Chapter 5: Bonds, Bond Valuation, and Interest Rates

Question 1

bond

Answer 1

long-term contract under which a borrower agrees to make payments of interest and principal, on specific dates to the holders of the bond. 4 types: treasury, corporate, municipal and foreign

Question 2

treasury bond ( T bonds) and Treasury bills (T bills)

Answer 2

issued by the federal government. gov is good on its promised payments so these bonds have almost no default risk.
-treasury bond prices decline when interest rates rise, so they aren’t free of all risks.

Question 3

Agency debt

GSE debt

Answer 3

1. debt issued by federal agencies like the tennessee value authority. it’s not officially backed by the government, but investors assume gov guarentees this debt so the bonds carry interest rates slightly higher than treasury bonds.
2. gov sponsored enterprise debt. an agency debt that isn’t backed by the government

Question 4

corporate bonds

Answer 4

issued by corps.
default risk- if the issuing company gets into trouble, it may not be able to make the promised interest and principal payments.
default risk aka credit risk –> the larger the credit risk, the higher the interest rate the issuer must pay

Question 5

municipal bonds

Answer 5

issued by state and local governments

• default risk
• interest earned on most of these bonds is exempt from federal taxes and state if they are a resident of the issuing state.
• lower interest rates than corporate bonds but with same default risk.

Question 6

foreign bonds

Answer 6

• issued by foreign gov/corps
• default risk
• more risk if the bonds are denominated in a currency other than that of the investor’s home currency.

Question 7

refunding operation

Answer 7

when a company issues debt at current low rates and uses the proceeds to repurchase one of its existing high coupon rate debt issues

Question 8

super poison put

Answer 8

enables a bondholder to turn in or “put” a bond back to the issuer at par in the event of a takeover, merger, or major recapitalization

Question 9

make whole provision

Answer 9

allows a company to call the bond but it has to pay a call price that’s essentially equal to the market value of a similar noncallable bond.
-lets companies have an easy way to repurchase bonds as part of a financial restructuring (merger)

Question 10

floating rate bond

Answer 10

bond’s coupon payment varies over time.
popular with investors worried about the risk of rising interest rates bc the interest paid on these bonds increase when the market rates rise.

Question 11

zero coupon bonds
original issue discount (OID) bond
payment in kind (PIK) bonds

Answer 11

1. bonds that pay no coupons at all but are offered at a substantial discount below their pay values so they provide capital appreciation
2. any bond originally offered at a price significantly lower than its par value
3. bonds don’t pay cash coupons but pay with additional bonds (issued by companies with cash flow problems)

Question 12

consol

Answer 12

any bond that pays interest perpetually

Question 13

redeemable at par

Answer 13

protect investors against a rise in interest rates

Question 14

key characteristics of bonds

Answer 14

o Par value- face value of the bond. Represents the amount of money the firm borrows and promises to repay on the maturity date.
o Coupon rate- stated rate of interest on a bond. interest/par value
o Maturity date- specified date when the bond must be repaid. Effective maturity of a bond declines each year after it has been issued.
o Call provision: states that if the bonds are called then the company must pay the bondholders an amount greater than the par value/call premium. Most bonds have a call provision. Allows bond issuers to redeem the debt before its maturity date.
- Sinking funds- an account containing money set aside to pay off a debt/bond. May help pay off the debt at maturity or assist in buying back bonds on the open market. Paying off debt early via a sinking fund saves a company interest expense and prevents the company from being put in financial difficulties in the future. Can administer in 2 ways:
o Company can call in for a redemption a certain % of the bonds each year
o Company may buy the required number of bonds on the open market
o Firm chooses cheapest method

Question 15

Understand what convertible, callable, and putable bonds are. Explain how sinking funds work, and why investors might prefer them. Understand the definition of warrant, income bond, and indexed bond.

Answer 15

1. convertible - owners of these can convert the bonds into a fixed number of shares of common stock
2. warrant - permit the holder to buy stock at a fixed price, thereby providing a gain if the price of the stock rises.
3. investors prefer sinking because they are safer. they have lower coupon rates.
4. income bond - required to pay interest only if earnings are high enough to cover the interest expense
5. indexed bond- aka purchasing power bonds. interest rate is based on inflation index like consumer price index. so the interest paid rises automatically when the inflation rate rises, thus protecting bondholders from inflation

Question 16

discount bond

premium bond

Answer 16

1. when the output is smaller than the par value

2. when the output is larger than the par value

Question 17

new issue, on the run, outstanding bond

Answer 17

a bond that’s just been issued is new, when those are actively traded they’re on the run and when its been on the market for a while its an outstanding.

