specifies all the rights and obligations of the issuer and owners

includes debt covenants

restrict the issuer from doing something

aka selling off assets--taking on additional debt

things the issuer must do

*maintain financial ratios--pay on time

step-up notes

initial coupon payments are deferred for some period--coupon payments accrue at a compound rate and are paid out in a lump sum after deferral

after the lump sum, the bond proceeds to pay normal equal coupons

coupon rate varies according to some index

coupon = index rate + margin

*coupon rates re-adjust every 6 or 12 months

coupon rates decreases when index rate increases

coupon rate = 12% - reference rate

for floating coupon rates

cap= max rate that can be achieved (benefits issuer)

floor=minimum rate that can be achieved (benefits holder)

collar= floating coupons with a cap and a floor

occurs when bonds are purchased in between coupon payments

the purchaser will recieve the next coupon in full, but must pay the seller the amount of interest accrued from the time of the last payment to the date of the sale

clean price = market price of the bond

dirty price= clean price + accrued interest

*dirty price is what the buyer actually pays

aka bullet bond or bullet maturity

pays interest only until maturity, then pays off principal in one lump sum

EX: treasury bonds and corporate bonds

equal payments composed of both interest and principal elements

last payment pays off all remaining principal

EX: mortgages and mbs

option for borrower to pay off full or partial amounts of the principal balance in advance--prior to maturity

*makes cash flows less predictable to investors

option for borrower to buy back bonds at a specified call price prior to maturity

*used when interest rates fall and current coupon payments are too high

refunding is like refinancing--using a new loan or bond issuance at a lower rate to pay off an old loan

some debt covenants prohibit refunding

*a bond may be callable (paid with cash) but not refundable (paid with a new loann)

provide for the repayment of principal through a series of payments over the life of the issue

EX: may require 20 mm in principal paid off each year

cash payment--paid to trustee who then retires some outstanding bonds through lottery--retired AT PAR

delivery of securities--the company purchases back bonds at market prices and delivers them to trustee for retirement--purchased AT MARKET

if FV is below par, delivery of securities is less expensive

if FV is above par, cash payment is less expensive

*same amount is spent, but more bonds can be retired under the less expensive option, meaning less cash towards interest payments

gives issuer the choice to retire more than the amount required in a sinking fund provision

*similar to prepay

conversion--convert bonds into common stock

put provision--put bonds back to the issuer at a specified price prior to maturity (Par if issued at par)

Floors--establish minimum coupon rates for bonds with floating coupons

*all of these benefit bondholders--decrease coupon rates--increase bond prices

call provisions--right to redeem bonds prior to maturity at agreed upon call price from indenture

prepayment option--right to pay off principal before maturity

accelerated sinking fund provisions--right to pay off more principal than required by the sinking fund provision

caps--set max coupon rate for bonds with floating coupons

*all of these benefit the issuer--higher coupon rates--lower prices

borrowing funds from broker or bank to purchase securities which serve as collateral for the loan itself

*require interest payments on loan

*margin requirements set by the Fed

lender convinces borrower to purchase a security temporarily with the promise to buy it back at a higher price after a short period of time

*similar to zero coupon bonds

*securities serve as collateral for the loan--if not repurchased--the buyer keeps them

*INT cost on repos are less than on margin loans

1.  Discount Rates

2.  Open-market operations

3.  The reserve requirements

4.  Persuasion to influence banks' lending policies

 Discount rate is the rate at which banks can borrow reserves from the Fed. 

A lower rate tends to increase bank reserves--encouraging lending

A higher rate tends to decrease bank reserves--discouraging lending 

Open Market Operations refers to the buying and selling of Treasury securities by the Fed in the open market.

Fed buys securities---cash replaces securities in investor accounts--more funds available for lending and interest rate decrease

Bank reserve requirements are the percentage of deposits banks are required to retain as reserve

By increasing the %age of deposits banks are required to retain as reserves, the Fed decreases the funds that are available for lending.  This will increase interest rates

Four general shapes to describe yield curves

1.  Normal or upward sloping

2.  Inverted or downward sloping

3.  Flat

4.  Humped

 Define Pure Expectations Theory

The Pure Expectations Theory states that the yield for a particular maturity is an average (NOT SIMPLE AVERAGE) of the short-term rates that are expected in the future.  If short-term rates are expected to rise in the future, interest rate yields on longer maturities will be higher than those on shorter maturities and the yield curve will be upward sloping. 

