FIN303 midterm 2: ch 7

What is a bond?

A long-term debt instrument in which a borrower agrees to make principal and interest (semi-annual) payments on specific dates to the bondholders.

Which entity issues Treasury bonds (T-bonds)?

The U.S. federal government.

What are municipal bonds (munis)?

Bonds issued by state or local governments, such as the state of California.

Corporate bonds

issued by corporations

What is the par value of a bond?

The face amount (face value) of the bond paid at maturity, generally assumed to be $1,000.

• government/company will pay you back when bond matures

Coupon interest rate

stated interest rate (generally fixed) paid by the issuer. Multiply by par value to get dollar payment of annual interest (Stated coupon interest rate × par value)

• ex. each year will get $60, $30 each 6 months

maturity date

The date when a bond matures and its principal, or face value, must be repaid.

• the government/company will pay you back face value

Issue date

when the bond was first issued

What is the Yield to Maturity (YTM) of a bond?

The rate of return earned on a bond held until maturity; also called the promised yield.

• buy bond at market price

convertible bonds

may be called/exchanged for common stock of the firm, at the holder’s option

warrants

long-term option to buy a stated number of shares of common stock at a specified price (usually issued to employees)

Putable bonds

It allows bondholders to sell the bond back to the issuing company before (prior to) maturity.

income bonds

It pays interest only when interest is earned by the issuing firm. (most bonds pay semi-annually interest payments)

• riskier (interest payments not gauranteed)

indexed bonds

interest rate paid is based upon the rate of inflation

call provision

most of corporate bonds. sell bond to company which bought from

Effect of A Call Provision: what does it allow?

issuer to retire the bond if interest rates decline (helps the issuer but hurts investors), which is similar to refinance your mortgage

Why do callable bonds require a higher yield/returns than non-callable bonds?

To compensate investors for call risk, since issuers are likely to call bonds when market interest rates fall.

• In many cases, callable bonds when issued include a deferred call provision (often 5 years up to ten years) and a declining call premium

when are most callable bonds called?

can be called at par, while some can be called at a call price (which is a bit higher than the par value; par + call premium)

What is a call premium?

An amount above par value paid by the issuer to bondholders when a callable bond is called early.

What is a deferred call provision?

A restriction preventing the issuer from calling the bond during a specified initial period, often five to ten years.

How do general callability provisions differ between Treasury bonds and municipal bonds?

Treasury bonds are generally not callable, while municipal bonds are usually callable.

What is a sinking fund?

A provision to pay off a loan over its life rather than all at the maturity. Similar to amortization on a term loan.

• company’s account - retire small portion of bond every year over time

• when big amount of bonds mature at same time, short flow of capital/cash

How does a sinking fund affect the risk level and average maturity of a bond issue?

It reduces default risk for investors and shortens the bond issue’s average maturity.

Why can a sinking fund provision disadvantage investors if interest rates decline after issuance?

If rates decline bond prices will increase. But bond investors will only get the par value back.

type of relationshop between interest rate & bond price

inverse relationship

when should you buy a bond

when above par value

when bond called? when retire on open market?

depends on price of bond & market interest rate

if rd (cost of debt) is below the coupon rate and the bond sells at a premium (the market price is higher than the face value of $1,000; when the market interest rates drop and the bond price rises above the face value of $1,000)

Call x% of the issue at par, for sinking fund purposes

• goal: to save interest payment

• retire x% every year

• buy back little bit yearly in open market

if rd (cost of debt) is above the coupon rate and the bond sells at a discount (the market price is less than the face value of $1,000; (when the market interest rates rise and the bond price drops below the face value of $1,000)

Buy bonds in the open market

• company won’t call bond, so can buy back for lesser amount

What is the fundamental formula for the value of any financial asset?

Value = Σ[CFt ÷ (1 + r)^t], from t = 1 to N.

• value → present value (price) of bond

• CFN → will receive coupon payments & face value

What Is Opportunity Cost of Debt Capital?

The discount rate i (r), and it is the rate that could be earned on other alternative investments of equal risk. It is also called the required rate of return for the bond.

bond is selling at par (face value)

If the coupon rate is equal to the required rate of return (rd) for the bond, the value of the bond should be $1,000 (face value)

bond is selling at a premium (a premium bond)

If the coupon rate is greater than the required rate of return (rd) for the bond, the value of the bond should be greater than $1,000 (face value).

bond is selling at a discount (a discount bond)

If the coupon rate is less than the required rate of return (rd) for the bond, the value of the bond should be less than $1,000 (face value).

if rd (required rate of return) remains constant: premium bond (> $1,000)

Its value/price would decrease over time, until it reaches/converges to $1,000.

if rd (required rate of return) remains constant: discount bond (< $1,000)

Its value would increase over time, until it reaches/converges to $1,000.

if rd (required rate of return) remains constant: par bond

Its value stays at $1,000

What will happen to its price over time for a bond with a coupon rate of 10% and required rate of return (rd) of 12%?

Price will increase because currently it is a discount bond

• price less than (<) $1,000 right now, price will gradually increase to converge to par value

What would happen to the value of these three bonds if the required rate of return remained at 10%?

