Finance Ch 5

is a promissory note issued by a business or a governmental unit.

sometimes referred to as government bonds, are issued by the Federal government and are not exposed to default risk.

are issued by corporations and are exposed to default risk. Different corporate bonds have different levels of default risk, depending on the issuing company's characteristics and on the
terms of the specific bond.

are issued by state and local governments. The interest earned on most municipal bonds is exempt from federal taxes, and also from state taxes if the holder is a resident of the issuing state. Foreign bonds are issued by foreign governments or foreign corporations. These bonds are not only exposed to
default risk, but are also exposed to an additional risk if the bonds are denominated in a currency other than that of the investor's home currency.

is the nominal or face value of a stock or bond. The par value of a bond generally represents the amount of money that the firm borrows and promises to repay at some future date. The par value of a bond is often $1,000, but can be $5,000 or more. The maturity date is the date when the bond's par value is repaid to the bondholder. Maturity dates generally range from 10 to 40 years from the time of issue.

provision may be written into a bond contract, giving the issuer the right to redeem the bonds under specific conditions prior to the normal maturity date. A bond's coupon, or coupon payment, is the dollar amount of interest paid to each bondholder on the interest payment dates.

is so named because bonds used to have dated coupons
attached to them which investors could tear off and redeem on the interest payment dates. The coupon interest rate is the stated rate of interest on a bond

In some cases, a bond's coupon payment may vary over time. These bonds are called

is popular with investors because the market
value of the debt is stabilized. It is advantageous to corporations because firms can issue long-term debt without committing themselves to paying a historically high interest rate for the entire life of the loan.

pay no coupons at all, but are offered at a substantial discount below their par values and hence provide capital
appreciation rather than interest income. In general, any bond originally offered at a price significantly below its par value is called an original issue discount bond (OID).

which gives the issuing corporation the right to
call the bonds for redemption. The call provision generally states that if the bonds are called, the company must pay the bondholders an amount greater than the par value, a
call premium.

give investors the right to sell the bonds back to the
corporation at a price that is usually close to the par value. If interest rates rise, investors can redeem the bonds and reinvest at the higher rates.

provision facilitates the orderly retirement of a bond issue. This can be achieved in one of two ways: The company can call in for redemption (at par value) a certain percentage
of bonds each year. The company may buy the required amount of bonds on the open market.

are securities that are convertible into shares of common stock, at a fixed price, at the option of the bondholder. Bonds issued with warrants are similar to
convertibles.

are options which permit the holder to buy stock for a stated
price, thereby providing a capital gain if the stock price rises.

pay interest only if the interest is earned. These securities cannot bankrupt a company, but from an investor's standpoint they are riskier than "regular" bonds.

of an indexed, or purchasing power, bond is based on an inflation index such as the consumer price index (CPI), so the interest paid rises automatically when the inflation
rate rises, thus protecting the bondholders against inflation.

are inversely related; that is, they tend to move in the
opposite direction from one another.

will sell at par when its coupon interest rate is equal to the going rate of interest, rd. When the going rate of interest is
above the coupon rate, a fixed-rate bond will sell at a "discount" below its par value. If current interest rates are below the coupon rate, a fixed-rate bond will sell at a
"premium" above its par value.

is the annual coupon payment divided by the current market
price. YTM, or yield to maturity, is the rate of interest earned on a bond if it is held to
maturity.

is the rate of interest earned on a bond if it is called. If
current interest rates are well below an outstanding callable bond's coupon rate, the YTC may be a more relevant estimate of expected return than the YTM, since the bond
is likely to be called.

Corporations can influence the default risk of their bonds by changing the type of bonds they issue.

...the corporation pledges certain assets as security
for the bond. All such bonds are written subject to an indenture, which is a legal document that spells out in detail the rights of both the bondholders and the corporation.

an unsecured bond, and as such, it provides no lien against specific property as security for the obligation.

holders are, therefore, general creditors whose claims are protected by property not otherwise pledged. Subordinated
debentures have claims on assets, in the event of bankruptcy, only after senior debt as named in the subordinated debt's indenture has been paid off. Subordinated debentures
may be subordinated to designated notes payable or to all other debt.

is a tax-exempt bond sold by state and local governments whose proceeds are made available to corporations for specific uses deemed (by Congress) to be in the public interest. Municipalities can insure their bonds, in which an insurance
company guarantees to pay the coupon and principal payments should the issuer
default. This reduces the risk to investors who are willing to accept a lower coupon
rate for an insured bond issue vis-a-vis an uninsured issue.

are normally assigned quality ratings by major rating agencies, such as Moody's Investors Service and Standard & Poor's Corporation. These ratings reflect the probability that a bond
will go into default. Aaa (Moody's) and AAA (S&P) are the highest ratings.

are based on qualitative and quantitative factors including the firm's debt/assets ratio, current ratio, and coverage ratios. Because a bond's rating is an indicator of its default risk, the rating has a direct, measurable influence on the bond's
interest rate and the firm's cost of debt capital.

are high-risk, high-yield bonds issued to finance leveraged buyouts, mergers, or troubled companies. Most
bonds are purchased by institutional investors rather than individuals, and many institutions are restricted to investment grade bonds, securities with ratings of Baa/BBB or above.

is the rate that a hypothetical riskless security pays each moment if zero inflation were expected. The real risk-free rate is not constant—r* changes over time depending on economic conditions. The real risk-free rate could also be called the
pure rate of interest since it is the rate of interest that would exist on very short-term, default-free U.S. Treasury securities if the expected rate of inflation were zero. It has been estimated that this rate of interest, denoted by r*, has fluctuated in recent years in the United States in the range of 2 to 4 percent.

rate of interest, denoted by rRF, is the real risk-free rate plus a premium for expected inflation.

is usually approximated by the U.S. Treasury bill rate,
while the long-term nominal risk-free rate is approximated by the rate on U.S. Treasury bonds. Note that while T-bonds are free of default and liquidity risks, they are subject
to risks due to changes in the general level of interest rates.

is the premium added to the real risk-free rate of interest to
compensate for the expected loss of purchasing power....is the average rate of inflation expected over the life of the security.

is the risk that a borrower will not pay the interest and/or principal on a loan as they become due. Thus, a default risk premium (DRP) is added to the real risk-free rate to compensate investors for bearing default risk.

refers to a firm’s cash and marketable securities position, and to its ability to meet maturing obligations. A liquid asset is any
asset that can be quickly sold and converted to cash at its “fair” value. Active markets provide liquidity. A liquidity premium is added to the real risk-free rate of interest, in
addition to other premiums, if a security is not liquid.

arises from the fact that bond prices decline when interest rates rise. Under these circumstances, selling a bond prior to maturity will result in a capital loss, and the longer the term to maturity, the larger the loss. Thus, a maturity risk premium
must be added to the real risk-free rate of interest to compensate for interest rate risk.

occurs when a short-term debt security must be “rolled over.”
If interest rates have fallen, the reinvestment of principal will be at a lower rate, with correspondingly lower interest payments and ending value. Note that long-term debt
securities also have some reinvestment rate risk because their interest payments have to be reinvested at prevailing rates.

is the relationship between yield to maturity and
term to maturity for bonds of a single risk class. The yield curve is the curve that results when yield to maturity is plotted on the Y-axis with term to maturity on the X-axis.

slopes upward, it is said to be “normal,” because it is like this
most of the time. Conversely, a downward-sloping yield curve is termed “abnormal”
or “inverted.”