Ch. 6: Interest Rates and Bond Valuation Study (questions)

More lengthy questions with longer in depth responses (a few repeating terms also)

7.1a What are the cash flows associated with a bond?

- Coupons- the stated interest payment made on a bond
- Face value- principle amount of a bond that is repaid at the end of the term, par value
- Coupon rate- annual coupon divided by the face value of a bond
Maturity- number of years until the face value is paid

7.1b What is the general expression for the value of a bond?

Bond Value = PV of the coupons + PV of the face value
Bond value = C (1-1/(1+r)^t)/r + F/(1+r)^t

7.1c Is it true that the only risk associated with owning a bond is that the issuer will not make all the payments? Explain

No, there is interest rate risk in proportion to the length of time

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 is

Interest rate risk EX: Imagine you buy a bond:

• You pay: $1,000 for a bond.

• Coupon rate: 5% per year.

• Interest payments: You get $50 every year (5% of $1,000).

Now, let’s say interest rates in the market go up to 7%.

What happens to your bond?

• New bonds are now paying 7%, which means people can buy new bonds and get $70 per year (7% of $1,000).

• Your bond is still paying $50 (5%).

Since new bonds are offering more money, nobody will want to buy your bond at $1,000 anymore. To sell it, you’d have to lower the price so that someone buying your bond still gets a good deal (comparable to new bonds). So the value of your bond drops.

Indenture

• The written agreement between the firm and the lenders 

• May include protective covenants

the indenture just sets the rules and details for the bond to make sure everything goes smoothly and everyone knows their rights and responsibilities.

Yield to maturity

• Interest rate that is required on a bond in the market

• The interest rate is moving 

• Sometimes called the going rate of interest in the market 

• Sometimes called the required rate of return

  total return an investor can expect to earn if they buy a bond today and hold it until it matures, assuming all interest payments are made on time.

Coupon rate

• The rate of interest that is paid on the bond 

• It is fixed for the life of the bond, for the term on the bond

fixed percentage of a bond’s face value that the issuer agrees to pay annually as interest to the bondholder.

Face value / Par value

original amount of money a bondholder will receive back from the issuer when the bond matures, typically $1,000 for most bonds.

Term

• The length of time until the bond matures and the principle is due

Protective covenants

• Used to protect the investor 

• A reassurance that some things would be protected

• Such as the debt / equity must remain at a certain ratio

clauses in a bond agreement that restrict the issuer from taking actions, such as incurring additional debt, to ensure that bondholders are protected against increased risk

Senor debt

The debt that would be paid off first in the case of company goes under

Sinking fund

• A method for early repayment of the debt / bond

• Firm is making periodic payments into this sinking fund account 

• The money in that accountant can be used to pay off the bond early

• Buying back your own debt

• Or use that money to call bonds in

a financial strategy where a bond issuer sets aside money regularly to repay a bond’s principal at maturity, reducing the risk of default and ensuring that funds are available when the bond comes due.

Call bond

A way for company to retire a debt early

Premium bond 

Above face value

Discount bond

Below face value 

Unsecured bond / Debenture

a type of bond that is not backed by any specific collateral, meaning that if the issuer defaults, bondholders rely solely on the issuer's creditworthiness (promise) for repayment.

7.2a What are the distinguishing feature of debt compared to equity?

1. debt is not ownership in the firm

2. payment on interest is a cost of doing business (tax deductible)

3. unpaid debt is a liability of the firmability.

Secured bond

• The company has pledge some of their assets that the creditors could seize if payment could not be made

type of bond that is backed by specific assets or collateral, meaning that if the issuer defaults, bondholders have a claim on those assets to recover their investment.

Convertible bond

• Can be converted into shares of stock 

• No ceiling, no floor

type of bond that allows the bondholder to convert it into a specified number of shares of the issuer's stock, usually at a predetermined price, giving them the potential to benefit from any increase in the company's stock value.

Junk Bond / high yield security

• Bonds that companies have issued while they were not financially secured or if the company was doing well but came into problems

a bond that has a lower credit rating, meaning it carries a higher risk of default, but offers higher interest rates to attract investors seeking greater returns.

Zero coupon bond

• Does not pay int, not coupon, 

• Make money buy it being at discount

type of bond that does not pay interest (or coupons) during its life; instead, it is sold at a discount to its face value and pays the full face value at maturity, allowing investors to earn a return over time.

Government bond

• They do not have default risk (federal gov bonds) 

• Not risk free, still carry int rate risk

• Tax advantage, they are except, do not have to pay state taxes

• Federal gov bonds are issued in the us treasury market, is the largest security market in the world, in terms of the amount of money changing hands 

a debt security issued by a government to raise funds, typically considered a safe investment because it is backed by the government's creditworthiness, and it usually pays interest over time. Treasury Bonds, Notes, Bills, Municipal Bonds (Munis)

Nominal rate

• is the quoted rate, not adjusted for inflation

the interest rate you see advertised, which doesn’t consider inflation, meaning it shows how much interest you’ll earn or pay without accounting for how prices might rise over time.

Real rate

• is adjusted for inflation 

interest rate that has been adjusted for inflation, reflecting the true purchasing power of the money you earn or pay over time.

