if current stock price > par value / # shares

12

Puttable bonds

(BKM - 14)

bond feature where the bondholder can extend the bonds life at a specified date

13

When is it desirable to extend puttable bonds?

(BKM - 14)

extend if the coupon rate > market rate on the put date

14

Floating rate bonds, example, & riskiness

(BKM - 14)

bond feature where coupon payments (interest rates) are tied to market rates

ex: coupon rate = current T-bill rate + 2% (spread)

more risky if the financial position of the firm worsens

15

Relationship between the coupon rate & the market rate for floating-rate bonds

(BKM - 14)

coupon rate increases as the market rate increases

16

International bonds & categories (2)

(BKM - 14)

bonds that are issued by a country other than the market they are sold in

categories:
1. foreign bonds - denominated in the currency of the country where they are sold (e.g. Germany sells dollar-denominated bond in the US)
2. Euro-bonds - denominated in a currency other than the country where they are sold (e.g. US firm sells a dollar-denominated bond in Germany)

17

Inverse floating-rate bonds (relationship b/w coupon rate & market rate)

(BKM - 14)

bond feature similar to floating rate bonds but where coupon rates fall when market rates increase

18

Asset-backed bonds

(BKM - 14)

bond feature where coupon payments are backed by income generated from a firm's assets

ex: mortgage-backed securities

19

Catastrophe bonds & relative riskiness

(BKM - 14)

type of bond that transfers catastrophe risk from the firm to the capital markets where the coupon payments are dependent on the occurrence of a CAT event (e.g. pays coupons up until a CAT event, then stops)

riskier for investors, so coupon rates are generally higher

20

Indexed bonds

(BKM - 14)

bond feature where coupon payments are tied to the price of a commodity or a price index

**coupon rate is fixed, but the par value changes each year based on actual price changes

21

Nominal rate of return for indexed bonds

(BKM - 14)

nominal ROR = (coupon + change in par value) / par value at BOP

22

Real rate of return for indexed bonds

(BKM - 14)

real ROR = (1 + nominal rate) / (1 + inflation rate) - 1

real ROR = coupon rate as long as the coupon rate is constant

23

Preferred stock

(BKM - 14)

technically an equity, but with fixed-income features such as dividend payments (which are similar to coupons)

24

Bond value (aka stated or flat price)

(BKM - 14)

bond value = PV(coupon payments) + PV(par value)

25

Relationship between bond value and par value when bonds are sold at a premium vs. a discount

(BKM - 14)

premium: bond value > par value

discount: bond value < par value

26

When does bond value = par value?

(BKM - 14)

when the coupon rate = interest rate

27

Characteristics reflected in a bond interest/discount rate (4)

(BKM - 14)

1. default risk
2. liquidity
3. tax attributes
4. call risk

28

Relationship between bond value, coupon rate, and interest/discount rate (2)

(BKM - 14)

all else equal:
1. bond value decreases as coupon rate decreases
2. bond value increases as interest/discount rate decreases

29

Reason short-term securities are generally considered to be less risky

(BKM - 14)

less sensitive to interest rate fluctuations

30

Biggest source of risk in the fixed-income market

(BKM - 14)

interest rate fluctuations

31

Convexity of bond prices

(BKM - 14)

relationship between bond price (y-axis) and interest rates (x-axis) where the bond price decreases as interest rates increase at a decreasing rate (flatter curve at higher interest rates)

32

Yield to maturity (YTM)

(BKM - 14)

average rate of return if a security is held to maturity

= interest rate that sets PV(cash flows) = bond price

33

Bond equivalent yield

(BKM - 14)

annualized YTM using simple interest = rate * number of coupon payments

34

Effective annual interest rate

(BKM - 14)

interest rate that accounts for compounding of interest

effective annual interest rate = (1 + YTM)^n - 1 where n = # coupon payments per year

35

Current yield

(BKM - 14)

current yield = annual coupon payment / bond price

36

Relationship between coupon rate, current yield, and YTM for premium vs. discount bonds

(BKM - 14)

premium: coupon rate > current yield > YTM

discount: coupon rate < current yield < YTM

37

Yield to call and adjustments for calculations (2)

(BKM - 14)

similar to YTM but assumes a bond will be called as soon as it is advantageous to do so

calculation adjustments:
replace time until maturity w/time until call
replace par value with the call price

38

Implicit assumption of YTM

(BKM - 14)

coupon payments are reinvested at an interest rate equal to the YTM

>> means YTM = realized compound return

39

Criticism of YTM

(BKM - 14)

in reality, interest rates fluctuate such that realized compound returns do not equal YTM

40

Realized compound return

(BKM - 14)

actual real return on the investment

solve: PV * (1 + rate) ^ # years = FV

41

Disadvantage of realized compound returns

(BKM - 14)

requires a forecast of reinvestment rates to calculate realized compound returns at the time of purchase

42

Holding period return (HPR) & calculation adjustments (2)

(BKM - 14)

realized compound return for the holding period (which is not = maturity)

calculations:
1. only account for the coupons received over the holding period
2. instead of using the par value at maturity, use the bond price (sale price) at the end of the holding period

43

Offsetting sources of risk for investors when interest rates change (2)

