Fin 101 Exam 3

is a bind that is backed by a pool of home mortgages. The bondholders receive payments derived from payments on the underlying mortgages, and these payments can be divided up in various ways to create different classes of bonds. Defaults on the bonds led to thee 2007-08 bondholders losses and housing crunch.

• critical to bonds. It is what businesses of all sizes have to pay to borrow money. Bond Values depend on interest rates.
• Normally interest only, meaning the borrower will pay interest every period until the end of the loan.

long term it usually does so by issuing, or selling, debt securities that are generically called bonds.

• EX: 1000 30 yr loan. 12% .12 x 1000=$120
• $120 interest is paid every year for 30yrs

$120 regular interest payment is called the bond coupons. sometimes called a level coupon bond because it is constant and paid every year.

EX: 1000 30 yr loan. 12% .12 x 1000=$120$120 interest is paid every year for 30yrs End of the 30yrs, 1000 principal paid back.

the par or face value is usually the 1000 for the corporate bond, a bond that sells for its par value is called a par value bond. Government bonds usually have much larger face or par values.

EX: 1000 30 yr loan. 12% .12 x 1000=$120$120 interest is paid every year for 30yrs

the annual coupond divided by the face value is calle dthe coupon rate on the bond. 120/1000 = 12%. the bond has a 12% coupon rate.

EX: 1000 30 yr loan. 12% .12 x 1000=$120$120 interest is paid every year for 30yrs

the number of years until the face value is paid is called the bonds time to maturity. A corporate bond will normally have a maturity of 30 yrs when it is originally issued but varies. Once the bond has been issued, the number of years to maturity decreases over time.

as time passes, interest rates change. The cash flows from a bond, however stay the same. The value of the bond will fluctuate. When interst rates rise, the PV of the bond's remaining cash flows declines, and the bond is worth less. When interest rates fall, the bond is worth more.

number of periods remaining until maturity, the face value, the coupon, and the market interest rate for bonds with similar features.

interest required in the market on a bond is called the bonds yield to maturity (YTM). Sometimes called the bonds yield for short.

• by calculating the present value of the coupon and the face or par value 1000 dollars at 8% (similar bonds have the 8% yield to maturity) 80 per year coupon interest.
• 1.
• Present value = $1000/1.08¹⁰ = 1000/2.1589 = $463.19
• 2.
• Annuity present value = $80 x (1-1/1.08¹⁰)/.08 = 536.81

• Total bond value = 463.19 + 536.81 = $1000
• This bond sells exactly at face value.

bond sells for less than the face value. interest rates rise.

interest rates drop and the bond sells at a premium

bond value falls

the bond value rises

the risk that arises for a bond owner from fluctuating interest rates. Sensitivity to interest rates depends on 2 things: the time to maturity and the coupon rate.

• 1. the longer the time to maturity, the greater the interest rate risk
• 2.the lower the coupon rate, the great the interest rate risk.

the value of the one with the lower coupon is propotionately more dependent on the face amount to be received at maturity. Its value will fluctuate more when interest rates change. The bond with a higher coupon rate has a larger cash flow early in its life, so its value is less sensitive to changes in the discount rate.

• brokers quote price: 955.14
• 6 yrs
• 8% coupon
• 1000 face or par value
• 955.14 = 80 x [1-1/(1+r)⁶]/r+10000/(1+r)⁶
• r is the unknown discount rate, or yield to maturity
• Substitute trial and error for r. logic says the yield to maturity must be above 8%.

the bonds annual coupon divided by its price (not the face or par value). Sometimes confused with yield to maturity.

• 1. debt is not ownership interest in the firm. Creditors generally do not have voting power.
• 2. The corporation's payment of interest on debr is considered a cost of doing business and is fully tax deductible. Dividends paid to stockholders are not tax deductible.
• 3. Unpaid debt is a liability of the fir,. This action can result in liquidation or reorganization, two of the possible consequences of bankruptcy. Thus, one of the costs of issuing debt is the possibility of financial failure. This possibility does not arise when equity is issued.

represents ownership interest, and its is a residual claim. This means that equity holders are paid after debt holders.

