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Bonds
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42
Finance
12/09/2010

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Cards

Term
Characteristics of Corporate Bonds
Definition
Bondholders normally receive interest payments every six months at the stated interest rate
Term
Coupon
Definition
Coupon is stated interest rate to be paid (like a fixed interest rate mortgage)
-7.25% coupon = $72.50 in interest per year
-Unless it’s a floating rate bond, interest paid will be fixed regardless of interest rate changes
Term
bond indenture
Definition
The legal conditions are described in a bond indenture, administered by trustee
Term
Why Corporations Sell Bonds
Definition
-To improve financial leverage, reduce cost of capital (it’s cheaper than bank debt)
-To get money to operate or expand
-Because the interest they pay bondholders is a tax deductible business expense
(dividends on common stock are not
deductible, but rather paid after tax)
-Most of the money raised by Wall Street is from debt securities (bonds)
Term
Debenture bond
Definition
Debenture bond
Most corporate bonds are debenture bonds backed only by the reputation of the issuing company
Term
Mortgage bond
Definition
Mortgage bond
A corporate bond that is secured by various assets of the issuing firm
Term
Subordinated debenture bond
Definition
Subordinated debenture bond
-An unsecured bond that gives bondholders a claim secondary to that of other designated bond holders with respect to interest payments and assets
Term
Zero Coupon
Definition
Zero Coupon
-Issued at deep discount, interest paid at maturity
-Best suited for A 35 year old woman with a high risk tolerance
and no need for current income
Term
Convertible bond
Definition
Convertible bond
Can be exchanged, at the owner’s option, for a specified number of shares of common stock
Term

 

