MGT 181 Chapter 7 Notes PDF

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Download MGT 181 Chapter 7 Notes PDF

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Chapter 7.1 -

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Bond- The security that is sold or issued when the government wants to borrow money from the public on a long-term basis - A bond is an interest-only loan, so the borrower only pays the interest periodically and repays the entire principal at the end of the bond’s duration Coupons- The regular interest payments that a party promises to make on a bond - Coupons are usually constant and paid every year, so the bond is also described as a level coupon bond Face (Par) Value- The value or amount that will be repaid at the end of the loan - A bond that sells for its par value is known as a par value bond Coupon Rate- Mathematically described as the annual coupon divided by the face value Maturity- The number of years until the face value is paid (time to maturity) When interest rates increase, the present value of the bond’s remaining cash flows declines, so the bond is worth less (all while the cash flows remain unchanged) When interest rates decrease, the bond has a higher worth What we need to determine the value of a bond at a particular point in time - Number of periods remaining until maturity - Face Value - Coupon - Market interest rate for bonds with similar features Yield- The interest rate required in the market on a bond (Bond’s Yield to Maturity (YTM)) A discount bond is where the bond sells for less than its face value - Since the bond pays less coupon than the going rate, investors will be willing to lend an amount less than the $1000 promised repayment A premium bond is where the bond sells for more than its face value - Since the bond pays more coupon than the going rate, investors will be willing to lend more than the promised repayment of $1000 Bond Value = PV(Coupons) + PV(Face Amount) = C[1-(1/(1+r)^t)//r + F/(1+r)^t - F is the face amount paid at maturity - C is the coupon paid per period - t is the number of periods until maturity - r is the yield per period Note: Bond yields are quoted like APRs, so the quoted rate is equal to the actual rate per period times the number of periods Interest Rate Risk- The risk that arises for bond owners from fluctuating interest rates - The amount of interest rate risk for a bond depends on the sensitivity of its price to interest rate changes, the sensitivity of which depends on the time to maturity and coupon rate When looking at a bond: - The longer the time to maturity, the greater the interest rate risk - The lower the coupon rate, the greater the interest rate risk Interest rate risk increases at a decreasing rate - A 10-year bond has much greater interest rate risk than a 1-year bond, but a 30-

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year bond doesn’t have that much greater of interest rate risk than a 20-year bond If two bonds with different coupon rates have the same maturity, then the value of the bond with the lower coupon is more dependent on the face amount at maturity, and this will result in more fluctuations in value as interest rates change (Higher coupon bonds have larger cash flows early on in its life, so sensitivity to interest rates decrease) Current Yield- A bond’s annual coupon divided by its price (not face amount) - Current yield is usually too low because it only considers the coupon aspect of your return, not the gain from the price discount - For premium bonds, current yield is too high because it ignores the loss from the price discount

Chapter 7.2 -

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Equity securities and debt securities are the classifications for securities issued by many corporations - A debt represents something that must be repaid; result of borrowing money When corporations borrow money, they promise to make fixed interest payments and repay the principal at the end The creditor/lender is the person or firm making the loan The debtor/borrower is the corporation borrowing the money Differences between debt and equity - Debt is not an ownership interest in the firm, so creditors do not have voting powers - Corporation’s interest payments on debt is considered a cost of business and are tax deductible, whereas dividends paid to stockholders are not tax deductible - Unpaid debt is a liability to the firm, so creditors can claim the assets if a debt is unpaid (liquidation or reorganization, consequences of bankruptcy), but this issue does not take place in matters of equity Corporations are usually seen creating hybrid securities with both debt and equity features, and this is done to obtain tax benefits as one reason Equity represents an ownership interest and is a residual claim, so equity holders are paid after debt holders. This means that risks and benefits with owning equity or debt differ (Ex. maximum reward for debt security is fixed by loan amount, whereas reward is limitless for equity interest) Note: All long-term debt securities are promises made by issuing firm to pay principal when due and to make fixed interest payments on unpaid balance Short-term debt securities (unfunded debt) have maturities of one year or less, whereas long-term debt securities have maturities of more than one year Debt securities are usually called notes, debentures, or bonds Notes have original maturities of 10 years or less, and bonds have original maturities that exceed 10 years The two major forms of long-term debt are public-issue and privately placed The main difference between the two forms is that privately placed debt is placed with a

