Bond Indenture3 things it includes
A legal document between bondholders and issuing company. It protects the bondholders.It includes...1. classifications of bonds- what type2. Basic terms of the bonds3. Total amount of bonds issued
Bond Classifications
1. Security2. Seniority
Face value/par value (FV)
Due at maturity of the bond, usually $1000
Coupon rate (r)
The interest amount of a bond. It determines the coupon (c) interest amount of a bond, paid at regular intervals until the maturity date.
C (coupon interest payment)
0
Yield to maturity
Rate required in the market. Discount rate that sets the PV of coupon payments equal to the current market price of the bond
Maturity date
The final repayment date of a bond.
Years to maturity (t)
The time it takes for a bond to mature
Price of a bond
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Zero Coupon bonds
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Coupon rate= Yield to maturity
Trade at par value
Coupon rate < Yield to maturity
Trade at a discount
Coupon rate > Yield to maturity
Trade at a premium
Interest rate risk
The potential changes in bond prices as interest rate fluctuates result in gain or losses to a bondholder
Sensitivity
The degree in the rate of change for a bond price. It directly depends on the coupon rates and years to maturity.Highly sensitive= high interest rate risk
How is YTM determined? What do investors expect to receive?3 components
There is a 'base' or 'real' return determined by the rate o return of treasury bills- considered to be 'risk free'3 components:Term premiumInflation premiumDefault Risk premium
Term premium (interest rate premium)
Compensation for investors in LT bonds for possessing a greater level of risk than investors in ST bonds.
Inflation premium
Compensation for expected future inflation (for goods predicted to become more expensive)
Default Risk premium
Compensation for possibility of default (company not being able to pay back the face value of the bond)
Fisher Effect relationship=
(1 + nominal rate)= (1 + rr of return) x (1 + inflation rate)
Liquidity premium
...
Treasury Securities
Are bonds issued by the government of a country. No risk of bankruptcy for government securities (because they can print more money)
Inflation
The same goods cost more in the future than they do today. And as goods become more expensive, investors will demand a greater rate of return for their investments.
Can corporations go bankrupt?
Yes, they have a default risk premium that government bonds don't have , it is to compensate investors for the possibility that the company may not be able to repay the bonds coupon interests or the face value/principal
How are bankruptcy probabilities monitored?2 types
By rating companies. These rating agencies categorise a company's default and degree of protection for creditors.Two types: 1. Investment grade2. Speculative grade
Investment grade
Standard + poors/Moody's:AAA/Aaa ie. least likely to go bankruptAA/AaA/ABBB/BaaDefault risk premium= small
Speculative grade
Standard + poors/Moody's:BB/BaBCCC/CaaCC/CaCD ie. most likely to go bankruptDefault risk premium= large