Question 18

yield to maturity

Answer 18

rate earned on a bond if it’s held to maturity. usually the same as the market rate of interest (Rd)

• return that investors will receive if all the promised payments are made
• expected rate of return on a bond held to maturity.

Question 19

yield to call

Answer 19

rate of interest earned on a bond if its called. YTC is more relevant if current interest rates are well below an outstanding callable bond’s coupon rate

Question 20

Current Yield

Answer 20

the annual interest payment/bond’s current price. gives info about the amount of cash income a bond will generate in a specific year.

Question 21

nominal risk free interest rate (Rrf)

Answer 21

quoted interest rate on a US treasury security. default-free and very liquid. real risk free rate + premium for expected inflation
-T bill rate is used for short term and T bond is used for long term.

Question 22

real risk free interest rate (r*)

Answer 22

rate that a hypothetical risk less security pays each moment if zero inflation was expected. changes over time depending on economic conditions

Question 23

inflation premium

Answer 23

premium added to the real risk free rate of interest to compensate for the expected loss of purchasing power. the avg rate of inflation expected over the life of security.
INFLATION RATE EXPECTED IN THE FUTURE AND THE AVG OF A SECURITIES LIFE

Question 24

maturity risk premium
interest rate risk
duration

Answer 24

• net effect of interest rate risk and reinvestment risk upon bond’s yield
• risk of a decline in bond values due to rising interest rates. reflects the length of time one is committed to a given investment
• finds the avg # of years the bond’s PV of cash flows remains outstanding

Question 25

reinvestment rate | what type of bonds have more risk for holders?

Answer 25

risk of an income decline because of a drop in interest rates relates to the income the portfolio produces -short term bond have reinvestment rate risk bc income fluctuates with interest rate

Question 26

default risk premium

Answer 26

premium added to the real risk free rate to compensate investors for the risk that a borrower may fail to pay the interest and/or principal on a loan when they become due

Question 27

indenture | restrictive covenants

Answer 27

1. legal document that spells out the rights of both bondholders and the issuing corporation 2. covers conditions where an issuer can pay off the bonds prior to maturity, levels the ratio needs to be maintained, etc

Question 28

mortgage bond debenture subordinated debenture revenue bond

Answer 28

1. secured by property, if it's issued before other bonds: first-mortgage bond 2. unsecured bond - provides no lien against specific property as security 3. debentures that have claims on assets 4. municipal bond that's revenue is secured by a specific project like a road or airport

Question 29

Explain why the market value of an outstanding fixed-rate bond will fall when interest rates rise on new bonds of equal risk, or vice versa.

Answer 29

if interest rates rise, investors will no longer prefer the lower fixed interest rate paid by a bond, resulting in a decline in its price.

Question 30

Explain the importance of bond ratings and list some of the criteria used to rate bonds.

Answer 30

- reflects the probability a bond will go into default. - based on financial ratios (invested capital, debt ratio, interest coverage ratio), bond contract terms (important to know if a bond is secured by a mortgage on specific assets, sinking funds, restrictive stuff, etc), and qualitative factors (effect from inflation, international operations, environment probs, etc) - important because a bond's rating is a good indicator of its default risk

Question 31

bond spread

Answer 31

difference between a bond's yield and yield on some other security of the same maturity lower rated bonds have higher yields spreads increase as maturity increases

Question 32

Explain what is meant by the term structure of interest rates, and graph a yield curve for a given set of data

Answer 32

-relationship between the long term and short term rates. helps investors figure out whether to buy long or short term bonds.

Question 33

Explain the two key factors (inflation, maturity risk) that determine the shape of the yield curve.

Answer 33

- normal yield curve (upward slope) = good economy | - inverted yield curve = economic recession

Question 34

Pure expectations theory

Answer 34

-the slope of the yield curve depends on expectations about future inflation rates and interest rates. if annual rate of inflation & IR increase then upward slope vice versa

Question 35

insolvent liquidation reorganization

Answer 35

1. book value of liabilities > market value of assets or they don't have enough cash to meet interest and payments. may then file for bankruptcy. 2. selling assets of the firm and distributing the proceeds to creditors & owners 3. drastic changes to the company so they dont have to file for bankruptcy

Question 36

Understand what is meant by "priority of claims" in bankruptcy.

Answer 36

if a company is going through with liquidation this is the order in which assets are sold off and cash is obtained.