Finance Chapter 7

American-style

a bond that makes coupon payments every six months. the amount equals one-half the coupon rate times the face value.

ask price or offer price

the high price at which a dealer is willing to sell to a buyer—the price at which the client buys

bearer bonds

bonds where the person holding the paper bond receives the bond’s cash flows. steal these

bellwether or benchmark bond

the most recently issued 30-year US treasury bond

bid price

the low price at which a dealer is willing to buy from a seller—the price at which the client sells

bid-ask spread

the per-unit profit a dealer makes by buying something at the low bid price and selling it high at the ask price. for example, a dealer may stand ready at a moment in time to buy a share of Manitowoc stock for $28.70 and sell a share of Manitowoc stock for $28.84. therefore, the dealer’s profit is the bid-ask spread of $0.14 per share of Manitowoc stock.

bond ratings

predictions by rating agencies as to the likelihood a bond issuer will default. the big three agencies are Moodys, Standard & Poors, and Fitch. ratings of BBB above are investment-grade debt. ratings of BB and below and below are speculative-grade debt, also known as non-investment grade, junk, or high-yield fixed income

bond trustee

a fiduciary hired by the bond issuer responsible for monitoring the bond indenture and ensuring the bond issuer fulfills its terms

callable or redeemable bond

a bond with a provision that gives the issuer the right to prepay the debt. since issuers will only exercise the call provision when interest rates fall, it imposes reinvestment risk on the bondholders. US Treasurys do not have call provisions, but munis and corporates may

capital gains yield

the annual percentage change in a bond’s price. it is the portion of a bondholder’s total return due to a change in the bond’s value

convexity

the curvature of a bond’s price response due to changes in yields

corporates

bonds issued by corporations that often have twenty-year maturities but may extend to one hundred years. corporate bonds have default risk because corporations must generate cash for the contractually obligated payments through the unforced sales of goods and services to their customers

coupon payment

the interest-only payment the bondholders receive regularly. the coupon rate times the face value is the total interest paid annually. if the bond is European-style, coupon payments are annual, whereas American-style bonds make semiannual payments

coupon rate

the percentage of the face value paid out annually as interest only

credit risk or default risk

the uncertainty about a bond issuer’s ability to make all its required payments

current yield

the annual coupons divided by a bond’s price. it is the portion of a bondholder’s total return due to the receipt of regular cash flows, the coupons

dealer

a market intermediary that always stands ready to buy from sellers at the bid (low) price and sell to buyers at the ask (high) price, thus taking the bid-ask spread as the per-unit profit

dealer market

a market where buyers and sellers for a good or service transact through an intermediary called a dealer. this market structure implies that the dealer must hold inventory and that there is a risk that the price of the inventory may change while waiting to be sold. they are also known as over-the-counter (OTC) markets

debenture

a bond without collateral. all US Treasurys are debentures

deep market

a highly active and liquid market with many buyers and sellers

default

failure on the part of the bond issuer to fulfill the terms of indenture, often by failing to make a coupon payment or pay the face value

discount bond

a bond whose price is less than its face value because its coupon rate is less than the yields on similar bonds. a discount bond’s price will, on average, rise as the time to maturity shortens

duration

the average time it takes for the bondholder to receive the value of the bond. it is the value-weighted average of the times when the bondholder receives bond payments

duration risk or interest rate risk or price risk

the risk that a bond’s price will change in unexpected ways due to unanticipated changes in interest rates. the longer a bond’s duration, the more sensitive the bond’s price to interest rate surprises. all else equal, bonds with longer times to maturity have more duration rate risk than bonds with shorter times to maturity. all else equal, bonds with smaller coupon payments have more duration risk that bonds with large coupons