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lender and not offered to the general public Indenture- The written agreement between the corporation (borrower) and creditors; Also known as the deed of trust - A trustee is appointed by the corporation to represent the bond-holders, and they must make sure that the indenture terms are obeyed, manage sinking fund, and represent bond-holders in default - Provisions of the Indenture - Basic terms of the bond - Total amount of bonds issued - Description of property used as security - Repayment Arrangements - Call Provisions - Details of protective covenants The principal value (par value) is stated on the bond certificate Registered Form- The form of bond issue in which the registrar of the company records bond ownerships (payments made directly to owner of record) Corporate bonds may be registered and have attached coupons; To obtain interest payments, the owner must separate coupons from the bond certificate and send it to the company registrar Bearer Form- Bond is issued without record of the owner’s name (payments made to whoever holds the bond) - Difficult to recover if lost or stolen, and bondholders cannot be notified of important events Debt securities are classified according to the collateral and mortgages used to protect the bondholder Collateral- Securities that are pledged as security for payment of debt; Any asset pledged on a debt Mortgage Securities- Secured by a mortgage on the real property of the borrower; Described by a legal document known as the mortgage trust indenture/trust deed Blanket Mortgage- Pledges all the real property owned by the company Debenture- Unsecured bond for which no specific pledge of property is made Note- Used for such instruments if maturity of unsecured bond is at most 10 years Seniority- Indicates preference in position over other lenders; Labeled for debts as well In events of default, holders of subordinated debt gives preference to other particular creditors, so subordinated lenders will be paid off after specified creditors have been compensated Sinking Fund- An account managed by the bond trustee with the purpose of repaying the bonds - Company makes annual payments to the trustee who uses these funds to retire portions of the debt via buying up bonds in the market or calling in a fraction of the outstanding bond - Some sinking funds start after 10 years of the initial issuance - Some sinking funds establish equal payments over the bond’s lifetime - Some high-quality bond issues establishing payments to sinking fund insufficient

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to redeem the entire issue (leads to large balloon payment at maturity) Call Provision- Allows the company to repurchase or “call” part of all of the bond issue at stated prices over a particular period (Referred to as callable bonds) - The call price is usually above the stated value for the bond (above par value) Call Premium- The difference between the call price and stated value Deferred Call Provision- Call provisions may not be operative during a particular part of a bond’s lifetime (0-n years of prohibiting call provisions) - During this period, the bond is “call protected” A “make-whole” call is a new feature of a callable bond where bondholders receive close to the bond’s actual worth when or if they are called (“made whole” since no loss is incurred) - Determine the price by calculating the PV of remaining interest and principal payments at a rate specified in the indenture - Call prices are higher when interest rates are lower, and vice versa Protective Covenant- The part of the indenture/loan agreement that limits actions a company may wish to take during the term of the loan - Classified into negative and positive (affirmative) covenants - Negative covenants limit or prohibit actions companies may take - Must limit amount of dividends paid according to some formula - Cannot pledge any assets to other lenders - Cannot merge with other firms - Cannot sell or lease major assets without approval by lender - Cannot issue additional long-term debt - Positive covenants specify actions companies agree to take or conditions that companies must abide by - Maintain working capital at or above a minimum level - Periodically furnish audited financial statements to the lender - Maintain any collateral or security in good conditions

