Chapter 7: Interest Rates and Bond Valuation Flashcards
(104 cards)
1
Q
Why are bonds issues?
A
When a corporation or government wishes to borrow money from the public on a long-term basis, it usually does so by issuing debt securities called bonds
2
Q
A bond is normally an ________ loan
A
interest-only
meaning the borrower pays the interest every period, but none of the principal is repaid until the end of the loan
3
Q
Coupons
bonds coupons
A
The stated interest payment made on a bond
Example: $1000 bond with a 5% interest. $1000 x 0.05 = $50 interest per year
4
Q
Face Value
AKA Par Value
A
The principal amount of a bond that is repaid at the end of the term.
Example: If you spend $1000 initially to buy the bond, at the end of the 10 year term (or any period) they give you back the $1000
5
Q
Coupon Rate
A
The annual coupon divided by the face value of a bond
Example: $50 interest per month / $1000 face value = 0.05 or 5%
6
Q
Maturity
A
Specified date at which the principal amount of a bond is paid.
Example: In 10 years you get your original $1000 back
A corporate bond may have a maturity of, say 5, 7, 10, or 30 years when it is originally issued. Once the bond has been issued, the number of years to maturity declines as time goes by
7
Q
When interest rates ______, the present value of the bond’s remaining cash flows declines, and the bond is worth less
A
rise
8
Q
When interest rates _____, the bond is worth more
A
fall
9
Q
Yield to Maturity (YTM)
AKA Bond’s Yield
A
The market interest rate that equates a bond’s present value of interest payments and principal repayment with its price.
10
Q
Example of Present value calculation of a bond
Cards 10 + 11+ 12
A
Present Value = $1000 / 10.56^10
= $579.91
This was a $1000 bond with a 10 year term with a 5.6% rate
11
Q
Annuity Present Value to figure out the bonds second half
A
Annuity Present Value = $56 x (1-1/1.056^10) / 0.056
11
Q
Annuity Present Value to figure out the bonds second half
A
Annuity Present Value = $56 x (1-1/1.056^10) / 0.056
12
Q
Total Bond Value =
A
$579.91 (slide 10) + $420.09 (slide 11) = $1,000
13
Q
When the bond’s coupon rate is equal to the going interest rate in the market, the bond will sell for its _______.
A
face value
14
Q
Discount
A
A bond that sells for less than its face value
This could be due to the interest rate going up (5.7% to 7.5%)
15
Q
Premium
A
Selling a bond at a price higher than what it was bought for
Aka the interest rate went down, so the bond went up
Interest rates below the bond’s coupon rate cause the bond to sell at a premium
16
Q
Most bonds are issued at close to ___, with the coupon rate set equal to the prevailing market yield or interest rate at that time
A
par
17
Q
Bond Value =
A
present value of the coupons + Present value of the face amount
18
Q
Bond Value = (equation)
A
C x (1 - 1 / (1 + r)^t / r) + F / ( 1 + r)^t
F = Face value paid at maturity C = Coupons paid per period T = Periods to maturity r = Yield of r per period
19
Q
Interest rate risk
A
The risk that arises for bond owners from fluctuating interest rates (market yields)
20
Q
How much interest rate risk a bond has depends on how sensitive its price is to interest changes, and the sensitivity is directly dependent on two things:
A
1) The time to maturity
2) The coupon rate
21
Q
Keep the following in mind when looking at a bond:
A
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.
22
Q
If two bonds with different coupon rates have the same maturity, the value of the one with the lower coupon is proportionately more dependent on the face amount to be received at maturity
A
As a result, all other things being equal, its value fluctuates more as interest rates change
23
Q
Put another way, the bond with the higher _____ has a larger cash flow early in its life, so its value is less sensitive to changes in the discount rate.
