Unit 04: Interest Rates and Bond Valuation

Comprehensive vocabulary flashcards covering bond valuation, yield measures, indenture provisions, risk premiums, and interest rate term structure from Unit 04.

Bond

A debt instrument issued by corporations or governments to borrow money for investments, generally structured as an interest-only loan where the borrower pays regular coupons and returns the principal at maturity.

Face Value (Par Value)

The principal amount of a bond that is borrowed and repaid to the investor at maturity, typically assumed to be $1,000$ if not explicitly stated.

Coupon Payment

The stated periodic dollar interest payment made to the bondholder, calculated as the periodic coupon rate multiplied by the face value.

Coupon Rate

The stated annual interest rate on a bond, used exclusively to compute the coupon payment rather than as the discount rate in valuation.

Yield to Maturity (YTM)

The market required rate of return or discount rate on a bond that accounts for risk and the time value of money, equating the bond's cash flows to its current market price.

Par Bond

A bond whose market price is exactly equal to its face value, which occurs when the Yield to Maturity equals the coupon rate.

Discount Bond

A bond that trades at a price below its face value, occurring when the Yield to Maturity is greater than the coupon rate.

Premium Bond

A bond that trades at a price above its face value, occurring when the Yield to Maturity is less than the coupon rate.

Current Yield

A bond's annual coupon payment divided by its current market price, measuring the short-term annual cash return generated by the bond ignoring price changes.

Capital Gains Yield (Bonds)

The percentage change in a bond's price over a holding period, calculated as $\frac{\text{New Price} - \text{Old Price}}{\text{Old Price}}$.

Zero-Coupon Bond

A bond that makes no periodic coupon payments (coupon rate of $0\%$) and sells at a discount to par, where the investor's return comes entirely from the difference between the purchase price and par value.

Price Risk

The risk of bond price fluctuations resulting from changes in market interest rates; it is higher for long-term bonds and bonds with low coupon rates.

Reinvestment Rate Risk

The uncertainty concerning the interest rates at which future cash flows (coupons) can be reinvested; it is higher for short-term bonds and bonds with high coupon rates.

Bond Indenture

The legally binding written contract between the issuing corporation and the lenders (investors) that specifies all the terms, covenants, and arrangements of the debt issue.

Trustee

A designated third party that represents the interests of bondholders by ensuring indenture provisions are followed, managing sinking funds, and representing creditors during default.

Collateral

Specific assets pledged by the borrower as security for debt repayment in the event that the issuer defaults.

Debenture

An unsecured corporate debt obligation that has an original maturity of $10$ years or more.

Note

An unsecured debt security issued with an original maturity of less than $10$ years.

Seniority

The order of preference in repayment priority among lenders in the event of bankruptcy or default, classifying debt claims as senior or junior.

Subordinated Debt

Debt that is repaid only after other specified senior creditors have been completely compensated; it still maintains legal claim priority over equity.

Sinking Fund

An account managed by the bond trustee to which the issuer makes regular payments to systematically retire a designated portion of the debt issue prior to final maturity.

Call Provision

A provision in a bond indenture granting the issuing corporation the option to repurchase the bond from investors at a specified price before maturity.

Call Premium

The extra dollar amount above the bond's stated par value that an issuer must pay to bondholders if it calls the bond before maturity.

Deferred Call Provision

A contractual restriction prohibiting the issuing company from redeeming a bond prior to a specified date, during which the bond is considered call-protected.

Put Bond

A bond that gives the bondholder the right to force the issuing firm to buy back the bond at a specified price prior to maturity.

Protective Covenant

A clause in the bond indenture designed to protect bondholders by restricting or mandating certain corporate management actions during the loan term.

Positive Covenant

An indenture clause that specifies actions the corporate borrower is obligated to perform, such as maintaining working capital or providing audited financial statements.

Negative Covenant

An indenture clause that limits or forbids specific corporate actions, such as restricting dividend increases, asset pledges, mergers, or issuing additional debt.

Floating-Rate Bond

A bond whose coupon payments adjust periodically based on fluctuations in an underlying benchmark interest rate or index.

Convertible Bond

A hybrid debt security that gives the investor the option to swap the bond for a fixed number of shares of common stock in the issuing firm.

Warrant

A security attached to a bond granting the holder the right to purchase shares of company stock at a predetermined price.

Debt Rating

An evaluation of a borrower's creditworthiness and probability of default assigned by agencies such as Standard & Poor's (S&P), Moody's, or Fitch.

Treasury Securities

Federal government debt securities backed by the U.S. government, categorised into T-bills ($\le 1$ year maturity), T-notes ($1$ to $10$ years), and T-bonds ($> 10$ years).

Municipal Securities

Debt issued by state and local governments whose interest income is exempt from federal income taxes.

Default Risk Premium

The additional yield required by investors above a risk-free rate to compensate for the possibility of default on promised bond cash flows.

Clean Price

The quoted price of a bond that excludes any accrued interest accumulated since the last coupon payment date.

Dirty Price

The full or invoice price actually paid by a bond purchaser, consisting of the clean price plus accrued interest.

Accrued Interest

The proportional share of the next upcoming coupon payment earned by the bond seller, calculated from the fraction of the coupon period that has elapsed.

Fisher Effect

The theoretical relationship between nominal rates ($R$), real interest rates ($r$), and expected inflation ($h$), expressed as $1 + R = (1 + r)(1 + h)$.

Term Structure of Interest Rates

The relationship between nominal interest rates (or yields) and investment maturity terms for default-free, pure discount securities.

Yield Curve

A graphical plot of the term structure of interest rates showing yields across varying maturities for debt securities of identical credit risk.

Inverted Yield Curve

A downward-sloping yield curve where short-term interest rates exceed long-term interest rates, historically serving as a leading indicator of economic recessions.