Chapter 7.3 -

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The two leading bond-rating firms that are paid to have debts rated are Moody’s and Standard & Poor’s (S&P) - These firms rate debt based on the creditworthiness of the issuer, and this means how likely the firm is to default and the protection of creditors in this event of default Note: Bond ratings are only concerned with the possibility of default! Bond ratings are mainly constructed from the context supplied by the corporation itself The highest possible bond rating is AAA (Aaa), which means that such debt is at the highest quality with the lowest level of risk - These ratings are not as common, as opposed to AA or Aa ratings which would indicate very good quality debt A major aspect of corporate borrowing is in the form of “junk” bonds (low-grade bonds), which are usually rated below investment grade if rated at all by the agencies (at least

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BBB) A bond’s credit rating can vary as the financial strength of the issuer improves or lessens! Fallen Angels- Bonds that lower their rating into “junk” territory The importance of credit ratings is immense because default is actually possible, and this can result in major losses for investors

Chapter 7.4 -

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Treasury Notes/Bonds- Bonds that are issued by the government when they wish to borrow money for more than one year (maturities range from 2 to 30 years) US Treasury issues have no default risk since the Treasury can always come up with money to make the payments, and Treasury issues are exempt from the state income taxes (not federal income taxes) Municipal Notes/Bonds- Bonds that are issued by state and local governments; Shorthand form is “munis” - Varies by degree of default risk and rated like corporate issues - Always callable and coupons are exempt from federal income taxes (not state income taxes) - These tax breaks justify why the yields on municipal bonds are much lower than those of taxable bonds After Tax yields are effective in determining which of two bonds has a better yield - Ex. A muni pays 4.09 percent on pretax and after tax basis. A corporate bond pays 4.38 percent before taxes, but it pays 0.0438*(1-0.3)=0.0301, or 3.01 percent after taxes. Hence, the municipal bond is a better deal - Note: Break-even tax rate is the tax rate where investors would be neutral between taxable and non-taxable issues Zero-Coupon Bond (Zeroes)- A bond that makes no coupon payments, so it is priced at a large discount as a result - The implicit interest of zero-coupon bonds is determined by amortizing the loan, and it is simply the change in bond value for the year - The current tax law requires that a deduction in interest is paid in taxes by the owner of the bond, and this decreases the attractiveness of zero-coupon bonds Floating-Rate Bonds- The coupon payments are adjustable, and such adjustments are connected to an interest rate index - The value of this bond depends on the definition of coupon adjustments - Holder has the right to redeem the note at par on the coupon date after some time (put provision) - Coupons are subject to a minimum (floor) and maximum (ceiling), so coupon rate is essentially “capped” Inflation-Linked Bond- Coupons are adjusted according to the current rate of inflation Cat Bonds- Reinsurance companies sell insurance to other insurance companies Warrant- The buyer is given the right to purchase shares of stock in the company at a fixed price

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This right would be extremely valuable if the market creates an increase in stock prices - Bonds with warrants are usually issued with very low coupon rates Income Bonds- Similar to conventional bonds, but coupon payments depend on the company income - Coupons are paid to bondholders only if the firm’s income is sufficient Convertible Bond- A bond that can be swapped for a fixed number of shares of stock at any point in time before the bond’s maturity date Put Bond- A bond that allows the holder to force the issuer to buy back the bond at a stated price; Reverse of the call provision Reverse Convertible Bond- Generally offers a high coupon rate, but redemption at maturity is paid in cash at par or via shares of stock Death Bond- Companies purchase life insurance policies from individuals expected to die in the next 10 years and sell bonds that are paid off via these insurance proceeds received at the time of the death of the policyholders Structure Notes- Bonds that are based on stocks, bonds, commodities, or currencies