A
coupon
24
Securities issued by corporations may be classified roughly as either:
1) equity securities
| 2) debt securities
25
Debt
At the crudest level, represents something that must be repaid; the result of borrowing money
26
Creditor / Lender
The person or firm making the loan
27
Debtor / Borrow
The corporation borrowing the money
28
From a financial point of view, the main differences between debt and equity are the following:
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 shareholders 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.
29
As a general rule, equity represents an ownership interest, and it is a residual claim.
This means that equity holders are paid after debt holders.
30
The maturity of a long-term debt instrument refers to the length of time the debt remains outstanding with some unpaid balance.
Debt securities can be short term (maturities of one year or less) or long term (maturities of more than one year)
31
Debt securities are typically called:
notes, debentures, or bonds
32
The two major forms of long-term debt are
public issue
| privately placed
33
The main difference between public-issue and privately placed debt is that
the latter is directly placed with a lender and not offered to the public. Since this is a private transaction, the specific terms are up to the parties involved.
34
Indenture (aka deed of trust)
Written agreement between the corporation and the lender detailing the terms of the debt issue.
Usually, a trustee (a trust company) is appointed by the corporation to represent the bondholders.
35
The trust company must do three thing:
(1) make sure the terms of the indenture are obeyed,
(2) manage the sinking fund (described later), and
(3) represent the bondholders in default; that is, if the company defaults on its payments to them.
36
The bond indenture document
-Can run several hundred pages in length
Includes:
1) The basic terms of the bonds.
2) The amount of the bonds issued.
3) A description of property used as security if the bonds are secured.
4) The repayment arrangements.
5) The call provisions.
6) Details of the protective covenants.
37
TERMS OF A BOND
Corporate bonds usually have a face value (that is, a denomination) of $1,000. This is called the principal value, and it is stated on the bond certificate.
So, if a corporation wanted to borrow $1 million, it would have to sell 1,000 bonds
38
SECURITY
Debt securities are classified according to the collateral and mortgages used to protect the bondholder.
39
Collateral
is a general term that, strictly speaking, means securities (for example, bonds and stocks) pledged as security for payment of debt
Examples: putting down someones phone to get the ball back, putting your house on the line to repay debt, etc/
40
Mortgage Securities
are secured by a mortgage on the real property of the borrower. The property involved may be real estate, transportation equipment, or other property.
41
Mortgage trust indenture (aka trust deed)
The legal document that describes a mortgage on real estate
42
Chattel mortgage
Anything that is not real estate, such as a train cart
43
Blanket mortgages
pledges all the real property owned by the company
44
Debenture
Unsecured debt, usually with a maturity of ten years or MORE.
No specific pledge of property is made (therefore no collateral)
45
Note
Unsecured debt, usually with a maturity UNDER 10 years.
46
SENIORITY
indicates preference in position over other lenders, and debts are sometimes labelled as “senior” or “junior” to indicate seniority
47
Subordinated debt
In the event of default, holders of subordinated debt must give preference to other specified creditors. Usually, this means the subordinated lenders are paid off from cash flow and asset sales only after the specified creditors have been compensated. However, debt cannot be subordinated to equity.
48
Sinking fund
Account managed by the bond trustee for early bond redemption. (aka the face value is repaid before maturity)
49
A call provision
Agreement giving the corporation the option to repurchase the bond at a specified price before maturity.
allows the company to repurchase or “call” part or all of the bond issue at stated prices over a specified period. Corporate bonds are often callable.
The call price is often more than the bond's stated value
50
Call premium
Amount by which the call price exceeds the par value of the bond.
51
Canada plus call
Call provision that compensates bond investors for interest differential, making it unattractive for an issuer to call a bond.
52
Protective covenant
Part of the indenture limiting certain transactions that can be taken during the term of the loan, usually to protect the lender’s interest.
For example, common covenants limit the dividends the firm can pay and require bondholder approval for any sale of major assets. This means that, if the firm is headed for bankruptcy, it cannot sell all the assets and pay a liquidating dividend to stockholders, leaving the bondholders with only a corporate shell.
