FIN4504 Exam 2 Study Guide 18 MC questions 2 open space questions you may use a calculator 1 Bond provisions Callable Bonds Callable bonds bonds that may be repurchased by the issuer at a specified call price during the call period Call provisions allow the issuer to repurchase the bond at a specified call price before the maturity date Example o Company issues a bond with a high coupon rate when market interest rates are high Interest rates later fall Firm wants to return the high coupon debt Issue new bonds at lower coupon rate to reduce interest payments Proceed from new bond issue are used to pay for the repurchase of the existing higher coupon bonds at the call price Called refunding Callable bonds typically come with a period of call protection an initial time when bonds are not callable Referred to as deferred callable bonds o The option to call bonds is valuable to the firm Allows it to buy back the bonds and refinance at lower interest rates when markets fall Firm s benefit is the bondholder s burden Holders of called bonds forfeit their bonds for the call price Give up the prospect of an attractive rate of interest on their original investment Convertible Bonds Convertible bonds a bond with an option allowing the bondholder to exchange the bond for a specified number of shares of common stock in the firm Conversion ratio gives the number of shares for which each bond may be exchanged o o Market conversion value the current value of the shares for which the bonds may be o exchanged Conversion premium the excess of the bond price over its conversion value Puttable Bonds Put bond a bond that the holder may choose either to exchange for par value at some date or to extend for a given number of years o Aka extendable o Example Bond s coupon rate exceeds current market yields Bondholder will choose to extend the bond s life Bond s coupon rate is too low Will be optimal not to extend Bondholder instead reclaims principal Can be invested at current yields Floating rate Bonds Floating rate bonds bonds with coupon rates periodically reset according to a specified market rate o Make interest payments that are tied to some measure of current market rates o Major risk involved in floaters has to do with changing credit conditions Yield spread is fixed over the life of the security If financial health of the firm deteriorates the investors will demand a greater yield premium than is offered by the security The price of the bond will fall o The coupon rate on floaters adjusts to changes in the general level of market interest rates Doesn t adjust to changes in the financial condition of the firm Other types of bonds Pay in kind bonds issuers may choose to pay interest either in cash or additional bonds Issuer is short on cash pays in bonds Catastrophe bonds A way to transfer catastrophe risk from insurance companies to the capital markets Investors receive compensation in the form of higher coupon rates for taking on the risk In the case of catastrophe bondholders will lose all or part of their investments disaster defined by either total insured losses or by other criteria Indexed bonds make payments that are tied to a general price index or the price of a particular commodity Tying pay value of the bond to the general level of prices coupon payments as well as the final repayment of pay value on these bonds increase in direct proportion to the consumer price index CPI 2 Operating performance items to improve bond ratings Bond rating agencies base their quality ratings largely on an analysis of the level and trend of some of the issuer s financial ratios 1 Coverage ratios ratios of company earnings to fixed costs Times interest earned ratio the ratio of earnings before interest payments and taxes to interest obligations Fixed charge coverage ratio includes lease payments and sinking fund payments with interest obligations to arrive at the ratio of earnings to all fixed cash obligations Low or falling coverage ratios signal possible cash flow difficulties 2 Leverage ratio debt to equity ratio A too high leverage ratio indicates excessive indebtedness signaling the possibility the firm will be unable to earn enough to satisfy the obligations on the bonds 3 Liquidity ratios measure the firm s ability to pay bills coming due with its most liquid assets Current ratio current assets current liabilities Quick ratio current assets excluding inventories current liabilities 4 Profitability ratios measures of rates of return on assets or equity Indicators of a firm s overall performance Return on assets EBIT total assets Return on equity net income equity Firms with higher return on assets or equity should be better able to raise money in security markets because they offer prospects for better returns on the firm s investments 5 Cash flow to debt ratio the ratio of total cash flow to outstanding debt 3 Discount premium aspects to bonds General rule Premium bonds Bonds bought at a price higher than the redemption value For premium bonds bonds selling above par value coupon rate is greater than current yield which in turn is greater than yield to maturity Must be a capital loss on the premium bond over the year to get the overall yield down to the promised YTM Discount bonds Bonds bought at a price lower than the redemption value o Think about buying something on sale or at a discount you re buying something for lower than what it s actually worth and vice versa for premium bonds For discount bonds bonds selling below par value these relationships are reversed 4 Zero coupon bond benefits issues Original issue discount bonds bonds that are issued intentionally with low coupon rates that cause the bond to sell at a discount from par value Zero coupon bond carries no coupons and provides all its return in the form of price appreciation o Essentially you receive 0 coupons throughout the term and a guaranteed lump sum at the end of the term o Only provide one cash flow to their owners on the maturity date of the bond o An extreme example of original issue discount bonds o Example US Treasury Bills Explained Before maturity should sell at discounts from pay because of the time value of money o Has a coupon rate of zero o Must sell for par value on maturity date o o As time passes price should approach par value o o If the interest rate is constant a zero s price will increase at exactly the rate of interest Return comes solely from the difference between the issue price and the payment of par value