FIN 3403 - Chapter 7 Part 1

Bonds

When a corporation or government wishes to borrow money on a long-term basis, it usually does so by issuing (i.e. selling) debt securities that are generically called bonds

Bond Payment Structure

Bonds have a payment structure like an interest-only loan

Coupon

the stated interest payment made on a bond

Face value

also known as par value, is the principal amount of a bond that is repaid at the end of the term

Coupon rate

the annual coupon divided by the face value of the bond

Maturity

the specified date on which the principal amount of a bond is paid

for a bond, the cash flows...

...remain the same! As a result, the value of the bond will fluctuate

When interest rates rise

the present value of the bond's remaining cash flows declines, and the bond is worth less

When interest rates fall

the bond is worth more

To find the value of a bond at a particular point in time, we need the following pieces of information

- Number of periods remaining until maturity. - Face value. - Coupon payment value. - Yield to maturity (YTM)

Yield to maturity (YTM)

or yield, which is the rate required in the market on a bond (THIS IS WHAT WE USE TO DISCOUNT CASHFLOWS)

Once a bond is issued, the coupon payments are

fixed (they are a fixed $ amount/rate)

Interest rates in financial markets change all the time!

new bonds issued will offer different interest payments to investors than existing bonds.

If that new bond interest rate is lower

(interest rates fell), the new bond offers lower interest payments

If a bond's price increases

its yield falls because the return the investor expects from purchasing the bond is lower.

If markets are efficient

the old bond's price should increase to the point where it's yield is equal to the new bond's yield

Par Value Bonds

Bonds that sell for exactly face value are called, yield = coupon rate

Premium Bonds

Bonds that sell for more than face value, yield < coupon rate

Discount Bonds

Bonds that sell for less than face value, yield > coupon rate

NPER (number of periods)

needs to be multiplied by the number of payments per year

RATE

needs to be divided by the number of payments per year

PMT

needs to be divided by the number of payments per year

When calculating TVM (time value of money) numbers that require an adjustment for payment timing (RATE, NPER, and PMT), you are receiving an answer in terms of

the rate of payment

Interest Rate Risk

The risk that arises for bond owners from fluctuating interest rates.

Interest Rate Risk depends on two things

Time to maturity (NPER). Coupon Rate (PMT)

The longer the time to maturity

the higher the interest rate risk

The lower the coupon rate

the greater the interest rate risk

Current yield

the bond's annual coupon divided by its price.

Securities issued by corporations may be classified roughly as...

...equity securities and debt securities

Differences between debt and equity are the following

- Debt is not an ownership interest in the firm. Creditors generally do not have voting power. - Corporation's payment of interest on debt is considered a cost of doing business and is tax deductible (up to certain limits). Dividends paid to stockholders are not tax deductible. - 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

long-term debt securities

promises made by the issuing firm to pay principal when due and to make timely interest payments on the unpaid balance

Short-term debt securities, or unfunded debt, have a maturity of

one year or less

Long-term debt securities have maturities of

more than one year

Maturity of a long-term debt instrument is the length of time

the debt remains outstanding with some unpaid balance

Debt securities are typically called

notes, debentures, or bonds

original maturity

Difference between notes and bonds

indenture (i.e., deed of trust)

the written agreement between the corporation (the borrower) and the lender detailing the terms of the debt issue

Indenture generally includes the following provisions

Basic terms of the bonds, Total amount of bonds issued, Description of property used as security, Repayment arrangements, Call provisions, Details of the protective covenants

trustee (e.g., a bank)

appointed by the corporation to represent the bondholders

the trustee must

Make sure the terms of the indenture are obeyed, Manage the sinking fund, Represent the bondholders in default

Principal value

is stated on bond certificate

registered form

meaning the registrar of the company records ownership of each bond with payment being made directly to the owner of record

bearer form

in which case the bond is issued without record of the owner's name with payment being made to whomever holds the bond

Bearer Form Aspects

Difficult to recover if bonds are lost or stolen (scammers have tried to peddle bonds). Because the company does not know who owns its bonds, it cannot notify bondholders of important events

Mortgage securities

are secured by a mortgage on the real property of the borrower, with the property involved typically being real estate (e.g., land or buildings)

mortgage trust indenture

also known as a trust deed, Legal document that describes the mortgage

Blanket mortgage

pledges all real property owned by the company

debenture

an unsecured debt, usually with a maturity of 10 years or more. Most public bonds issued in the U.S. by industrial and financial companies are debentures

note

an unsecured debt, usually with a maturity under 10 years (e.g. 1 year)

Seniority

indicates preference in position over other lenders, with debts sometimes labeled as senior or junior to indicate seniority

sinking fund

an account managed by the bond trustee for early redemption.

Call provision

an agreement giving the corporation the option to repurchase a bond at a specified price prior to maturity. Corporate bonds are usually callable

the call premium

the difference between the call price and the stated value

Deferred call provisions

prohibit the company from redeeming a bond prior to a certain date

During period of prohibition, the bond is said to be

call-protected

"Make-whole" call

a new type of call provision where bondholders receive approximately what the bonds are worth if they are called

To find the make-whole call price

calculate the PV of the remaining interest and principal payments at a rate specified in the indenture

protective covenant

limits certain actions that might be taken during the loan's term, usually to protect the lender's interest

Negative covenant

a "thou shalt not" type of covenant that limits or prohibits actions the company might take

Negative covenant examples

Firm must limit amount of dividends paid, according to some formula, Firm cannot pledge any assets to other lenders, Firm cannot merge with another firm, Firm cannot sell or lease any major assets without lender's approval, Firm cannot issue additional long-term debt

Positive covenant

a "thou shalt" type of covenant that specified an action the company agrees to take or a condition the company must abide by

Positive covenant examples

Company must maintain working capital at or above some specified minimum level, Company must periodically furnish audited financials to lender, Firm must maintain any collateral or security in good condition