Chapter 7: Bond Valuation and Interest Rates

Vocabulary flashcards covering bond terminology, types, pricing characteristics, risks, and ratings from Chapter 7 lecture notes.

Bond

A long-term contract under which a borrower agrees to make payments of interest and principal on specific dates to the holders of the bond.

Treasury Bonds

Bonds issued by the federal government that have no default risk, have maturities ranging from $10\text{ to }30\text{ years}$, and decline in value when interest rates rise.

Corporate Bonds

Bonds issued by business firms that are exposed to default risk (credit risk) rated from $\text{AAA}$ to $\text{BBB}$ to $\text{D}$, where the riskier the company, the higher the interest rate.

Municipal Bonds

Bonds issued by state and local governments that are exposed to default risk, whose interest earned is exempt from federal taxes and state taxes if the holder resides in the issuing state.

Foreign Bonds

Bonds issued by foreign governments or foreign corporations that are exposed to default risk and currency exchange risk.

Price Risk (Interest Rate Risk)

The risk of a decline in bond values (prices) due to an increase in market interest rates.

Par Value

The stated face value of the bond, representing the amount of money the firm borrows and promises to repay on the maturity date.

Coupon Payment

The specified number of dollars of interest paid each year on a bond.

Coupon Interest Rate

The stated annual interest rate paid on a bond.

Fixed-Rate Bonds

Bonds whose interest rate is fixed for their entire life.

Floating-Rate Bonds

Bonds whose interest rate fluctuates with shifts in the general level of interest rates.

Original Issue Discount (OID) Bond

A bond originally offered at a price significantly below its stated par value.

Maturity Date

A specified date on which the par value of a bond must be repaid.

Original Maturity

The number of years to maturity at the time a bond is issued, typically ranging from $10\text{ to }40\text{ years}$.

Sinking Fund Provision

A provision in a bond contract that requires the issuer to retire a portion of the bond issue each year.

Yield to Maturity (YTM)

The rate of return earned on a bond if it is held for its full lifetime until maturity.

Yield to Call (YTC)

The rate of return earned on a bond when the issuer exercises the right to pay it off and call it before its scheduled maturity date.

Mortgage Bonds

Bonds backed by specific fixed assets, where first mortgage bonds have senior priority to the claims of second mortgage bonds.

Debenture

A long-term bond that is not secured by a mortgage or lien on specific property.

Subordinated Debentures

Unsecured bonds having a claim on assets only after senior debt has been paid in full in the event of liquidation.

Investment Grade Bonds

Bonds rated triple-B ($\text{BBB}$) or higher, including extremely safe triple-A ($\text{AAA}$) and double-A ($\text{AA}$) bonds, which many banks and institutions are permitted by law to hold.

Determinants of Bond Ratings

Factors used to evaluate bond safety, including financial ratios, qualitative bond contract terms, and miscellaneous qualitative factors such as the strength of the economy.

Reinvestment Risk

The risk that cash flows from a bond will have to be reinvested at a lower interest rate when market rates decline.

Over-the-Counter (OTC) Market

The decentralized market where corporate bonds are primarily bought and sold.

Discount Bond

A bond whose price is less than its par value ($< \$1{,}000$), occurring when the market interest rate is greater than the coupon rate.

Premium Bond

A bond whose price is greater than its par value ($> \$1{,}000$), occurring when the market interest rate is less than the coupon rate.