53
Protective covenants can be classified into two types:
1) Negative covenants
| 2) Positive Covenants
54
A negative covenant
“thou shalt not.”
It limits or prohibits actions that the company may take.
Examples:
- The firm must limit the amount of dividends it pays according to some formula.
- The firm cannot pledge any assets to other lenders.
- The firm cannot merge with another firm.
55
A positive covenant
“thou shalt.”
It specifies an action that the company agrees to take or a condition the company must abide by
Examples:
- The company must maintain its working capital at or above some specified minimum level.
- The company must periodically furnish audited financial statements to the lender.
- The firm must maintain any collateral or security in good condition.
56
Debt ratings
an assessment of the creditworthiness of the corporate issuer
57
The definitions of creditworthiness used by bond rating agencies
are based on how likely the firm is to default and what protection creditors have in the event of a default
58
Descriptions of ratings used by DBRS (Long-term obligations rating scale)
Types of Bond Ratings (Figure 7.2)
AAA - Highest quality, exceptionally high payment
AA - Superior credit quality - Financial obligations considered high
------------------------------------------- High Grade
A - Good credit quality, may be vulnerable to future events
BBB - Speculative, capacity for payment is uncertain, vulnerable for future events
---------------------------------------------- Medium Grade
BB - Speculative, non-investment grade. Vulnerable and uncertain
B - Highly speculative credit quality. High level of uncertainty
CCC / CC / C - Very highly speculative credit quality. Little difference between categories. Highly likely to default
D - Issuer filed bankruptcy, insolvency, or winding up statue etc.
C + D = Very Low Grade
59
Investment Grade Bonds
Rated minimally a BBB.
AKA; AAA, AA, A or BBB
60
High yield bonds
Also known as Junk Bonds
As they yield as interest rate several percentage points higher than AAA-rated debt
61
Financial Engineering
When financial managers or their investment bankers design new securities or financial processes, their efforts are referred to as financial engineering
-Successful financial engineering reduces and controls risk and minimizes taxes
-Financial engineering is a response to globalization, deregulation, and greater competition in financial markets
-
62
Convertible bond
- The most common example of a hybrid security
- gives the bondholder the option to exchange the bond for company shares
- can be swapped for a fixed number of shares of stock any time before maturity at the holder’s option.
- Convertibles are debt–equity hybrids that allow the holder to profit if the issuer’s stock price rises.
63
Interest paid on corporate debt ___ tax deductible
is
It is allowed!!
64
Dividends paid to shareholders is tax deductable?
Fuck No!
65
Stripped Bonds (AKA Xero-coupon bond)
Zero coupon bond
A bond that makes no coupon payments, thus initially priced at a deep discount.
- Stripped bonds start life as normal coupon bonds. Investment dealers engage in bond stripping when they sell the principal and coupons separately.
- For tax purposes, the issuer of a stripped bond deducts interest every year even though no interest is actually paid
66
Floating-Rate Bonds (floaters)
- the coupon payments are adjustable
| - The adjustments are tied to the Treasury bill rate or another short-term interest rate
67
In addition, the majority of floaters have the following features:
1) The holder has the right to redeem his or her note at par on the coupon payment date after some specified amount of time. This is called a put provision,
2) The coupon rate has a floor and a ceiling, meaning the coupon is subject to a minimum and a maximum.
68
Catastrophe, or cat bonds
Example: FIA in 2006
-Most cat bonds, however, cover natural disasters
-
69
Income bonds
- Similar to conventional bonds, except that coupon payments depend on company income
- coupons are paid to bondholders only if the firm’s income is sufficient
- In Canada, income bonds are usually issued by firms in the process of reorganizing to try to overcome financial distress.
- The firm can skip the interest payment on an income bond without being in default
70
Real return bonds
have coupons and principal indexed to inflation to provide a stated real return
71
Asset-backed bonds
- backed by a diverse pool of illiquid assets such as accounts receivable collections, credit card debt, or mortgages
- If an issuing company defaults on its bond debt repayments, bondholders become legally entitled to cash flows generated from these illiquid pools of assets
72
A retractable bond / Put bond
- Bond that may be sold back to the issuer at a prespecified price before maturity.