• long and short term. Called notes, debentures, or bonds. A bond is a secured debt. In common usage, a bond referes to all kinds of secured and unsecured debt.
• 2 major forms: public issue and privately placed.
• Dimensions: security, call features, sinking funds, ratings, and protective covenants.

The written legal agreement between the corporation (borrower) and the lender (creditor) detailing the terms of the debt issue.

• Provisions included in the document:
• 1. The basic terms of the bonds
• 2. The total amount of the bonds issued
• 3. A description of property used as security
• 4. The repayment arrangements
• 5. The call provisions
• 6. Details of the protective covenants 

Corporate bonds have a face value of 1000 or 2000. This called the principal value, and it is stated on the bond certificate. The par value is almost always the same as the face value.

the form of bond issue in which the registrar of the company records ownership of each bond, payment is made directly to the owner of record.

the form of bond issue in which the bond issued without record of the owners name; payment is made to whomever holds the bond.

2 drawbacks: they are difficult to recover if they are lost or stolen, and the company does not know who owns the bonds, they can not be notified of events.

• Debt secutities are classified according to the collateral and mortgages used to protect the bondholder.
• AKA collateral (any asset pledged on a debt)
• Mortgage securities are secured by a mortgage on the real property called a mortgage trust indenture or a trust deed.

• Most utility and railroad bonds are secured by a pledge of assets.
• Bonds represent unsecured obligations of the company.

An unsecured debt, usually with a maturity of 10 years or more. Unsecured bond, with no pledge of property is made.

Almost all piblic bonds issued in the US by industrial and fiancial companies are debentures.

An unsecured debt usually with a maturity under 10 years.

• indicates preference in position over other lenders and debts are sometimes labeled as senior and junior to indicate senority. Subordinated lenders twill be paid off only after the specified creditors have been compensated.
• Debt can not be subordinated to equity

bonds can be repaid at maturity, receiving the face value of the bond or they may be paid in part before the maturity. Early repayment is handled through a sinking fund.

• An account managed by the bond trustee for early bond redemption. The company makes annual payments to the trustee, who then uses the funds to retire a portion of the debt. Trustee either buys up some of the bonds in the market or calling in a fraction of the outstanding bonds.
• 1. some sinking funds start 10 yrs after issuance
• 2. some sinking funds establish equal payments over the life of the bond.
• 3. some high quality cond issues establish payments to the sinking fund that are not sufficient to redeem the entire issue. Possiblity of a large balloon payment at maturity.

• An agreement giving the corporation the option to repurchase the bond at a specific price prior to maturity.
• Generally the call provision is above the bonds stated value (par value) difference between the par value and the stated is a call premium. The amount of the call premium becomes smaller over time.
• Defered call provision for the first 10 yrs which is said to be call protected

• a part of the indenture limiting certain actionsthat might be taken during the term of the loan, usually to protect the lender.
• 2 types: negative covenants, and positive or affirmative covenants.
• Thou shalt not statement i.e. limiting to dividends to some formula, can not merge

• firms pay to have their bonds rated: S&P and Moodys
• Creditworthyness is assessed
• Only concerned with default, not interest rate risk.
• Highest rating is AAA or Aaa and is judged to have the best quality and have the lowest degree of default risk. D is debt that is default.
• Junk bonds are low grade corp bonds Below BBB or Baa

highest borrower in the world by a wide margin.

• government wants to borrow more than one year. 2-30 years for maturity
• US treasury bonds are regular coupon bonds. Older issues are callable.
• US Treasury bonds have no default risks.
• exempt from state income taxes, though not federal income taxes.

