Finance 6

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  1. when a corporation (or govt) wishes to borrow money from the public on a longterm basis, it usually does soby issuing, or selling, debt securities that are generically called
  2. Bonds
    normally an interest only loan
  3. coupon
    stated interest payment made on a bond

    Ex: $1,000 bond for 30 years 12% interest, 120 a year for 30 years, 120 is your coupon

    - if level and constant, it can be called a level coupon bond
  4. face value/par value
    the amount that will be repaid at the end of the loan
  5. coupon rate
    the annual coupon divided by the fave value of the bond

    (interest rate of the bond)

    120 is coupon, 1000 is the face value, 120/1000= 12% coupon rate
  6. maturity
    date on which the principal amount of the bond is paid

    - number of years until the face value is paid (i.e. 30 years)
  7. as interest rates change, the cash flows from the bond stay the same, but the value of the bond will fluctuate
    when interest rates rise, the PV of the bonds remaining cash flows declines, and the bond is worth less

    when interest rates fall, the bond is worth more
  8. determine value of a bond at a point in time
    • number of periods remaining
    • the face value
    • the coupon
    • market interest rate (YTM, yield to maturity)
  9. discount bond
    bond sells for less than face value
  10. premium bond
    bond sells for more than face value
  11. bond value
    • = C*[1-1/(1+r)t]/r   +   F/(1+r)t
    • = PMT * PV of coupons  +  PV of face amt
  12. interest rate risk
    - depends on how sensitive its price is to interest rate changes

    • - time to maturity
    • - coupon rate

    • *All other things equal
    • 1. the longer the time to maturity, the greater the interest rate risk
    • 2. the lower the coupon rate, the greater the interest rate risk
  13. current yield
    bonds annual coupon divided by the price

    *not to be confused with the yield to maturity
  14. equity and debt securities
    securities issues by corporations
  15. differences between debt and equity
    1. debt is not an ownership interest in the firm. Creditors do not have voting power

    2. the corporations payment of interest on debt is considered a cost of doing business and it fully tax deductible. DIvidends paid to stockholders are NOT tax deductible

    3. Unpaid debt is a liability of the firm. If it is not paid, the creditors can legally claim the assets of the firm. This action can result in liquidation or reorganization, 2 of the possible conseqences of bankruptcy. Thus, one of the costs of issuing debt is the possibility of finaincial failure. (this does not arise when issing equity!)

    *One reason that corporations try to create a debt security that is really equity is to obtain the tax benefits of debt and the bankruptcy benefits of equity.

    *Equity represents an ownership interest, and it is a residual claim. Equity holders are paid after debt holders
  16. Long Term Debt
    • promises made by the issuing firm to pay principal when due and to make timely interest payments on the unpaid balance
    • maturity is the length of time the debt remains outstanding with some unpaid balance
    • debt securities can be short term
    • also known as notes, debentures, or bonds
    • A bond is a secured debt
    • public issue and privately placed
  17. unfunded debt
    short term debt
  18. indenture
    • written agreement between the corporation (the borrower) and its creditors
    • deed of trust
    • usually a trustee is appointed to represent the bondholders
  19. responsibility of the trust company in an indenture
    • make sure the terms are obeyed
    • manage the sinking fund
    • represent the bondholders in default (if the company fails to pay them)
  20. bond indenture includes
    • basic terms of the bond
    • total amount of the bonds issued
    • description of property used as security
    • repayment arrangements
    • call provisions
    • details of the protective covenants
  21. principal value
    • face value
    • par value
    • initial accounting value
  22. registered form
    the form of the bond issue in which the registrar of the company records ownership of each bond; payment is made directly to the owner of the record
  23. bearer form
    form of bond issue in which the bond is issued without record of the owner's name; payment is made to whomever holds the bond

    • drawnback:
    • difficult to recover if lost or stolen
    • company cannot notify bondholders of important events

    • benefit:
    • mot traceable (taxes)
  24. collateral
    general term that frequently means securities that are pledged as security for payment of debt
  25. debenture
    unsecured debt, usually with a maturity of 10 years or more
  26. note
    unsecured debt, usually with a maturity under 10 years
  27. gilts
    bonds issued by the british government are called treasury "stock"

    in the UK, a debenture is a secured obligation
  28. sinking fund
    account managed by the bond trustee for early bond redemption, purpose of repaying the bonds
  29. Call provision
    an agreement giving the corporation the option to repurchase the bond at a specific price prior to maturity

    allows the company to repurchase or "call", part or all of the bond issue at stated prices over a specific period

    corporate bonds are usually callable
  30. call premium
    difference between the call price and the stated value

    becomes smaller over time
  31. deferred call provision
    a call provision prohibiting the company from redeeming the bond prior to a certain date

    during this period, it is called call protected
  32. make whole call
    • very popular recently in the corp bond market
    • bondholders receive exactly what the bonds are worth if they are called
    • calculate the PV of the remaining interest and principal pmts at a rate specified in the indenture
    • call price is higher when interest rates are lower (and vice versa)
  33. protective covenants
    part of the indenture limiting certain actions that might be taken during the term of the loan, usually to protect the lender

    • Negative covenant - "thou shalt not", limits or prohibits actions the company might take 
    • OR
    • Positive (affirmative) covenant - "thou shalt" specifies an action that the company agrees to take or a condition that company must abide by
  34. bond ratings
    • creditworthiness is based on how likely the firm is to default
    • highest AAA (S&P) or Aaa (Moodys) best quality, lowest degree of default risk
    • lowest rating is D debt in default
    • investmen grade bonds are atleast BBB or Baa
    • crossover, or split rating BBB or Baa and BB and Ba, rated differently by agencies
    • bonds that drop into junk territory are called fallen angels
    • NCAA no coupon at all
  35. Types of bonds
    • government bonds
    • zero coupon bonds
    • floating rate bonds
    • income bonds
    • convertible bonds
    • put bonds
  36. government bonds
    • US treasury notes/bonds are issued when the govt wants to borrow money for more than 1 year with maturities ranging from 2-30 years
    • older issues are callable
    • no default risk because they can't default (hopefully) and they are exempt from state income taxes (not federal)
    • when state and local govt borrow money its called a municipal bond
    • munis are almost always callable
    • coupons are exempt from federal income taxes (and state in some situations), attractive to high income, high tax bracket investors
    • yields are lower then taxable bonds
  37. compare aftertax yields
    Mucis mond 4.8%
    corp bond 6.3%
    ignoring state and local taxes, the munis bond pays 4.8% both pretax and after tax

    corp pays 6.3% aftertax, to calculate after tax .063*(1-.30)= .044 or 4.4%

    munis is better
  38. Zero coupon bond
    • a bond that makes no coupon payments and thus is initially priced at a deep discount
    • must be offered at a price that is much lower than its stated value
  39. Floating Rate Bonds (floaters)
    • coupon payments are adjustable
    • adjustments are tied to an interest rate index (like the Treasury Bill interest rate, or 30 yr treasury bond rate)
    • the rate is equal to 90% of the average yield on ordinary 5 yr treasury notes over the previous 6 months
    • majority of floaters have the following features
    • holder has the right to redeem the note at par on the coupon payment date after some specified amount of time. This is called the put provision
    • the coupon rate has a floor and a ceiling, meaning that the coupon is subject to a minimum and a maximum. Coupon rate is "capped" and the upper and lower rates are sometimes called the collar
    • one kind of floating bond is an inflation linked bond that adjust according to inflation, TIPS, treasury inflation protection securities
  40. other types of bonds
    income bonds- similiar to conventional bonds, except that coupon payments are dependent on company income
Card Set:
Finance 6

Finance 6
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