FIN 3403 Study Guide Exam 2 CHAPTER 7 INTEREST RATES AND BOND VALUATION I Bonds Features and Prices a Companies and governments issue bonds when they wish to borrow money from the public on a long term basis the states interest payment made on a bond b Coupons i par value coupon rate c Level coupon bond every year d Face Par value end of the term when the coupon of a bond is constant and paid the principal amount of a bond that is repaid at the i Typically par value is 1 000 for corporations ii Government bonds often have a higher face value e Maturity the number of years until the face value is paid back i A corporation will normally have a maturity of 30 years but it II Bond Values and Yields a When interest rates rise the PV of bond s remaining cash flows b To determine the value of a bond at a particular point in time you can vary decline and vice versa must know i The number of periods remaining until maturity ii The face value iii The coupon iv He market rate for bonds with similar features c Yield to maturity yield the rate required in the market on a bond i Discount bond if the market interest rate is less than the coupon rate then the bond must be sold at a lower price then its face value if the market interest is more than the coupon rate then the bond must be sold at a higher price then its face value ii Premium bond III d Bond value PV of coupons PV of the face amount Interest Rate Risk interest rates a How much interest rate risk a bond has depends on how sensitive its risk that arises for bond owners from fluctuating price is to interest rate changes That sensitivity depends on i Time to maturity rate risk 1 The longer time to maturity the greater the interest 2 On the function of cash flows the steepness tells us that a relatively small change in interest rates will lead to a substantial change in the bonds value a The steeper the curve the more a change in interest rates will make a difference in the bonds value 1 The lower the coupon rate the greater the interest rate ii Coupon rate risk IV Finding the Yield to Maturity a Current yield a bond s annual coupon divided by its price i Not to be confused with a bonds yield to maturity ii The current yield considers only the coupon portion of your return 1 That being said the current yield is too low for discounted bonds because it doesn t consider the built in gain from the price discount 2 Subsequently the current yield is too high for premium bonds because it doesn t account for the higher price of the bond V The main differences between debt and equity a Debt is not an ownership in the firm creditors have no voting power b The corporations payment of interest on debt is considered a cost of doing business and is fully tax deductible while dividends to stockholders are not c Unpaid debt is a liability of the firm and if they fail to repay creditors have the legal claim over the assets of the firm i This can result in liquidation or reorganization of the firm ii Thus one of the costs of issuing debt is the possibility of financial failure A possibility of that is not present when equity is issued VI Long Term Debt promises made by the issuing firm to pay principal when due and to make timely payments on the unpaid balance a Short term debt aka unfunded debt maturities of one year or less b Debt securities come in the forms of notes debentures or bonds i Notes debt securities with an original maturity of 10 years or c Two major forms of long term debt i Public issue in the form of an IPO ii Privately placed debt that is placed with a lender d Secured bonds bonds backed by a specific asset s i Mortgage securities bonds secured by mortgages on real less property 1 The legal document that describes the terms of this is called a trust deed or a mortgage trust indenture 2 Blanket mortgage a pledge of a firm s real property ii Collaterized securities asset backed securities iii Debenture unsecured bonds e Call provision the company can repurchase the debt before maturity i This will cause the interest rate to be higher because the lender could potential lose compounded interest payments e the price of a bond plus some extra interest in case the firm VII assigned to bonds based on a firm s credit rating the written agreement between the corporation and the letter f Call pric uses the call option g Rating Indenture detailing the terms of the debt issue a Sometimes referred to as the deed of trust b Legal document c Includes the following provisions i Basic terms of bond 1 2 Bearer bond bond belongs to whoever is in possession of it a Difficult to recover if lost b Company does not know who to notify when important events arise 3 Registered bond bond owner is the individual who it is registered to it ii Total amounts of bonds issued iii A description of property used as security iv The repayment arrangements v Call provisions vi Details of the protective covenants it event d Bearer bond e Registered bond bond belongs to whoever is in possession of it bond owner is the individual who it is registered to VIII Seniority a b Senior debt holders will be paid before junior debt holders in the Indicates preference in position over other lenders c Subordinated creditors will not be paid until the other specified IX creditors have been paid Repayment a Sinking fund purpose of repaying the bonds an account managed by the bond trustee for the i Some start about 10 years after the initial issuance ii Some establish equal payments over the life of the bond iii Some high quality bond issues establish payments to the sinking fund that are not sufficient to redeem the entire issue As a consequence there is a possibility of a large balloon payment at maturity the difference between the call price and the stated X The Call Provision a Call premium value b Deferred call provision a call provision prohibiting the company from redeeming a bond prior to a certain date c Call protected bond bond that during a certain period cannot be redeemed by the issuer XI that part of the indenture or loan agreement that Protective Covenants limits certain actions a company might otherwise wish to take during the term of the loan a Negative covenant a thou shall not type of covenant i Ex a firm must limit the amount of dividends paid according to b Positive covenant a thou shalt type of covenant i Ex the company must maintain its working capital above a some formula certain level XII Bond Ratings a The two leading bond rating firms are Moody …
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