Unit 4: Interest Rates and Bond Valuation

Finance 3010

bond

a debt security issued by companies or government agencies

par value (face value)

pricipal repaid to investor, usually $1000

discount bond

initial price < par value; YTM > coupon rate

premium bond

initial price > par value; YTM < coupon rate

coupon rate

annual interest rate

coupon payment

stated interest payment = periodic coupon rate * face value

maturity date

specified date on which principal is repaid

required return/yield to maturity (YTM)

market interest rate on a bond

r or I/Y

periodic YTM

when bond value = principal (par bond)

coupon rate = yield

bond valuation

PV of coupon payments plus PV of par value

as interest rates (yields) increase…

bond prices decreases

twice a year

how often coupons are usually paid

bond price and YTM

inversely related

current yield

annual coupon / price

yield to maturtiy

current yield + capital gains

capital gains

money made on the change in price of a bond (percent change)

current yield > YTM

for a premium bond bc CY ignores build-in loss from premium price

current yield < YTM

for a discount bond bc CY ignores build-in gain from price discount

zero coupon bonds

make no periodic interest payments (coupon rate = 0%)

zero coupon bond selling price

cannot sell for more than par value (ex. treasury bills)

price risk

change in price due to change in interest rates. long-term and low coupon rate bonds have higher price risk

interest rate risk (reinvestment risk)

uncertainty concerning rates at which CF can be reinvested. short-term, high coupon rate bonds have higher risk

rate risk takeaway

if you expect interest rates to increase, worry about price risk. If you expect interest rates to decrease, worry about reinvestment risk

bond indenture

a written agreement between the corporation and the lender detailing the terms of the debt

third-party trustee

represents bondholders and must ensure terms are obeyed, manage sinking fund, and represent bondholder in default

legal

a bond indenture is a BLANK document

bond indentures generally include

basic terms, total amount of bonds issued, description of collateral, repayment agreements, call provisions, and protective covenants

collateral

assets that are pledged as security for payment of debt

mortgage securities

secured by a mortgage on a real property of the borrower (your house)

unsecured debt

debentures and notes

debenture

original maturity 10+ years and no security

notes

original maturity under 10 years and no security

seniority

senior debt holders, junior debt holders, subordinated debt holders, equity holders

subordinated

paid off only after all other specified creditors have been compensated (cannot be subordinated to equity)

when can bonds be repaid?

at maturity or in part/entirety before maturity

sinking fund

account managed by the bond trustee for the purpose of repaying the bonds

call provision

an agreement giving the corporation the option to repurchase a bond at a specified price prior to maturity

why would a firm want to include a call provision?

pay less interest on debt if paid off early

put bond

allows holder to force issuer to buy back the bond at a stated price (reverse of callable bond)

protective covenants

a part of the indenture limiting certain actions that might be taken during the terms of the loan

positive covenants

thou shalt (ex. must maintain a certain level of working capital)

negative coveneants

thou shalt not (ex. cannot increase dividends)

floating rate bonds

coupons are adjustable based off some base rate

structured notes

bonds based on stocks, commodities, or currencies

collar

coupon rate has a floor and ceiling (capped)

warrant

gives buyer of the bond the right to purchase shares of stock in the company at a fixed price

convertible bond

can be swapped for a fixed number of shares

do firms prefer to issue debt or equity?

debt because it is cheaper and less financial stress

debt rating

assessment of the creditworthiness of the corporate issuer (how likely the firm is to default)

bonds with lower ratings will have…

higher yields bc riskier

treasury securities

federal government debt so all bonds are backed by U.S. gov (ex. t-bills, t-notes, t-bonds)

how are treasury securities funded?

taxes

municipal securities

debt of state and local governments. can be linked to hospitals, universities, utilities, local tax, etc

which securities are tax exempt at the federal level?

municipal

default risk premium (credit risk)

compensation for possibility of default. demand higher yield as there is risk you wont’ receive promised payments

taxability premium

compensation for unfavorable tax treatment

liquidity premium

compensation for lack of liquidity

clean price

price of a bond net of accrued interest (typical quoted price)

dirty price (full/invoice price)

price of bond including accrued interest (buyer actually pays)

accrued interst

taking fraction of time that has passed between coupons and multiplying by next coupon payment

clean and dirty price will be BLANK for zero coupon bonds

equal

nominal

not adjusted for inflation

real

adjusted for inflation (shows purchase power)

Fisher Effect

explains the relationship between nominal returns, real returns, and inflation

term structure of interest rates

relationship between the interest rate and the investment term

normal yield curve

upward-sloping, long-term yields are higher than short-term

inverted yield curve

downward-sloping, long-term yields are lower than short-term

real rate of interest (pure TVM)

compensation investors demand for forgoing the use of their money

inflation premium

compensation investors demand for reduction in purchase power due to inflation

interest rate risk premium

compensation for holding long-term bonds and bearing risk of loss resulting from change in interest rates

asked price

price at which a dealer will sell a bond