Finance 300: Chapter Seven Interest Rates and Bond Valuation Assessment Preparation 1 Mark J. Laplante, Ph.D. Wisconsin School of Business University of Wisconsin-Madison Key Terms American-style A bond that makes coupon payments every six months. The amount equals one half the coupon rate times the face value. bearer bonds Bonds where the person holding the paper bond receives the bond’s cash flows. Steal these. bond A long-term standardized debt instrument that may trade in secondary markets. bonds issued The total number of bonds issued. The number of bonds issued times the face value is the total amount of the loan. As the bonds issued increases, so does the probability of default. bond issuer The borrower on one side of a bond issue. bondholder The lender on one side of a bond issue. bond ratings Predictions by rating agencies as to the likelihood a bond issuer will default. The big three agencies are Moodys, Standard & Poors, and Fitch. Ratings of BBB above are investment-grade debt. Ratings of BB and below are speculative-grade debt, also known as non-investment grade, junk, or high-yield fixed income. call provision A feature of some bonds that gives the issuer the right to prepay the debt. Since issuers will only exercise the call provision when interest rates fall, it imposes reinvestment risk on the bondholders. U.S. Treasurys do not have call provisions, but munis and corporates may. capital gains yield The annual percentage change in a bond’s price. It is the portion of a bondholder’s total return due to a change in the bond’s value. corporates Bonds issued by corporations that often have twenty-year maturities, but may extend to one hundred years. Corporate bonds have default risk because corporations must generate cash for the contractually obligated payments through the unforced sales of goods and services to their customers. coupon payment The interest-only payment the bondholders receive regularly. The coupon rate times the face value is the total interest paid annually. If the bond is European-style, coupon payments are annual, whereas American-style bonds make semiannual payments. coupon rate The percentage of the face value paid out annually as interest only. convexity The curvature of a bond’s price response due to changes in yields. credit risk or default risk The uncertainty about a bond issuer’s ability to make all its required payments. current yield The annual coupons divided by a bond’s price. It is the portion of a bondholder’s total return due to the receipt of regular cash flows, the coupons. debenture A bond without collateral. All U.S. Treasurys are debentures. default Failure on the part of the bond issuer to fulfill the terms of the indenture, often by failing to make a coupon payment or pay the face value. discount bond A bond whose price is less than its face value because its coupon rate is less than the yields on similar bonds. A discount bond’s price will, on average, rise as the time to maturity shortens.2 European-style A bond that makes a single coupon payment each year. The amount equals the coupon rate times the face value. face value or par value The principal amount of a bond repaid at the end of the term. It’s typically $1,000, but it could be anything. Fisher Effect The relationship between nominal interest rates, real interest rates, and expected inflation. fixed income Another term for bonds. indenture The written agreement between the bond issuer and the bondholders detailing all of the terms of the debt issue. inflation A general increase in prices with a corresponding reduction in the purchasing power of money. For example, something that costs $1.00 today might cost $1.50 next year. interest rate risk or price risk The risk that a bond’s price will change in unexpected ways due to unanticipated changes in interest rates. All else equal, bonds with longer times to maturity have more interest rate risk than bonds with shorter times to maturity. All else equal, bonds with smaller coupon payments have more price risk than bonds with large coupons. interest rate risk premium The additional compensation bondholders require for the increased price risk of bonds with longer times to maturity. inverted yield curve The situation where long-term Treasurys have lower yields than short-term bonds. Inverted yield curves are uncommon and result from expectations that inflation or productivity will be much lower in the future. liquidity The ability to buy or sell an asset quickly at its full market value. There is an inverse relationship between liquidity and bid-ask spreads. U.S. Treasury bonds are highly liquid, trading in very deep OTC markets with small bid-ask spreads. Municipals are illiquid with large bid-ask spreads, while corporates fall in between Treasurys and munis. maturity date The date specified in the indenture on which the issuer pays the principal amount of a bond, thus paying off the loan. municipals or munis Bonds issued by state and local governments. These bonds have default risk because the issuers have a limited ability to tax. Maturity dates range from twenty to forty years. Coupon payments are tax-exempt at the federal level. nominal interest rate The percentage change in dollars per period. The periodic rate in all of our time value of money formulae. par bond A bond whose price equals its face value because its coupon rate is the same as the yields on similar bonds. premium bond A bond whose price is greater than its face value because its coupon rate is greater than the yields on similar bonds. A premium bond’s price will, on average, fall as the time to maturity lengthens. priority claim The ranking of creditors’ claims should the borrower enter bankruptcy. Shareholders have the lowest priority claim, hence the name residual claimant. protective covenants A part of the indenture either limiting or requiring certain actions by the issuer during the term of the loan to protect the lenders. real interest rate The percentage change in purchasing power for a given period. registered bonds Bonds where the issuer keeps track of who receives the bond’s cash flows. Don’t steal these.3 reinvestment risk The risk that a bondholder will reinvestment a bond’s cash flows at a lower rate of return when interest rates fall. All else equal, bonds with shorter times to maturity have more of it than bonds with longer times