• State and local government issued. munis
• Almost all callable.
• coupons exempt from federal income taxes (some state taxes) which make them attractive to the high tax bracket.
• Yields are much lower cuz tax break

• A bond that makes no coupon payments and thus is intitally priced at a deep discount.
• zeros
• the issuer of a zero coupon bond deducts interest every year even though no interest is actually paid.
• Owner must pay taxes on interest acured every year, even though no interest is actually received.
• interest determined by amortizing the loan. Calculate the bonds value at the beginning of each year,

• coupon payments are adjustable.
• adjustments are tied to an interest rate index such as the Treasury bill interest rate or the 30 yr treasury bond rate.
• In most cases, the coupon adjusts with a lage to some base rate.
• Floater features:
• 1. The holder has the right to redeem the not at par on the coupon payment date after some specified amount of time. This is called a put provision.
• 2. The coupon rate has a floor and a ceiling, meaning that the coupon is subject to a min and a max. In this case, the coupon rate is said to be capped and the upper and lower rates are somtimes called the collar.

Inflation linked bond: coupons adjust to the rate of inflation. The principal amount may be adjusted too. TIPS Treasury Inflation Protection Securities.

• Income bond: coupon payments are dependant on the companies income.
• Comvertible bonds: can be swapped for a fixed # of shares of stock anytime before maturity at the holders option.
• Put Bond: allos the holder to force the issur to buy the bond back at a stated price.

• Largest securities market is the US treasury market
• No transparency, or little or no centralized reportiing.
• estimated prices are used as it is almost impossible to get current prices.

• 2002 transparency in the corporate bond market began to improve.
• Must report trade info through the TRACE transactions Report and compliance Engine.
• Bid and ask price and bid spread
• Treasury prices are quoted in 32nds. 1/32 is the smallest price and called the tick size.
• Last ordinary bond listed is the bellwether bond. It is the yield usually reported in the evening new. If the interest rate rose, the yield on the bond went up and the its price went down.

The price a dealer is willing to pay for a security

The price a dealer is willing to take for a security

The difference between the bid price and the ask price.

• Clean Price: the price you pay is usually more than the price you are quoted. Standard convention in the bond market to quote the net of "accrued interest" meaning accrued interest is deducted to arrive at the quoted price.
• Dirty Price the price you actually pay includes accrued interest. Full or invoice price.

• Interest rates or rates of return that have been adjusted for inflation
• The real rate on an investment is the perentage change in how much you can buy with your dollars, the percentage change in your buying power.

• Interest rates or rates of return that have not been adjusted for inflation
• The nominal rate on an investment is the percentage change in the number of dollars you have

• The relationship between the nominal returns and the real returns and inflation.
• 1+ R = (1 + r) x (1 + h)
• h = inflation
• r = real rate
• R = Nominal Rate

The relationhip between nominal interest rates on defaul free, pure discount securities and time to maturity, the pur time value of money.

The difference between shor and long term rates has ranged from zero to serveral percentage points both positive and negative.

The portion of a nominal interest rate that represents compensation for expected future inflation

The compensation investors demand for bearing interest rate risk

a plot of the yields on treasury notes and bonds relative to maturity

• The portion of a nominal interest rate or bond yield that represents compensation for the possibility of default.
• Junk bonds named high yield bonds or high promised yeild bonds.

the portion of a nominal interest rate or bond yield that represents compensation for unfavorable tax status.

The portion of a nominal interest rate or bond yield that represents compensation for lack of liquidity

• harder to value than a bond, no promised cash flows are known, the ife of the investment is forever, and no maturity.
• Present value of future cash flows for a share of stock and thus determine its value.

Present Value of a stock today with a 10 dividend, expecting a 25% return.

• Present value - (10+70)/1.25 = 64
• P_o = the value of the stock today
• P₁ = value in 1 period
• D₁ = cash dividend paid at the end of period

a share of common stock in a company with a contant dividend is much like a share of preferred stock.

d₁ = d₂ = d₃ = constant

dividend grows at a steady rate (growing perpetuity)

D₁ = D₀ x (1 + g)

• 2 periods
• D₂ = D₁ x (1 + g)

A model that determins the current price of a stock as its divident next period divided by the discountred rate less the dividend growth rate.

allow for supernormal growth rates over some finite length of time. The growth rate cannot exceed the required return indefinitely, but it certainly could do so for many years. It is required the dividends grow at a constant rate in the future.