Bond Type

Impact on Interest Rate Paid By Corporation

Debenture bond

Interest rate based on general credit rating and bond terms

Mortgage bond

Lowers rate, bondholder generally has more security

Subordinated bond

Increases rate since bondholder has less security

Callable bond

Increases rate, bondholder has risk of early call

Zero coupon

Increases the rate, bondholder receives no interest until maturity

Convertible bond

Decreases rate, bondholder accepts lower rate for possible upside on conversion

Definition
Term
Why Investors Buy Corporate Bonds 1
Definition
-For interest (income yield)
-Investors know the interest rate
-Interest will be paid to investors twice a year
Term
Why Investors Buy Corporate Bonds?
Definition
-Appreciation of bond (capital gain yield)
-May be able to sell the bond to someone else at a higher price if the interest rate on the bond is higher than the market rate
-Bond face amount will be repaid at maturit
Term
Three Bond Valuation Relationships-1
Definition
First: The value of a bond is inversely related to changes in the investor’s required return (current rates). As interest rates increase (decrease), the value of the bond decreases (increases).
Term
Three Bond Valuation Relationships-2
Definition
Second: The market value of the bond will be less than par if the investor’s required rate of return (current interest rate) is above the coupon rate; it will be valued above par if the required return is below the coupon rate
Term
Three Bond Valuation Relationships-3
Definition
Three Bond Valuation Relationships
Third: Long term bonds have greater interest rate impact than short term bonds because most of the PV is in the interest stream
Term
Interest rates fall
Definition
Suppose interest rates fall immediately after we issue the bonds. The required return on bonds of similar risk drops to 10%.
Term
interest rates rise
Definition
Suppose interest rates rise immediately after we issue the bonds. The required return on bonds of similar risk rises to 14%.
Term
Treasury Bills (T-Bills)
Definition
Treasury Bills (T-Bills)
-$100 minimum
-Three months to one year
-Federal but no state tax on interest earned
Term
Treasury Notes
Definition
Treasury Notes
-$1,000 minimum
-Two to ten year term
-Higher interest rate than T-bills
Term
Treasury Bonds
Definition
Treasury Bonds
-$1,000 units
-10 -30 year maturity
-Interest paid every six months
-Treasury suspended new issuances in Oct. 2001
Term
TIPS - Treasury Inflation Protected
Securities (safest of the safe)
Definition
TIPS - Treasury Inflation Protected
Securities (safest of the safe)
-Principal increases with inflation (or decreases with deflation)
-5, 10, and 20 year notes
Term
Series EE
Definition
Series EE
-Usually purchased and held to maturity
-Discounted ($25 today =$50 at maturity)
-New fixed interest rate
Term
Series HH
Definition
Series HH
-Sold in $500 - $10,000 amounts
-Pay interest every six months
Term
Government Sponsored Entities
Definition
-Essentially risk free but earn higher interest than treasury options
-Issued for 1-40 years with 15 years the average
-Fannie Mae
-Federal National Mortgage Association
-Ginnie Mae
-Government National Mortgage Association
-Freddie Mac
-Federal Home Loan Mortgage Corporation
Term
Municipal bonds
Definition
Municipal bonds - called munis
-Municipalities includes cities, counties, school districts, and special taxing districts
-Use funds to build schools, bridges etc.
Term
General obligation bonds
Definition
General obligation bonds are backed by the state or local government that issues them
Term
Revenue bonds
Definition
Revenue bonds are repaid from money generated by the project the funds finance
Term
Characteristics of Municipal Bonds
Definition
-The market sets interest rates for munis to reflect this tax free status
-The U.S. government is effectively subsidizing part of the cost of state/local government interest by allowing interest to be tax free
-Muni bonds should ALWAYS be in a taxable account and NEVER in a tax deferred (401-K) or tax free account (Roth IRA)
Term
Taxable Equivalent Yield
Definition
Tax-exempt yield divided by
(1 - Your marginal tax rate)
Term
Tax Considerations
Definition
-Corp. bond/treasuries: interest taxed at marginal rate
-Muni bond interest is exempt from federal tax
-U. S. Savings bond interest defers tax, tax still payable
-Zero coupon interest accrues for tax before maturity
-Premium/discount amortized for capital gain determination
-TIPS “principal” adjustments are income
Term
Current % Yield of a Bond
Definition
Dollar Amount of annual Interest divided by
Current Market value
Term
Yield To Maturity (rate of return)
Definition
The expected rate of return on a bond.
The rate of return investors earn on a bond if they hold it to maturity
Term
discount
Definition
If a bond is purchased at a discount, its YTM will be greater than its current yield (current yield plus capital gain = YTM
Term
premium
Definition
If a bond is purchased at a premium, its YTM will be less than its current yield (current yield less capital loss = YTM)
Term
Primary and Secondary Bond Markets
Definition
-Primary
-Buy via an investment bank or company representative
-Secondary
-Buy through a broker from another investor who wants to sell it, and pay a commission
-Bond markets are less liquid than equity markets, leading to higher fees implicit in large spread between bid and ask
Term
Recommended if you have a large portfolio
Definition
5% diversification suggestion
Term
A well diversified bond portfolio will have
Definition
-Debt issued in the U. S
-Foreign debt
-Various terms
-Various credit quality
Term
Interest rate movements
Definition
-The value of bonds declines if rates go up
-The value of bonds increases if rates go down
-Even treasury securities are subject to this risk
-Falling rates = longer debt terms
-Increasing rates = shorter debt terms
Term
A change in credit rating
Definition
A change in credit rating
-The value of the bond will decrease with a lower rating, while improved ratings will increase bond values
Term
rising inflation
Definition
-Rapidly rising inflation/interest rates = a bond portfolio with shorter maturities & TIPS
Term
Review
Definition
-Bonds have a place in your portfolio as you get older
-110 minus age for equities, balance in fixed income
-Bond mutual funds the best way to go
-Diversification still very important
-Most investors should use mutual bond funds
-Buy U.S. debt directly from the U.S. Treasury
-Always use yield to call, not yield to maturity
-Interest rate and default risk increase with maturity
-Understand the risk associated with each class of bonds, provisions, & ratings
-Pay attention to interest rates
-Falling rates = potential gains in FMV
-Rising rates = potential losses in FMV
Term
If interest
rates fall for comparable bonds
Definition
If interest
rates fall for comparable bonds, you
would expect the fair market value
of the bond to