Bonds and Their Valuation Flashcards

Vocabulary flashcards covering key bond concepts, terminology, valuation formulas, price sensitivity, and risk factors from Business Finance (FINC 318).

Bond

A debt contract in which a borrower of funds agrees to pay back the principal with interest on specific dates in the future.

Indenture

The legal contract that describes the terms of a borrowing arrangement between a firm that sells a bond issue and the investors who purchase the bonds.

Treasury bonds

Bonds issued by the federal government (also called Treasuries or government bonds) that have no default risk.

Corporate bonds

Bonds issued by business firms that are exposed to varying levels of default risk depending on the issuing company's characteristics and bond terms.

Municipal bonds

Bonds issued by state and local governments whose interest earned is generally exempt from federal taxes and from state taxes if held by a resident of the issuing state.

Foreign bonds

Bonds issued by a foreign government or foreign corporation, exposed to default risk and potential currency risk if denominated in a currency other than the investor's home currency.

Par value

The face value paid at maturity, typically $1,000$.

Coupon rate

The fixed annual rate of interest set by the issuing company at the time of issue, used to determine periodic interest payments.

Coupon payment

The regular interest payment received by a bondholder, calculated as the coupon rate multiplied by the par value.

Maturity date

The expiration date of a bond on which the final interest payment and par value are paid back to the bondholder.

Yield to maturity (YTM)

The expected or required rate of return based on the market price of a bond, serving as the discount rate ($r$) dependent on market and economic conditions.

Current yield

The yield of a bond at the present moment, calculated as $\text{Current yield} = \frac{\text{Annual Coupon}}{P_B}$ where $P_B$ is the current bond price.

Zero-coupon bond

A bond that pays no periodic interest over its life and is sold at a discount, priced using $P_B = \frac{\text{Par value}}{(1 + r)^t}$.

Premium bond

A bond where the coupon rate is greater than the yield to maturity ($\text{Coupon rate} > \text{YTM}$), causing its price to be higher than par value ($\text{Price} > \text{Par value}$).

Par value bond

A bond where the coupon rate equals the yield to maturity ($\text{Coupon rate} = \text{YTM}$), causing its price to equal par value ($\text{Price} = \text{Par value}$).

Discount bond

A bond where the coupon rate is less than the yield to maturity ($\text{Coupon rate} < \text{YTM}$), causing its price to be lower than par value ($\text{Price} < \text{Par value}$).

Interest rate risk (price risk)

The concern that rising interest rates ($r_d$) will cause the value of a bond to fall, which is highest for long-term and low-coupon bonds.

Reinvestment risk

The concern that interest rates ($r_d$) will fall and future cash flows will have to be reinvested at lower rates, reducing income; it is highest for short-term and high-coupon bonds.

Default risk

The risk that an issuer will fail to make promised interest or principal payments, resulting in actual returns being less than promised returns.

Investment Grade Bonds

Bonds with higher credit ratings (ranging from AAA to BBB- under Fitch/S&P or Aaa to Baa3 under Moody's) indicating lower probability of default.

Junk bonds (Speculative-grade bonds)

Bonds with lower credit ratings (rated BB+ or below under Fitch/S&P or Ba1 or below under Moody's) that carry higher default risk and offer higher required returns.