- As long as the issuer remains solvent, the put feature sets a floor price for the bond. It is, therefore, just the reverse of the call provision
73
Are more stocks traded a day or bonds?
Bonds, sir
74
What is the largest securities market in the world?
U.S. Treasury market.
75
The bond market is almost entirely _______, meaning it has little to no transparency
Over the counter (OTC)
76
If you buy a bond between _______, the price you pay is usually more than the price you are quoted
coupon payment dates
77
Clean price
The price of a bond net of accrued interest; this is the price that is typically quoted.
78
Dirty price (aka full price / invoice 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
79
The accrued interest on a bond is calculated by taking the fraction of the coupon period that has passed, in this case two months out of six, and multiplying this fraction by the next coupon, $30.
So, the accrued interest in this example is 2/6 x $30 = $10. The bond’s quoted price (i.e., its clean price) would be 1,080 - 10 = $1070
80
A bond fund
-a mutual fund that invests in bonds and other debt securities
-In addition to Canada bonds, these include mortgages as well as provincial, corporate, and municipal debt
-
81
Real rates
Interest rates or rates of return that have been adjusted for inflation.
Adjusted for inflation
82
Nominal rates
Interest rates or rates of return that have not been adjusted for inflation.
NOT adjusted for inflation
83
The Fisher Effect Description
The relationship between nominal returns, real returns, and inflation.
84
The Fisher Effect Equation
1 + R = (1 + r) x (1 + h)
```
R = Nominal Rate (aka not adjusted for inflation)
r = Real Rate (Aka adjusted for inflation)
h = Inflation Rate
```
85
Rearranged Fisher Effect (low key sucks)
R = r + h + r x h
86
The nominal rate is then approximately equal to the real rate plus the inflation rate:
R ~ r + h
87
Inflation on present value calculations
1) either discount nominal cash flows at a nominal rate
| 2) or discount real cash flows at a real rate
88
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.
In easy terms: The relationship between short- and long-term interest rates
89
What makes an interest rate "pure"
because they involve no risk of default and a single, lump-sum future payment
90
Upward sloping
When long-term rates are higher than short-term rates
91
Downward sloping
when short-term rates are higher than long-term rates
92
What determines the shape of the term structure?
There are three basic components.
The first two are the real rate of interest and the rate of inflation.
The real rate of interest is the compensation investors demand for forgoing the use of their money.
You can think of it as the pure time value of money after adjusting for the effects of inflation.
93
Inflation Premium
The portion of a nominal interest rate that represents compensation for expected future inflation.
94
If investors believe that the rate of inflation will be higher in future, then
long-term nominal interest rates will tend to be higher than short-term rates
95
Interest rate risk premium
The compensation investors demand for bearing interest rate risk.
96
Canada Yield Curve
A plot of the yields on Government of Canada notes and bonds relative to maturity.
97
Canada yields depend on the three components that underlie the term structure
—the real rate, the expected future inflation, and the interest rate risk premium.
98
Canada bonds have three important features
they are default-free, they are taxable, and they are highly liquid
99
Default risk premium
The portion of a nominal interest rate or bond yield that represents compensation for the possibility of default.
100
Liquidity premium
The portion of a nominal interest rate or bond yield that represents compensation for lack of liquidity.
101
As a result, all else being the same, less liquid bonds will have _______ yields than more liquid bonds.
higher
102
We find that 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) tax status, and
(5) lack of liquidity. As a result, determining the appropriate yield on a bond requires careful analysis of each of these effects.
103
Equity Slide
- Ownership interest
- Common shareholders vote for the board of directors
- Dividends are not tax deductible
- Dividends are not required and shareholders have no legal recourse if dividends are not paid
