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Bond Indenture - Contract that specifies all the rights and obligations of the issuer and owners of a fixed income security. Negative Covenants - Prohibitions on the borrower. Affirmative Covenants - Actions that the borrower promises to perform. Maturity or Term to Maturity - Length of time until loan contract or agreement expires. Remaining life of bond. Par Value - Amount borrower promises to pay on or before maturity date. Coupon Rate - Rate when multiplied by Par Value gives amount of annual interest payment. Zero-Coupon Bonds - Bonds that do not pay interest; Instead sold at a deep discount from par values. Market convention states semi-annual compounding used when pricing zeros.
Non-Amortizing Bond (Bullet Bond or Bullet Maturity) - Characteristic of most T- Bonds and Corporate bonds. Pay only interest until maturity, at which time full face value is paid back. Bullet Bonds - Pay entire principal in one lump sum at maturity. Serial Bonds - Pay off principal thru series of pmts over time. Amortizing Securities - Make periodic principal and interest pmts (i.e., MBS & ABS). Sinking Fund Provisions - Provide for the retirement of a bond thru a series of predefined principal pmts over the life of the issue. Sinking-Fund Provisions - Cash Payment - issuer deposits cash with trustee who retires applicable proportion of bonds at par using lottery selection. Delivery of Securities - issuer purchases the bonds with equal total par value in the market and delivers them to trustee who will retire them. Investor options - Conversion features, put provisions, and floors.
Refunding Provisions - Nonrefundable bonds prohibit premature retirement of issue using proceeds of a lower cpn bd. Bds that carry these provisions can be freely callable, but not refundable. Non-Refundable Bond - Prohibit call of an issue using proceeds from a lower coupon bond issue. Conversion Option - Grants bondholder right to convert bond into a fixed number of common shares. Options adds value to bond. Exchange Option - Similar to conversion option, but allows conversion into a security other than common stock. Floating Rate Securities - Bonds that pay a variable rate of interest. Coupon Formula (Floater) - Formula used to find new rate on a floating-rate security [New Coupon Rate = Reference Rate (+) or (-) Quoted Margin]. Deleveraged Floater - Scaling factor New Coupon Rate = (b * Reference Rate) (+) or (-) Quoted Margin.
Inverse Floater - Cpn moves in direction opposite to reference rate New Coupon Rate = Constant Rate (K) - (L * Reference Rate) Where K is the constant and L is the multiplier Coupon Rate Cap - Maximum rate paid by borrower/issuer. Coupon Rate Floor - Minimum periodic coupon interest payment received by lender/security owner. Coupon Rate Collar - Simultaneous combination of both cap and floor. Regular Redemption - When bonds are redeemed under the call provisions specified in the bond indenture. Special Redemption - When bonds are redeemed to comply with a sinking fund provision or because of a property sale mandated by government authority. In Margin Buying - One borrows funds from a broker or a bank to purchase securities and the securities themselves are the collateral for the margin loan.
Interest Rate Risk - The effect of changes in the prevailing market rate of interest on bond values. Inverse relationship btwn interest rates and bd prices. i.e., When rate goes up, bond prices fall. Interest Rate Risk and Bond Features - LT to Mat bds exhibit higher int rate risk (all else the same). Bds w/ smaller cpns exhibit higher int rate risk (all else the same). Low cpn then high price vol. High cpn then low price vol. LT to Mat then high price vol. ST to Mat then low price vol. Interest Rate Risk and Bond Features (Market Interest Rates) - When mkt int rates are high, price vol will be lower than when mkt int rates are low. Increase int rate then decrease vol. Decrease int rate then increase vol. Interest Rate Risk and Bond Features
(Deep Discount Bonds 1) - Deep Disc Bd w/ low cpn relative to mkt then bd has increased price vol. Deep Disc Bd w/ high cpn relative to mkt then bd has decreased price vol. Interest Rate Risk and Bond Features (Deep Discount Bonds 2) - Compared w/ Bds selling at par, deep disc bds have greater price vol. Investors expecting declining int rates prefer zeros w/ long term to mat. Decreasing Int Rates then Reinvestment Rate Decreases and will not earn initial YTM Int Rate Decrease then Bd Price Increases with Increased Cap Gain. Investors expecting increasing int rates will not prefer zeros w/ long term to mat. Premium Bond Constant Discount Rate - Cpn Rate > Current Yld > YTM Cpn Rate > required mkt yld, then bd price > par value Premium/Price decreases to par as bd approaches mat. Discount Bond Constant Discount Rate - Cpn Rate < Current Yld < YTM
Call Risk - Risk of investor's principal being returned when interest rates fall, and as a result reinvesting at a lower rate. Which Call provision gives investors protection against call risk? - Call protection period. Prepayment Risk - Similar to Call Risk, risk of prepayment when interest rates fall, requiring investor to reinvest at a lower rate. What is the relationship between interest rate volatility and Call or Prepayment Risk? - Positive, higher volatility in rates increases probability of yields falling to level where bonds will be called. Reinvestment Risk - Risk of reinvesting principal and interest cash flows at lower rates reducing investor returns. Reminder - YTM calc assumes cpn pmts reinvested at YTM rate. Reinvestment Risk - If int rate declines investors forced to reinvest cpns at lower ylds. Reinvestment Risk
