Chapter 7 Flashcards Quizlet PDF

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5/21/2020

Chapter 7 Flashcards | Quizlet

Chapter 7 Leave the first rating

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BETA

Key concepts: less than one year

bid and ask

discounted cash flows

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Bond

long-term IOUs, usually interest-only loans (interest paid by the borrower every period with the principa repaid at the end of the loan). -Debt securities issued by a corporation or government as a way to borrow money from the public on a long-term basis

Par value (face value)

amount repaid at the end of the bond's life. We will usually assume that this is $1,000.

Coupon rate

interest payment. Not all bonds pay a coupon.

Maturity date

when does the bond holder receive par value?

Yield or Yield to maturity

the rate that makes the discounted cash flows from bond equal to the bond's market price.

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Chapter 7 Flashcards | Quizlet -estimated rate of return based on the assumption i is held until maturity date and not called

As interest rates increase, what

present value decreases

happens to present value?

As interest rates increase, what

bond prices decrease - inverse relationship

happens to bond prices?

Price below par value is a...

discount bond

Why does a discount provide a

Current market rates for bonds with similar risk

yield above the coupon rate?

should have the same YTM (required rate of return). Suppose an older bond has a coupon rate of 8%, bu the current interest rate for bonds of that risk is 9%. So, new bonds are sold such that coupon rate = YTM (interest rate) at a price of $1,000. Would you pay $1,000 for a bond with an 8% coupon when you can pay $1,000 for a 9% coupon? No - so the old bond must be priced less than $1,000, since current YTM i greater than the 8% coupon.

Price above par is called a ...

premium bond

Do discounts and premiums still

yes, they just get their return differently

get the same total return?

-some are more expensive today and will have a higher coupon rate

Price risk

-Change in price due to changes in interest rates. -Long-term bonds have more price risk than shortterm bonds. -Low coupon rate bonds have more price risk than high coupon rate bonds.

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Reinvestment rate risk

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-Uncertainty concerning rates at which cash flows can be reinvested. You might have to reinvest cash flows at lower future rates. -Short-term bonds have more reinvestment rate risk than long-term bonds. -High coupon rate bonds have more reinvestment rate risk than low coupon rate bonds.

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Short-term and/or high-coupon

-low price risk

bonds

-high reinvestment risk

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Chapter 7 Flashcards | Quizlet Long-term and/or low-coupon

-high price risk

bonds

-low reinvestment risk

Duration

for bonds with similar coupon rates, the bond with longer maturity is exposed to more price risk

Which is more sensitive to

30-year bond (the slope of the line is steeper)

interest rate changes... a 30-year

-called duration risk

bond or a 1-year bond?

Bond pricing "theorem"

-Bonds of similar risk (and maturity) will be priced to yield about the same return, regardless of the coupon rate. Similar risk, similar returns! This is true for all financial assets.

Debt

-Not an ownership interest - don't own a piece of th bond -Creditors do not have voting rights -Interest is considered a cost of doing business and tax deductible -Creditors have legal recourse if interest or principa payments are missed -Excess debt can lead to financial distress and bankruptcy -debt increases risk

Equity

-Ownership interest -Common stockholders vote for the board of directors and other issues -Dividends are not considered a cost of doing business and are not tax deductible -Dividends are not a liability of the firm, and stockholders have no legal recourse if dividends are not paid -An all equity firm can not go bankrupt merely due debt since it has no debt

Indenture

a contract between the company and the bondholder that includes 1. The basic terms of the bonds 2. The total amount of bonds issued 3. A description of property used as security, if applicable.

Collateral

general term that frequently means securities that a pledged as security for payment and debt -banks loan by collateral because it lowers the cost of the loan by giving something tangible

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When are bonds repaid and

repaid at maturity and the bondholder will receive

how much will the bondholder

the stated or face value of the bond

receive at this time?

Sinking fund

account managed by the bond trustee that pays off the bond over time -the company makes annual payments to the trustee who then uses the funds to retire a portion of the debt

Call provision

allows the company to repurchase or "call" part or a of the bond issue at stated prices over a specific period -call price is usually above the bond's stated rate -often not operative during the first part of a bond's life

Call premium

the difference between the call price and the stated rate

Protective covenant

part of the indenture or loan agreement that limits certain actions a company might otherwise wish to take during the term of the loan -negative covenant: limits or prohibits actions the company might take -positive covent: specifies an action the company agrees to take

Registered vs Barer bonds

Bearer bonds are not registered the firm and are essentially obsolete -no name on them -not really in existence anymore

Bond ratings are concerned

only with the possibility of default

with...