European-style

a bond that makes a single coupon payment each year. the amount equals the coupon rate times the face value

face value or par value

the principal amount of a bond repaid at the end of the term. its typically $1,000 but it could be anything

fixed-income securities

another name for bonds

floaters

bonds that do not have constant coupon payments; instead, the payments vary with an inflation or interest rate index

holding period yield (HPY)

a bondholder’s realized rate of return having owned the bond for some time interval. typically, we calculate it given some final sales date that occurs before the maturity date. in that case, the holding period yield and the yield to maturity almost always differ

indenture

the written agreement between the bond issuer and the bondholders detailing all of the terms of the debt issue

inflation risk

the chance that unanticipated inflation will erode the purchasing power of the payments the bondholder receives

interest rate risk premium

the additional compensation bondholders require for the increased price risk of bonds with longer time to maturity

inverted yield curve

the situation where long-term Treasurys have lower yields than short-term bonds. they are uncommon and result from expectations that inflation or productivity will be much lower in the future

investment grade bonds

bonds rated BBB or above

liquidity

the ability to buy or sell an asset quickly at its full market value. there is an inverse relationship between liquidity and bid-ask spreads. US Treasury bonds are highly liquid, trading in very deep OTC/dealer markets with small bid-ask spreads. municipals are illiquid with large bid-ask spreads, while corporates fall in between Treasurys and munis

long-bonds

treasury bonds with twenty and thirty years to maturity

market maker

they act as an intermediary trading for their own benefit, but in doing so, match up buyers and sellers and improve market liquidity. dealers are a type of this

maturity date

the date specified in the indenture on which the issuer pays the principal amount of the bond, thus paying off the loan

municipals or munis

bonds issued by state and local governments. these bonds have default risk because the issuers have a limited liability to tax. maturity dates range from twenty to forty years. coupon payments are tax-exempt at the federal level

off-the-run

all the bonds of a type that were previously issued but are not the most recent. for example, if a 30-year bond was just issued, all other 30-year bonds previously issued are this type of bonds

on-the-run

the most recently issued debt for a given maturity date. for example, the most recently issued 30-year treasury bond is this kind of bond

par bond

a bond whose price equals its face value because its coupon rate is the same as the yields on similar bonds

premium bond

a bond whose price is greater than its face value because its coupon rate is greater than the yields on similar bonds. this bond’s price will, on average, fall as the time to maturity shortens

priority claim

the ranking of creditors’ claims should the borrower enter bankruptcy. shareholders have the lowest, hence the name, residual claimant

protective covenants

a part of the indenture either prohibiting specific actions by the issuer, or requiring others during the loan term to protect the lenders

registered bonds

bonds where the issuer keeps track of who receives the bond’s cash flows. dont steal these

reinvestment risk

the risk that a bondholder will reinvest a bond’s cash flows at a lower rate of return when invest rates fall. all else equal, bonds with shorter times to maturity have more of it than bonds with longer times to maturity

senior debt

creditors with high priority claims on the cash flows of a borrower. they often may have the right to seize collateral if a default occurs.

sinking fund

a feature of some bonds designed to reduce the probability of default at maturity by using funds to remove bonds from the market over time

sovereign bonds

debts issued by national governments

speculative or high-income or high-yield or junk bonds

bonds rated BB and below

subordinated debt or junior debt

creditors with low priority claims on the cash flows of a borrower

term structure of interest rates

the relationship between yield-to-maturity and time-to-maturity, all else equal. in general, as the time-to-maturity increases, so do yields-to-maturity, though historically, there have been important exceptions to this pattern

thin market

an illiquid market with relatively few buyers and sellers, resulting in low volume and high bid-ask spreads

time-to-maturity

the number of years until the issuer pays the face value of the bond

Treasury bills

short-term US Treasury debt with maturities of one year or less. these are zero-coupon bonds

Treasury notes

intermediate-term US Treasury debt with maturities of two to ten years. these bonds pay regular coupon payments

Treasury bonds

long-term US Treasury debt with thirty years to maturity, also called bellweather bonds. these bonds pay regular coupon payments

Treasurys

bonds issued by the federal governments. investors consider US Treasurys to be default riskless because the US government has a strong ability to tax economic activity

yield curve

a graph of US Treasury times to maturity and their corresponding yields. yield curves generally slope upward

yield-to-maturity (YTM) or yield or cost of debt

the interest rate the bondholders will earn if they hold the bond until maturity. yields are annual percentage rates (APRs) and change with market conditions. you use trial and error to solve for bond yields. this may have two components: the current yield and the capital gains yield

zero-coupon bond

a bond that does not make regular interest-only coupon payments. Treasury bills and pure discount loans are examples