Chapter 7.5 -

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In terms of trading volume (the amount of money trading hands), the largest security is the US Treasury Market Reminder: Most trading in bonds occurs over the counter, or OTC, and this means that there is no particular place for buying and selling The bond markets are massive because the number of issued bonds drastically exceeds the number of issued stocks - Reasons for this include corporations having only one common stock outstanding but dozens of outstanding bonds Transparency- It is possible to easily observe prices and trading volumes - It is easy to see transactions in the stock market but not so much for the bonds since transactions are usually negotiated privately For bond markets, the common way to get a sense of the prices is to obtain various sources of estimated prices Beginning in 2002, transparency in the bond markets began to improve by new regulations requiring corporate bond dealers to report trade information through the Trade Reporting and Compliance Engine (TRACE) - The Financial Industry Regulatory Authority (FINRA) provides a daily snapshot from TRACE by reporting on the most active issues Bid Price- Represents what a dealer is willing to pay for a security Ask Price- Represents what a dealer is willing to take for a security Bid-Ask Spread- The difference between both the bid and ask prices; Represents the dealer’s profit For the “bellwether” bond, long-term interest rates rising implies that the yield increased and the price decreased If a bond is bought in between coupon payment dates, the price you pay exceeds that of

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the quoted price because prices are quoted net of “accrued interest”, which means that accrued interest is deducted to arrive at the quoted price, known as the clean price - Clean Price = Dirty Price - Accrued Interest Dirty Price- The price you actually pay, which includes the accrued interest; Also known as “full” or “invoice” price To calculate the accrued interest, take the fraction of the coupon period that has passed and multiply by the next coupon payment amount

Chapter 7.6 -

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Real Rates- Interest rates/rates of return that have been adjusted for inflation Nominal Rates- Interest rates that have not been adjusted for inflation The nominal rate for an investment is the percentage change in the number of dollars you have, and the real rate for an investment is the percentage change of how much you can buy with your dollars Fisher Effect- The relationship between nominal returns, real returns, and inflation - R = Nominal rate - r = Real rate - h = Inflation rate - 1 + R = (1+r)*(1+h) - R = r+h+(r*h) - Three components of the nominal rate, R - Real rate on the investment, r - Compensation for decrease in value of money due to inflation, h - Compensation for fact that dollars earned are worth less due to inflation - R = r+h Reminder: Financial rates such as interest rates, discount rates, and rates of return are almost always quoted in nominal terms The effect of inflation on the present value is that you either discount nominal cash flows at a nominal rate or discount real cash flows at a real rate, and the same answer will be achieved as long as there is consistency

Chapter 7.7 -

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Term Structure of Interest Rates- The relationship between short-term and long-term interest rates; Tells us what nominal interest rates are on default-free, pure discount bonds of all maturities - These rates are “pure” because they involve no risk of default and a single, lump sum future payment - This structure tells us the pure time value of money for different lengths of time If long-term rates are exceeding short-term rates, the term structure is upward sloping If short-term rates are higher, the term structure is downward sloping The term structure can be “humped” by initial increasing of rates and then steady decreases as rates become more long-term

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Components determining the term structure’s shape - Real rate of interest - Rate of inflation - Interest rate risk Real rate of interest influences the overall level of interest rates, not the shape of the entire term structure Inflation strongly influences the shape because investors recognize that inflation erodes the value of the returns, so they demand compensation via higher nominal rates, and this compensation is known as the inflation premium - If investors believe inflation rates will increase in the future, then long-term nominal interest rates will tend to be higher than short-term rates, so upwardsloping term structure will reflect anticipated increases for inflation Investors recognize the risk of loss for longer-term bonds and as a result demand extra compensation via higher rates for bearing it, and this compensation is known as the interest rate risk premium Treasury Yield Curve- A plot of the Treasury notes yields and bonds in relation to maturity Note: The shape of the yield curve reflects the term structure of interest rates Term structure is based on pure discount bonds, whereas yield curve is based on coupon bond yields Reminder: Treasury notes/bonds are default-free, taxable, and highly liquid For municipal bonds issued by corporations, we must look at: - Credit Risk - Possibility of default - Treasury may not make all promised payments, so investors demand a higher yield as compensation (default risk premium) - Tax-Free - Munis have lower yields than taxable bonds - Investors demand extra yield on a taxable bond as compensation for unf...