Financial Management Theory and Practice Chapter 5

long term contract under which a borrower agrees to make payments of interest and principal on specific dates to the holders of the bond
Treasury bonds
aka government bonds, issued by the us federal governement, almost no default risk, bond prices decline as interest rates increase.
agency debt and GSE debt
Gov’t sponsored organizations and government agencies, not officially backed by the US Gov’t but investors assume the gov’t will guarantee the debt so the interest rate is only slightly higher than treasury bonds
corporate bonds
issued by corporations, exposed to default risk, subject to companyes characteristics and the terms of the specific bond
default risk is often referred to as credit risk
municipal bonds
issued by state and local governments
major benefit is interest earned on most municipal bonds is exempt from federal state taxes if holder is a resident of issuing state
foreign bonds
subject to exchange rates not just companies performance
What are the four main types of bonds?
treasury, corporate, municipal,foreign
why are us treasury bonds not riskless?
bc if interest rates go up the price of the bonds goes down
what types of risk are investors of foreign bonds exposed?
default risk, exchange rate risk
par value
stated face value of the bond
coupon payment
fixed number of dollars paid every year in interest
coupon interest rate
coupon payment divided by the par value
floating rate bonds
rate is set for the initial 6 months and then adjusts there after
zero coupon bonds
bonds with no coupons at all but are offered at a substantial discount below their par values and hence provide capital appreciation
original issue discount bond
any bond offered at a price significantly below its par value
payment in kind bonds aka PIK bonds
bonds that do not pay cash coupons but rather pay coupons consisting of additional bonds or percentage of bonds
maturity date
date which the par value must be repaid
original maturities
maturity at the time the bond is issued
call provision
gives the issuing corporation the right to call the bonds for redemption, generally states that the company must pay the bondholders an amount greater than the par value if they are called
call premium
an additional sum, often set equal to 1 years interest if the bonds are called during the first year and declines each year there after (int/n)
deferred call
bonds are not callable for several years
call protection
bonds are said to have call protection when there call has been deferred for a set amount of years
refunding operation
selling securities at a lower interest rate and using the funds to buy back callable bonds that have a high interest rate
redeemable at par
if interest rate rise the bonds price decreases, redeemable at par allows an investor to turn in the bond for par value.
event risk
is the chance that some sudden event will occur and increase the credit risk of a company, lowering the firms bond rating and the value of its outstanding bonds
super poison put
enables a bondholder to turn in, or put a bond back to the issuer at par in the event of a take over, merger, or major recapitilization
make whole call provision
allows a company to call the bond, but it must pay a call price that is essentially equal to the market value of a similar noncallable bond
sinking fund provision
facilitates a the orderly retirement of the bond issue
deposited money with a trustee which invests the funds and then uses the accumulated sum to retire the bonds when they mature.
convertible bonds
bonds that may be converted into a fixed number of shares of common stock, allows investors to share in the upside if the company does well
options that permit the holder to buy stock at a fixed price, thus providing a gain if the stock does well
income bond
required to pay interest only if earning are high enough to cover the interest expense, if earnings are not high enough to pay the interest then investors cannot not force payment. ie these are riskier bonds
indexed bonds aka purchasing power bonds
interest payments and maturity payment rise automatically when the inflation rate rises, thus protecting bond holder against inflation
discount bond
whenever the going rate of interest rises above the coupon rate, a fixed rate bonds price will fall below its par value
premium bond
whenever the going interest rate falls below the coupon rate, a fixed rate bonds price will rise above its par value
new issue
a bond that has just been issued, lasts for about a month, called on the run bonds
outstanding bond aka seasoned issue
bond that has been on the market for a while
current yield
payment/ pv
capital gains yield
(pv 1 – pv 2) / original pv1
total rate of return or yield
(pmt – difference between pv1 and 2) / pv 1
yield to maturity
rate of interest you would earn on your investment if you bought a bond and held it to maturity
yield to call
expected rate of return if a bond were callable
current yield
annual interest payment divided by the bonds current price
real risk free rate of interest r*
the interest rate that would exist on a riskless security if no inflation were expected
indexed bonds
bonds with payments linked to inflation
Treasury Inflation Protected Securities TIPS
bonds linked to inflations offered by the US Treasury
inflation premium
the average expected inflations rate over the life of the security
nominal, quoted risk free rate, rRF
real risk free rate plus inflation premium
legal document that spells out the rights of both bondholders and the issuing corporation
usually a bank, an officilal who represents the bond holders and makes sure the terms of the indenture are carried out
restrictive convenants
cover such points as the conditions under which the issuer can pay off the bonds prior to maturity, levels at which certain ratios must be maintained if the company is to issue additional debt, and restrictions against the payment of dividends unless earnings meet certain specifications
mortgage bond
bond issued by company and secured by assets
uncsecured bond
subordinated debentures
below or inferior to senior debt
development bonds aka pollution control bonds
tax exempt bonds issued by state or local agencies
investment grade bonds
lowest rated bonds that many banks and other institutional investors are permitted by law to hold
junk bonds
significant probability of default, double b rating and lower
bond spread
difference between a bonds yield and the yield on some other security of the same maturity
maturity risk premium
two sources of risk make up maturity risk premiums, interest rate risk and reinvestment risk
yield curve
set of data for a given date plotted on a graph
normal yield curve
upward sloping curve
leveraged buyouts
company take overs financed by junk bonds