Two reason why people call a bond in a Call Provision

• Interest rates decreased since it was issued

  • This allows the issuer to reduce their interest payments, as they will be paying a lower rate on the new bonds compared to the old ones.

• It can reduce their costs

  • This means they can save money on interest payments, which can be particularly beneficial for companies or governments looking to improve their cash flow or manage their finances more efficiently.

Refunding debt

• When the company would issue bonds at a new interest rate 

• If want to eliminate protective covenants 

when a company replaces an old bond with a new one at a lower interest rate to save money on interest payments.

Three ways to encourage investors to buy bonds with a call feature

• 1. Call Premium, extra payment that will pay the investor, they will get more than face value

• 2. Protection Period, the company can not call the bond back for an x number of years

• 3. Pay a little bit higher int rate, to compensate the investor for the risk that the bond would be called back  

Bond Default Ratings

• Bond ratings are a measure of a bond's risky

• Did not make the scheduled payments

evaluations by credit rating agencies that indicate the likelihood of a bond issuer failing to make interest or principal payments, helping investors assess the risk of investing in that bond.

Three companies that publish bond ratings

• S&P

• Moody’s

• Fitch 

• These ratings impact a company's cost of debt

2 categories of ratings

• Investment grade

  • These ratings indicate a lower risk of default and include ratings such as AAA, AA, A, and BBB.

• Speculative (Junk) grade, Double B and below

  • These ratings indicate a higher risk of default and include ratings such as BB, B, CCC, and lower.

Interest rate risk premiums

additional returns that investors demand for holding bonds that are subject to the risk of fluctuating interest rates.

• Has a positive slope, the in rate

• Base rate, real rate of int, the compensating that you demand as an investor just for giving up the use of your money

Each type of risk premium

• (1.)Inflation risk premium, compensates investors for the potential loss in future purchasing power of their returns due to rising inflation rates.

• (2.)Maturity Risk Premium, also known as the interest rate risk premium, reflects the additional yield investors require for holding longer-term bonds that are more sensitive to interest rate fluctuations.

• (3.) Default Risk Premium, based on the perceived likelihood that the bond issuer may fail (default) to make interest or principal payments, leading to a higher required return for riskier bonds.

• (4.) Liquidity Risk Premium, compensates investors for the potential difficulty in selling an asset quickly at a fair price, particularly in less active markets.

• (5) Taxability Risk Premium, exists because corporate bonds often face taxes on interest payments, while Treasury bonds may offer tax advantages, leading investors to require a higher return for the additional tax risk associated with corporate bonds.

7.3a What does a bond rating say about the risk of fluctuations in a bond’s value resulting from interest rate changes?

Nothing, they are not dependent

Interest rate risk affects all bonds, regardless of their credit rating, and is more dependent on factors like maturity and coupon rate

7.4a Why might an income bond be attractive to a corporation with volatile cash flows? can you think of a reason why income bonds are not more popular?

because they only pay interest when they have enough earnings, which helps them avoid financial stress. This setup can lower borrowing costs and keep the company stable during tough times. However, income bonds are less popular with investors because they are seen as riskier, as interest payments are not guaranteed, so many prefer regular bonds that pay fixed interest

7.4b What do you think would be the effect of a put feature on a bond’s coupon? how about a convertibility feature? Why?

put feature allows holder to force issuer to buy back bond at a state price. convertibility allows holder to swap bond for fixed # of shares

A put feature on a bond generally leads to a lower coupon rate because it gives investors the option to sell the bond back to the issuer if interest rates rise, offering added protection. Similarly, a convertibility feature allows bondholders to convert their bonds into stock, also resulting in a lower coupon rate since investors are willing to accept less interest for the potential upside of equity appreciation.

7.5a Why do we say bond markets may have little to no transparency?

the bond market is almost entirely over the counter

7.5b In general, what are bid and ask prices?

the price a dealer is willing to pay and take for a security

Let’s say you’re at a market, and someone is selling apples. The ask price for the apple is $2 (the seller wants $2 for it), but the most you’re willing to pay (your bid price) is $1.50. The transaction will only happen if either the seller agrees to lower their ask price, or you agree to raise your bid price.

7.5c what is the difference between a bonds clean price an its dirty price?

clean price the price excluding any accrued interest, representing the market value of the bond itself

the dirty price is the clean price including accrued interest (what the buyer actually pays)

7.6b What is the Fisher effect?

states that the nominal interest rate equals the real interest rate plus the expected inflation rate, indicating that higher inflation leads to higher nominal interest rates. This means that if investors anticipate rising inflation, they will require higher interest rates to ensure their returns maintain purchasing power.

7.7a what is the term structure of interest rates?

shows how interest rates vary for bonds of different maturities, usually illustrated by a yield curve that helps investors understand potential future economic conditions.

7.7b what is the Treasury Yield curve?

a graph that plots the yields (interest rates) of U.S. Treasury securities (like Treasury bills, notes, and bonds) against their maturities, ranging from short-term (a few months) to long-term (up to 30 years). It reflects the relationship between the time until maturity and the interest rates investors require, helping to indicate market expectations for interest rates, inflation, and overall economic conditions.

7.7c what six components make up a bond’s yield?

1. Real Rate of interest

2. expected future inflation

3. interest rate risk

4. default risk

5. taxability

6. lack of liquidity