Term
| Characteristics of Corporate Bonds |
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Definition
| Bondholders normally receive interest payments every six months at the stated interest rate |
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Term
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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 |
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Term
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Definition
| The legal conditions are described in a bond indenture, administered by trustee |
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Term
| Why Corporations Sell Bonds |
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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) |
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Term
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Definition
Debenture bond
Most corporate bonds are debenture bonds backed only by the reputation of the issuing company |
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Term
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Definition
Mortgage bond
A corporate bond that is secured by various assets of the issuing firm |
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Term
| Subordinated debenture bond |
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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 |
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Term
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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 |
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Term
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Definition
Convertible bond
Can be exchanged, at the owner’s option, for a specified number of shares of common stock |
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Term
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Bond Type
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Impact on Interest Rate Paid By Corporation
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Debenture bond
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Interest rate based on general credit rating and bond terms
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Mortgage bond
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Lowers rate, bondholder generally has more security
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Subordinated bond
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Increases rate since bondholder has less security
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Callable bond
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Increases rate, bondholder has risk of early call
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Zero coupon
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Increases the rate, bondholder receives no interest until maturity
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Convertible bond
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Decreases rate, bondholder accepts lower rate for possible upside on conversion
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Definition
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Term
| Why Investors Buy Corporate Bonds 1 |
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Definition
-For interest (income yield)
-Investors know the interest rate
-Interest will be paid to investors twice a year |
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Term
| Why Investors Buy Corporate Bonds? |
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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 |
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Term
| Three Bond Valuation Relationships-1 |
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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). |
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Term
| Three Bond Valuation Relationships-2 |
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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 |
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Term
| Three Bond Valuation Relationships-3 |
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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 |
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Term
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Definition
| Suppose interest rates fall immediately after we issue the bonds. The required return on bonds of similar risk drops to 10%. |
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Term
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Definition
| Suppose interest rates rise immediately after we issue the bonds. The required return on bonds of similar risk rises to 14%. |
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Term
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Definition
Treasury Bills (T-Bills)
-$100 minimum
-Three months to one year
-Federal but no state tax on interest earned |
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Term
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Definition
Treasury Notes
-$1,000 minimum
-Two to ten year term
-Higher interest rate than T-bills |
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Term
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Definition
Treasury Bonds
-$1,000 units
-10 -30 year maturity
-Interest paid every six months
-Treasury suspended new issuances in Oct. 2001 |
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Term
TIPS - Treasury Inflation Protected
Securities (safest of the safe) |
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Definition
TIPS - Treasury Inflation Protected
Securities (safest of the safe)
-Principal increases with inflation (or decreases with deflation)
-5, 10, and 20 year notes |
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Term
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Definition
Series EE
-Usually purchased and held to maturity
-Discounted ($25 today =$50 at maturity)
-New fixed interest rate |
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Term
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Definition
Series HH
-Sold in $500 - $10,000 amounts
-Pay interest every six months |
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Term
| Government Sponsored Entities |
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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 |
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Term
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Definition
Municipal bonds - called munis
-Municipalities includes cities, counties, school districts, and special taxing districts
-Use funds to build schools, bridges etc. |
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Term
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Definition
| General obligation bonds are backed by the state or local government that issues them |
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Term
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Definition
| Revenue bonds are repaid from money generated by the project the funds finance |
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Term
| Characteristics of Municipal Bonds |
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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) |
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Term
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Definition
Tax-exempt yield divided by
(1 - Your marginal tax rate) |
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Term
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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 |
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Term
| Current % Yield of a Bond |
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Definition
Dollar Amount of annual Interest divided by
Current Market value |
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Term
| Yield To Maturity (rate of return) |
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Definition
The expected rate of return on a bond.
The rate of return investors earn on a bond if they hold it to maturity |
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Term
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Definition
| If a bond is purchased at a discount, its YTM will be greater than its current yield (current yield plus capital gain = YTM |
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Term
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Definition
| If a bond is purchased at a premium, its YTM will be less than its current yield (current yield less capital loss = YTM) |
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Term
| Primary and Secondary Bond Markets |
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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 |
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Term
| Recommended if you have a large portfolio |
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Definition
| 5% diversification suggestion |
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Term
| A well diversified bond portfolio will have |
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Definition
-Debt issued in the U. S
-Foreign debt
-Various terms
-Various credit quality |
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Term
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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 |
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Term
| A change in credit rating |
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Definition
A change in credit rating
-The value of the bond will decrease with a lower rating, while improved ratings will increase bond values |
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Term
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Definition
| -Rapidly rising inflation/interest rates = a bond portfolio with shorter maturities & TIPS |
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Term
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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 |
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Term
If interest
rates fall for comparable bonds |
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Definition
If interest
rates fall for comparable bonds, you
would expect the fair market value
of the bond to |
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