Coupon - Bds w/ larger cpns have greater reinvmt risk. Reinvestment Risk Embedded Call Options - Bds w/ embedded call options have greater reinvestment risk. All or part of principal can be repaid in low int rate environment. Do non-callable coupon bonds have reinvestment risk before maturity? - Yes, since the coupon interest payments must be reinvested, those cash flows are subject to reinvestment risk. Do non-callable zero-coupon bonds have reinvestment risk before maturity? - No, since there are no cash flows to reinvest until maturity. Credit Risk - Risk of issuer's creditworthiness deteriorating, increasing required return and decreasing the security's value. Credit Risk Three Types - (1) Default Risk (2) Credit Spread Risk (3) Downgrade Risk
Reinvestment Risk - Risk of reinvesting principal and interest cash flows at lower rates reducing investor returns. Volatility Risk - Risk associated with fixed-income securities that have embedded options, such as call options, prepayment options, or put options. Changes in interest rate volatility affect the value of these options. Event Risk - Risks outside the financial markets like natural disasters, corporate takeovers, etc. Types of Event Risk - 1) Disaster
- Corporate Restructuring
- Regulatory Issues. Yield Curve Risk - The possibility of changes in the shape of the yield curve. Relation between bond yields and maturity. Non-parallel shift.
What do changes in the shape of the Yield Curve tell investors? - Yields are changing by different amounts for bonds with different maturities. Clean Bond Price - Agreed price of bond between buyer and seller, exclusive of accrued interest. Cumulative Coupon Bond - Bond traded with next coupon attached. Ex-Coupon Bond - Bond traded without right to next coupon. Full (or Dirty) Bond Price - Total amount paid for bond, including accrued interest. Full Price - Full Price (Dirty) = Clean Price + Accrued Interest. Bond Trading "Flat" - Bond trading without accrued interest due to issuer being in default. Sovereign Risk - Risk of changes in governmental attitudes and policies toward the repayment and servicing of debt.
What does a bond's duration tell us? - The interest rate risk of a bond, or parallel shift changes in the yield curve (rate changes at every maturity). What measure approximates the interest rate risk on bonds? - Duration. What term can be use to describe the ratio of the percent change in price to change in yield in percent for a bond? - Duration. Variable Rate Bond Interest Rate Risk - Variable Rate Bond Interest Rate Risk is highest 1 day after reset date. What happens to the price of a no-cap floating rate security on its reset date, ceterus paribus (all else the same)? - Price returns to par. Floating-Rate Security Sensitivity and Market Yields - A floating-rate security will be much less sensitive to changes in market yields than a fixed-coupon bond of equal maturity and thus lesser duration. Floating-Rate Security Sensitivity and Reset Dates - The longer the time period between the two reset dates for a floating rate security (coupon reset period), the
greater the amount of potential bond price fluctuation and therefore greater duration. Effect on interest rate risk and duration Maturity increases - Interest rate risk and duration increases. Effect on interest rate risk and duration Coupon Increases - Interest rate risk and duration decreases. Do non-callable coupon bonds have reinvestment risk before maturity? - Yes, since the coupon interest payments must be reinvested, those cash flows are subject to reinvestment risk. Do non-callable zero-coupon bond have reinvestment risk before maturity? - No, since there are no cash flows to reinvest until maturity. Callable Bond Disadvantages - Less Certain Cash Flow, Cap on price appreciation, Reinvestment risk. Reinvestment Risk - A bond has more Reinvestment Risk when:
What is the relationship between interest rate volatility and Call or Prepayment Risk? - Positive. Increase in Yield Volatility and Callable Bond - If there is an Increase in Yld Vol then Increase value of call option & Decrease the market value of callable bond. Value of a Callable Bond - Callable Bond Value = Value of Option Free Bond - Value of Call Increase in Yield Volatility and Putable Bond - If there is an Increase in Yld Vol then Increase value of put option & Increase the market value of putable bond. Value of a Putable Bond - Putable Bond Value = Value of Option Free Bond + Value of Put. How Central Govts Issue Sovereign Bonds - 1) Regular Cycle Auction-Single Price
- Regular Cycle Auction - Multiple Price
- Ad Hoc auction System
- Tap System. T-Bills - 1) Three maturity cycles - 4 weeks, 1 month & 3 Months
- Carry No Coupon & sold at discount T-Notes - 1) 2,3,5 & 10 years Maturity
- Carry Coupon & Non-Callable T-Bonds - Bonds have maturity of more than 10 years (20 to 30 years). Non-Callable. On-the-run issues - The most recently auctioned Treasury issue, also known as the current issue. Off-the-run issues - Older issues that have been replaced by a more recently auctioned issue. Treasuries with several subsequent issues are termed well off-the-run.