(BKM - 14)

1. price risk = risk of reduced portfolio value b/c as rates increase bond prices decrease

2. reinvestment rate risk - as rates increase, reinvested coupons will compound more quickly (offsetting price risk)

44

Imputed interest

(BKM - 14)

interest on the bond price appreciation for bond's sold at a discount

**price appreciation is based on a constant YTM = initial YTM

45

Methods for calculating the pre-tax HPR (2)

(BKM - 14)

1. PV * (1 + HPR)^t = FV and solve for HPR

2. HPR = (coupon + imputed interest) / initial price

46

After-tax HPR for OID bonds

(BKM - 14)

HPR = (coupon + imputed interest - tax) / original price

where tax = tax rate * (coupon + imputed interest)

47

Default risk and bond ratings

(BKM - 14)

higher-rated (investment grade) bonds have less default risk compared to lower-rated (junk/high-yield bonds)

48

Financial ratios used to determine bond ratings (5)

(BKM - 14)

1. coverage ratios
2. leverage ratios
3. liquidity ratios
4. profitability ratios
5. cash flow-to-debt ratios

49

Coverage ratios and times-interest-earned ratio example & levels/trends

(BKM - 14)

ratios of company earnings to fixed costs

times-interest-earned ratio = earnings before interest & taxes / interest obligations

low or decreasing ratios suggest CF problems

50

Leverage ratios & levels/trends

(BKM - 14)

ratios of debt to equity

high or increasing ratios suggest excessive debt (company may not be able to meet obligations)

51

Liquidity ratios, current ratio example, & levels/trends

(BKM - 14)

ratios that measure company ability to meet short-term obligations

current ratio = current assets / current liabilities

low or decreasing ratios suggest the company may not have enough liquid assets to pay its bills

52

Profitability ratios, ROE example, & levels/trends

(BKM - 14)

ratios of profit to assets or equity

ROE = net income / equity

low or decreasing ratio means firm may have trouble raising capital (b/c investors can earn a higher ROR elsewhere)

53

Cash flow-to-debt ratios & levels/trends

(BKM - 14)

ratios of total CF to outstanding debt

low or decreasing ratios suggest potential distress

54

Indenture provisions & common types (4)

(BKM - 14)

contract provisions that protect the bondholder

1. sinking funds
2. subordination of further debt
3. dividend restrictions
4. collateral

55

Sinking funds and options (2)

(BKM - 14)

indenture provision that spreads out the final repayment of par value over several years

firm can re-purchase a fraction of outstanding bonds either:
1. in the open market each year
2. at a special call price (paying minimum of the market price and the call price)

56

Advantage and disadvantage of sinking funds

(BKM - 14)

advantage: increases the likelihood of principal repayment

disadvantage: firm may be able to re-buy bonds at prices below market value, resulting in a loss to the investor

57

Differences between sinking funds and conventional bonds (2)

(BKM - 14)

1. limited to re-purchasing only a fraction of bonds at the sinking fund call price

2. sinking fund call price generally = par value (vs. above for conventional bonds)

58

Subordination of further debt

(BKM - 14)

indenture provision that ensures additional debt taken on after bond issuance is subordinated to the bond (more senior debt is paid first)

59

Dividend restrictions

(BKM - 14)

indenture provision that limits the amount of dividends the firm can pay

>> benefit to bondholder b/c it forces the firm to retain assets

60

Collateral

(BKM - 14)

indenture provision in the form of property or another asset kept by the bondholder in the event of default (safer compared to unsecured bonds)

61

Difference between promised yield and expected yield

(BKM - 14)

promised yield = max possible YTM if there is no default

expected yield considers default risk of the bond

62

Default premium

(BKM - 14)

spread between promised YTM and a comparable risk-free bond

63

Relationship between default risk, bond price, and promised yield

(BKM - 14)

as default risk increases, bond price decreases and promised yield increases (b/c investors demand higher returns)

64

Credit Default Swaps (CDS)

(BKM - 14)

an insurance policy for a bond's default risk

annual "premiums" are paid to the CDS seller and the bondholder is compensated for the loss of the bond value in the event of default

65

Premiums for credit default swaps (CDS) & relationship with risk

(BKM - 14)

premium is approximately equal to the yield spread b/w AAA rated bonds & the bond-grade being priced

price of CDS increases as risk increases

66

Collateralized Debt Obligations (CDO)

(BKM - 14)

purchasing of a large number of bonds/loans and partitioning them into classes called tranches with different seniority levels

- more senior tranches are exposed to less credit risk
- junior tranches receive higher coupons because they are exposed to more risk

67

Quick ratio

(BKM - 14)

a liquidity ratio

quick ratio = current assets excl. inventories / current liabilities

68

Altman's Z-score

(BKM - 14)

combination of financial ratios to determine firm safety

Z = 3.1 * EBIT / total assets + 1.0 * sales / assets + .42 * shareholder's equity / total liabilities + .85 * retained earnings / total assets + .72 * working capital / total assets

Z < 1.23 indicates firm vulnerability to bankruptcy

69

Taxes on original issue discount (OID) bonds

(BKM - 14)

bonds sold at a discount must pay tax on imputed interest to cover the bond's price appreciation