Securities

-collateral: secured by financial securities -Mortgage: secured by real property, normally land or a building -debentures: unsecured bond, for which no specific pledge of property is made -note: unsecured bond with original maturity less than 10 years

Seniority

-senior debt: lower risk debt *get paid first

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Chapter 7 Flashcards | Quizlet -junior (subordinated) debt: gets paid after senior debt *higher return because higher risk -hybrid financing: can be converted to equity -common equity: shareholders get paid last *if there is money left over

What does coupon rate depend

the risk characteristics of the bond when issued

on?

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when yield increases, what

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price decreases

happens to price?

Which bonds are riskier:

secured debt is less risky because there is an asset

secured debt vs debenture

backing it

Which bonds are riskier:

subordinated debt is paid after senior debt, so more

subordinated debenture versus

risky

senior debt

Which bonds are riskier: a bond

without a sinking fund - systematic retirement of deb

with a sinking fund versus one

is less risky

without

Which bonds are riskier: a

bondholders bear the risk of the bond being called

callable bond versus a non-

early when rates are low (callable bond)

callable bond

If things are riskier...

Default

yields are higher and required rate of return is highe

failure to meet the terms of the indenture -this is firm specific and can be reduced by forming well-diversified portfolio of bonds

Loss of purchasing power

inflation reduces real return -higher inflation = higher rates: you lose money because the value of the money is going down

High grade ratings

AAA, AA -capability to pay is extremely/very strong -very few companies

Medium grade rating

A - capability to pay is strong, but more susceptible to changes in circumstances

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Chapter 7 Flashcards | Quizlet BBB - capability to pay is adequate, adverse conditions will have more impaction on the firm's ability to pay -probably get your money back, but a little cheape

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Low grade ratings

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Ba, B, BB, and B -considered possible that the capacity to pay will degenerate

Very low grae

C (and below) -income bonds with no interest being paid, or in default with principal and interest in arrears -may not get your money back

Government bonds

Treasury notes & bonds - when the government wishes to borrow for more than one year, it sells these to the public Treasury bills: a short-term government debt (less than one year) - pure discount bonds

Non marketable federal

bonds you can't sell

government debt

-Series EEE bonds: educational bonds

Most U.S. Treasury issues are....

just ordinary coupon bonds 1. they have no default risk because (we hope) the Treasury can always come up with the money to make the payments 2. Treasury issues are exempt from state income taxe (but not federal income taxes)

Risk associated with

1. safe from default

Government bonds

2. risk from price fluctuations 3. purchasing power risk - inflation reduces real returns

Municipal bonds

state and local governments -tax exemption: interest is exempt from federal income taxation -popular with higher income investors

Risk associated with municipal

1. changes in interest rate

bonds

2. purchasing power risk 3. default - always callable

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Zero coupon bonds

makes no periodic interest payments (coupon rate = 0%) -the entire YTM comes from the difference between the purchase price and the par value -they do not sell for more than par value, since you won't have a negative return -sometimes called zeros, deep discount bonds, or original issue discount bonds -treasury strips are good examples of zeros *a strip is created by "taking apart" a Treasury bond * create a zero coupon bond from just the lump sum you get when the bond matures

Floating-Rate bonds

coupon rate floats depending on some index value -coupons may have a "collar" - the rate can go abov a specified "celling" or below a specified "floor" Examples -adjustable rate mortgages and inflation-liked treasuries -there is less price risk with floating rate bonds but greater reinvestment risk *the coupon floats, so it is less likely to differ substantially from the YTM

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Disaster bonds

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issued by property and casually companies -pay interest and principal as usual unless claims reach a certain threshold for a single disaster -at that point, bondholders may lose all remaining payments

Income bonds

coupon payments depend on level of corporate income -if earnings are not enough to cover the interest payment, it is not owed

Convertible bonds

bonds can be converted into shares of common stock at the bondholders discretion

Put bonds

bondholder can force the company to buy the bond back prior to maturity

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What type of trade is usually

primarily over-the-counter transactions with dealers

made in bond markets?

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Bond markets

extremely large number of bond issues, but genera low daily volume in single issues -makes getting up-to-date prices difficult, particularly on small company or municipal issues

Bid

what someone is willing to buy something for

Ask

What someone is willing to sell something for

When does a transaction occur?

when bid and ask match up

Bid ask spread

difference between the bid and the ask

Asked yield

use the asks the price

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