Fixed Income Flashcards
Money-market securities vs. Capital-market securities
original maturity <1 year vs. original maturity >1 year
Bond price and the yield to maturity are inversely related.
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A bond that is selling for more than its par value is trading at a premium.
A bond that is selling for less than its par value is trading at a discount.
Coupon rate
annual percentage of par value that will be paid to bondholders.
Negative covenants = restrictions on asset sales, and restrictions on additional borrowing
- serve to protect the interests of bondholders and prevent the issuing firm from taking actions that would increase the risk of default.
Positive Covenants == to make timely interest and principal payments, maintain assets and comply with the laws.
Specific Purpose Entities in US
= Specific Purpose Vehicles in Europe
- Both of these entities issue securitized bonds. Often, SPE can use bonds at lower interest rate than bonds issued by the originating corporation. This is because the assets supporting the loans are owned by the SPE and are used to make payments to holders of the securitized bonds even if the company itself runs into financial trouble.
Unsecured bonds represent a claim to the overall assets and cash flows to the issuer.
Secured bonds are backed by a claim to specific assets of a corporation.
Unsecured bonds represent a claim to the overall assets and cash flows to the issuer.
Secured bonds are backed by a claim to specific assets of a corporation, which reduces the risk of default, and consequently, the yield that investors require on the bonds.
- most popular type of securitized bonds = mortgage backed security
A call option gives the issuer the right to redeem all or part of a bond issue at a specific price, if they choose.
*The issuer will only choose to exercise the call option when it is to their advantage; they can reduce the interest expense by calling the bond and issuing new bonds at a lower yield.
A put option gives the bondholder the right to sell the bond back to the issuing company at a pre-specified price, typically par.
- The bondholder is likely to exercise a put option when the fair value of the bond is less than the put price because interest rates have risen or the credit quality of the issue has fallen.
- put option bonds will sell at a higher price compared to an otherwise identical option-free bond, as it has more value to the bondholder.
Convertible bonds give bondholders the ability to exchange the bond for a specific number of shares of the issuing corporation’s common stock.
- The owner of a convertible bond had downside protection of a bond, but the yield is reduced, and the upside opportunity of equity shares.
Conversion price
the price per share at which the bond (at its par value) may be converted to common stock
Conversion Ratio
Equal to the par value of the bond, divided by the conversion price.
*ex. If a bond with an $1,000 par value has a conversion price of $40 per share, its conversion ratio is 1,000/40 = 25 shares per bond.
Conversion Value
The market value of the shares that would be received upon conversion.
- a bond with a conversion ratio of 25 shares when the current market price of a common share is $50, would have a conversion value of (25*50) = $1,250
Warrants give their holders the right to buy the firm’s common shares at a given price over a given period of time.
- can be dealt with a straight bond when the bond is issued.
Yield to Maturity
The market discount rate appropriate for discounting a bonds value
For bonds, when using the CF settings on your calculator,…
PV < 0, PMT & FV > 0
When bond yields decrease, the PV of bonds payments, its market value, increases.
- A zero-coupon bond is the PV of the maturity payment.
Relationships between price and yields for bonds
- A decrease in bond YTM will increase its price
- If coupon rate > YTM, the price will be at a premium to YTM. If coupon rate < YTM, the price will be at a discount to YTM.
- The price-yield relationship is convex, meaning as the bond gets closer to maturity, the spread between yield and price approach zero.
- The price of a bond with a lower coupon rate is more sensitive to a change in yield.
- The price of a bond with longer maturity is more sensitive to a change in the yield.
Spot rates are the market discount rates for a single payment to be received in the future.
= [CPN1/(1+S1)] + [CPN2/(1+S2)^2] + … + [(CPNn + FVn)/ (1+Sn)^n]
Also equals the no arbitrage price of a bond.
Current Yield
annual cash coupon payment / bond price
Forward Rates
Yields for future periods.
*i.e. the rate of interest on a 1-year loan that would be made two years from now.
Forward yield curve shows the future rates for bonds or money market securities for the same maturities for annual period in the future.
1y1y is the rate for a 1-year loan, 1 year from now.
2y1y is the rate for a 1-year loan, 2 years from now.
3y2y is the rate for a 2-year loan, 3 years from now
Relationship between forward rates and spot rates
What it is saying is, that borrowing for three years at the 3-year spot rate, or borrowing for one year periods in three successive years, should have the same cost.