Price of premium bonds will decrease while price of discount bonds will increase over time, converging to face value

Capital Gains Yield (CGY)

change in price/ beginning price

expected total return

=YTM=expected CY + expected CGY

current yield

return from coupon payment (not total return)

What is Price Risk?

the concern that rising rd will cause the value of a bond to fall

• if price goes up/down, if market interest rate changes, what happens to price?

• what direction does interest rate move?

Does A 1-year or 10-year Bond with A 10% Coupon Rate Have A Higher Price Risk?

The 10-year bond (long-term bond) is more sensitive to interest rate changes and hence has more (a higher) price risk

What does a graph comparing one-year and ten-year bond values at different YTMs illustrate?

Price risk: longer-term bonds experience much larger price changes than short-term bonds when YTM changes.

• 10-year bond → more sensitive in price if interest rate changes → changes more in price than short-term bond

What is reinvestment risk?

the concern that rd will fall, and the future CFs will have to be reinvested at lower rates, hence reducing income.

Suppose you just won $500,000 playing the lottery. You intend to invest the money and live off the interest. You may invest in either a 10-year bond or a series of ten 1-year bonds. Both 10-year and 1-year bonds currently yield 10%. If you choose the 1-year bond strategy:

After Year 1, you receive $50,000 in income and have $500,000 to reinvest. But, if 1-year rates fall to 3% thereafter, your annual income would fall to $15,000.

• drops from $50,000

• drops from 10%

• get less income in future

Suppose you just won $500,000 playing the lottery. You intend to invest the money and live off the interest. You may invest in either a 10-year bond or a series of ten 1-year bonds. Both 10-year and 1-year bonds currently yield 10%. If you choose the 10-year bond strategy:

You can lock in a 10% interest rate, and $50,000 annual income for 10 years, assuming the bond is not callable.

Short-term AND/OR High-coupon Bonds: Price risk

Low

Short-term AND/OR High-coupon Bonds: Reinvestment risk

High

Long-term AND/OR Low-coupon Bonds: Price risk

High

Long-term AND/OR Low-coupon Bonds: Reinvestment risk

Low

Semiannual Bonds (2x a year)

• bonds pay semiannual coupon payments

1. Multiply years by 2: Number of (semi annual) periods = 2N

2. Divide nominal rate by 2: Periodic rate (I/YR) rd/ 2

3. Divide annual coupon by 2: PMT = Annual coupon ⁄ 2

what value does money have?

time value

When Is A Call More Likely to Occur?

In general, if a bond sells at a premium (a premium bond)

• Therefore, investors should expect to earn:

  • YTC on premium bonds.

  • YTM on par and discount bonds.

selling at discount, won’t call the bond

Evaluating Default Risk: Bond Ratings

designed to reflect the probability of a bond issue going into default.

• only rate corporate bonds → don’t rate government bonds

Evaluating Default Risk: Bond Ratings: Investment Grade

Moody’s - Aaa Aa A Baa

S&P - AAA AA A BBB

• AAA → lowest return (a little higher than t-bonds)

Evaluating Default Risk: Bond Ratings: Junk Bonds

Moody’s - Ba B Caa C

S&P - BB B CCC C

• high risk, high return, high yield

• C → highest return

Factors Affecting Default Risk And Bond Ratings: Financial performance

• Debt ratio → company has high debt ratio, bond rating decrease because increased chance of bankruptcy

• TIE ratio

• Current ratio

company’s pov

Factors Affecting Default Risk And Bond Ratings: Qualitative factors: Bond contract terms

• Secured vs. unsecured debt

• Senior vs. subordinated debt

• Guarantee and sinking fund provisions

• Debt maturity

company’s pov

Other Factors Affecting Default Risk

• Miscellaneous qualitative factors

  • Earnings stability

  • Regulatory environment

  • Potential antitrust or product liabilities

  • Pension liabilities

  • Potential labor problems

macro pov

Bankruptcy: If a company can’t meet its obligations…

• It can file to stop creditors from foreclosing, taking assets, and closing the business and it has 120 days to file a reorganization plan.

• Court appoints a “trustee” to supervise reorganization.

• Management usually stays in control.

Bankruptcy: Company must demonstrate in its reorganization plan that it is “worth more alive than dead.”

If the company doesn’t do that, the judge will order total liquidation

Why is an issuer unlikely to call a bond that is selling at a discount?

Market interest rates are above the coupon rate, so refinancing would increase the issuer’s borrowing cost.

Priority of Claims in Liquidation

1. Secured creditors from sales of secured assets

2. Trustee’s costs

3. Wages, subject to limits

4. Taxes

5. Unfunded pension liabilities

6. Unsecured creditors

7. Preferred stock

8. Common stock residual claims

• if company goes bankrupt as a shareholder, should NOT expect anything left (ex. in line waiting to buy something, when it gets to your turn, everything is sold out)

Reorganization: In a liquidation, unsecured creditors generally receive nothing.

This makes them more willing to participate in reorganization even though their claims are greatly scaled back.

Reorganization: Various groups of creditors vote on the reorganization plan.

If most of the creditors and the judge (need both) approve, the company “emerges” from bankruptcy with lower debts, reduced interest charges, and a chance for success