If short-term rates are expected to fall over time--longer maturity bonds will be offered at lower yields

Market Segmentation Theory is based on the idea that investors and borrowers have preferences for different maturity ranges.  The supply of bonds (desire to borrow) and the demand for bonds (desire to lend) determine equilibrium yields for the various maturity ranges

Another argument is that there are legal or institutional policy restrictions that prevent investors from purchasing securities with maturities outside a particular maturity range.

Preferred Habitat Theory

yields also depend on supply and demand for various maturity ranges but investors can be induced to move from their preferred maturity ranges when yields are sufficiently higher in other (non-preferred) maturity ranges

1.  Short-term (ST) rates expected to rise in the future--upward sloping yield curve

2.  ST rates are expected to fall in the future--downward sloping yield curve

3.  ST rates are expected to rise then fall--humped yield curve

4.  ST rates are expected to remain constant--flat yield curve

Define Liquidity Preference Theory

Under Liquidity Preference Theory the yield curve may take on any of the shapes we have identiied.  If rates are expected to fall a great deal in the future, even adding a liquidity premium to the resulting negatively sloped yield curve can result in a downward sloping yield curve. 

A humped yield curve could still be humped even with a liquidity premium added to all the yields.

Market Segmentation Theory (MST) of the term structure is consistent with any yield curve shape. 

Under the MST it is supply and demand for debt securities at each maturity range that determines the yield for the maturity range. 

The appropriate discount rates for individual future payments are called Spot Rates

The spot rates for different time periods that correctly value the Cash Flow from a Treasury Bond are called

Arbitrage-free Treasury spot rates or the Theoretical Treasury spot-rate curve

Absolute Yield Spread is the difference between yields on two bonss  This simple measure is sometimes called the nominal spread--usually expressed in basis points (100ths of 1%)

Absolute yield spread = yield on the higher-yield bond - yield on the lower-yield bond

Relative Yield Spread is the absolute yield spread expressed as a percentage of the yield on the benchmark bond

Relative Yield Spread = Absolute yield spread/yield on the benchmark bond

Yield Ratio is the ratio of the yield on the subject bond to the yield on the benchmark bond

Yield Ratio = subject bond yield/ benchmark bond yield

**Yield ratio is one + the relative yield spread

Example Computing Yield Spreads

Bond X yield 6.5%

Bond Y yield 6.75%

Use Bond X as benchmark bond

Compute absolute yield spread, relative yield spread and yield ratio for these bonds

Absolute Yield Spread=6.75% -6.5% = .25% or

25 basis points

Relative Yield Spread=.25% / 6.5% = .038 = 3.8%

Yield Ration=6.75%/6.5% = 1.038

Credit of Quality spread is the difference in yields between two issues that are similar in all respects except for credit rating

Example: Difference in yields between long AA rated general obigation (GO) municipal bonds and long A rated GO minus (an intramarket spread as well). 

**Credit Spreads are related to the state of the economy

Expanding economy--credit spread declines as corp have stronger cash flows

From bondholder's perspective, a Noncallable bond is preferred to a bond that is otherwise identical but callable

Investors will require a higher yield on the callable bond compared to the same bond without the call feature

True/False

Bonds that have less liquidity have lower spreads to Treasuries

False

Bonds that have less liquidity have higher spreads to Treasuries.  Investors prefer more liquidity to less and will pay a premium for greater liquidity

True/False

Liquidity is affected by the size of an issue.

True

Liquidity is affected by the size of an issue. Larger issues normally have greater liquidity because they are more actively traded in the secondary market.  Empirical evidence suggests that issues with greater size have lower yield spreads.  When compared to identical but smaller issues, larger-size issues have lower yield due to their greater liquidity

After-Tax Yield on a taxable security

After-tax yield = taxable yield x (1-marginal tax rate)

Example: Computing After-Tax yield

What is the after-tax yield on a corporate bond with a yield of 10% for an investor with a 40% marginal tax rate?

Taxable Equivalent Yield is the yield a particular investor must earn on a taxable bond to have the same after-tax return they would receive from a particular tax exempt issue

Taxable-Equivalent Yield=tax-free yield/(1-marginal tax rate)

London Interbank Offered Rate in reference to the rates paid on negotiable CDs by banks and bank branches located in London

LIBOR is the most important benchmark or reference rate for floating-rate debt securities and short term lending

LIBOR is most important for short-term rates for one year or less