Public debt
Bonds, traded in the public financial markets.
Long period of time and prefer to lock in a fixed rate of interest.
Anyone with money to invest can choose to participate.
Private debt
Loan incurred through a loan from a financial institution. Debt is not publicly traded.
Smaller firms almost exclusively borrow from banks to raise debt capital because of the costs associated with issuing bonds
Private market transaction
Loan only involving two parties. (borrowing firm and the financial institution)
Floating rate loans
Made in the private financial market, every month or quarter the rates of interest charged by the lender is adjusted up or down depending on the movements of an agreed-upon benchmark rate of interest.
LIBOR (London Interbank Offered Rate)
Most popular benchmark rate of interest for floating rate loans. A daily rate based on interest rates banks offer to lend in the London wholesale or interbank market (market where banks loan each other money)
Floating rate loan typically specifies:
-the spread or margin btwn the loan rate and the benchmark rate, expressed as basis points (100 basis points equals 1 %)
-max and min (ceiling and floor) to which the rate can adjust
-maturity date
-collateral, which can be seized by the lender in the eve
Types of Bank Loans - Classified by Intended Use
1. Working capital loans
2. Transaction loans
Types of Bank Loans- Classified by the Collateral Used to Secure the Loan
1. Secured debt
2. Unsecured debt
Working capital loan
Open line of credit based on an open-ended agreement, firm has prior approval to borrow up to a set limit.
Transactions loans
Finance a specific asset. Installment payments. Examples are home mortgage and car loans.
Secured debt
Collateral. Promise to pay by granting the lender a specific piece of property (any tangible business asset, including a/r, inventory, pp&e and real estate)
Unsecured debt
No collateral
Key distinction between public and private financial institutions
To sell a debt security to the public the issuing firm has to meet the legal requirements for doing so as specified by the securities laws.
Firms raise debt capital by
Borrowing from a financial institution, or by selling debt securities to individual investors as well as to financial institutions such as mutual funds.
Corporate bond
security sold by corporations that has promise future payments and a maturity date.
Bond Indenture
The legal agreement between the firm issuing the bonds and the bond trustee who represents the bondholders. 100+ pages w/ majority defining protective provisions for bondholder. Bond trustee assigned task of overseeing relationship between bondholder and
Claims on Assets and Income
Borrowing firm unable to pay, then the claims of the debt hoders must be honored before those of the firm's stockholders. If interest is not paid, the bond trustees can classify the firm as insolvent and force it into bankruptcy.
Par or face value of a bond
Amount that must be repaid to the bondholder at maturity. $1,000 is what the bondholder will receive when the bond matures.
Coupon Interest Rate
The % of the par value of the bond that will be paid out annually in the form of interest.
Corporate bonds that have a fixed coupon interest rate must be paid on:
the principal amount, or par value, of the debt and this rate does not change over the life of the bond.
Determines the bonds current yield.
Current Yield
Determined by the coupon rate, the ratio of the annual interest payment to the bond's current market price. In effect, the current yield is the return that an investor would receive if the investor purchased the bond at its current price and simply receiv
Current Yield caculation
Annual Interest Payment / Current Market Price of the Bond
EX: 8% coupon, $1,000 par, market price $700. Current yield = 11.4% [(0.08 x $1000)/700]
Maturity and Repayment of the Principal
The maturity of a bond indicates the length of time until the bond issuer returns the par value to the bondholder and terminates or redeems the bond.
Call Provision
Provides issuer of the bond with the right to redeem or retire a bond before it matures
Call provision most valuable when
the bond is sold during a period of abnormally high rates of interest, such that there is a reasonable expectation that rates will fall in the future before the bond matures.
What does a call feature allow a bond issuer to do?
Issue new bonds should rates decline, then use proceeds to retire the higher cost bonds.
Conversion Feature allows bondholder to
convert the bond to shares of the firm's stock
lower rate of interest than straight bonds
Bond Ratings
Provided by Moodys, Standard and Poor's, Fitch Investor Services
Based on evaluation of probablility that the bond issuer will make the bond's promised payments.
How do rating agencies come up with bond ratings?
Analyze borrowers financial statements, reliance on debt versus equity financing, looking at the issuers profitability and the variability of its past profits, and judge the firms management and business strategies.
Why are bond ratings important to the financial manager?
Provide indication of default risk and affect the rate of return that lenders require and the firm's cost of borrowing.
How does a bond rating received affect the rate of return demanded on the bond bond by the investors?
The lower the bond rating the higher the risk of default and the higher is the rate of return demanded in the capital markets.
Bond Rate Investment Grade: Prime or highest strong
AAA (S&P)
Aaa (Moody's)
Highest quality, extremely strong capacity to pay.
Bond Rate Investment Grade: High quality
AA (S&P)
Aa (Moody's)
Very strong capacity to pay.
Bond Rate Investment Grade: Upper medium
A (S&P)
A-1, A (Moody's)
Upper medium quality. Strong capacity to pay.
Bond Rate Investment Grade: Medium
BBB (S&P)
Baa-1, Baa (Moody's)
Lower medium quality. Changing circumstances could impact the firm's ability to pay.
Bond Rate Non-Inv: Speculative
BB (S&P)
Ba (Moody's)
Speculative elements, faces uncertainties.
Bond Rate Non-Inv: Highly Speculative:
B, CCC, CC (S&P)
B, Caa, Ca (Moody's)
Extremely speculative and highly vulnerable to nonrepayment.
Bond Rate Non-Inv: Default
D (S&P)
C (Moody's)
Income bond, doesn't pay interest.
The value of corporate debt is equal to:
the present value of the contractually promised principal and interest payments (the cash flows) discounted back to the present using the market's required yield to maturity on similar risk.
Valuation of corporate debt relies on 3 basic principles of finance:
Principle 1: Money has time value
Principle 2: There is a risk return tradeoff
Principle 3: Cash flows are the source of value
Steps in Valuing Bonds by Discounting Future Cash Flows
1. Determine Bondholders cash flows
2. Estimate discount rate on a bond of similar risk, where the discount rate is the return the bond will yield if it is held to maturity and all bond payments are made. Use markets YTM as discount rate.
3. Calculate the
Yield to Maturity
discount rate that equates the present value of the bond's contractual or promised cash flows with the current market price of the bond
Spreads to Treasury Bonds
terms that quote market yield to maturity data and is regularly reported
EX: 99 basis points over the 4.56% yield earned on a similar 30 yr treasury bond.
Promised versus Expected Yield to Maturity
Promised yield to maturity can be an optimistic estimate of the yield that the bondholder will actually earn. Expected factor in defaults.
Quoted Yields to Maturity for Corporate Bonds
The financial press quotes yields to maturity using contractual interest and principal payments so they are promised yields.
Markets required YTM
promised rate of return for a comparable risk bond
4 relationships in bond valuation
1. The value of a bond is inversely related to changes in the market's yield to maturity.
2. If market YTM>coupon rate then market value<Par value
3. As maturity date approaches, the market value of a bond approaches its par value.
4. Long term bonds have
Increase in interest rates causes the bondholder to incur a
loss in market value.
Interest-rate risk
Bond investor exposed to the risk of changing values as interest rates vary.
Premium bond
Sells at a higher price than the bond's par value. Sells for less as maturity approaches.
Discount bond
Bond bought for less than its par value. Sells for more as maturity approaches.
Debentures
-Any form of unsecured long term debt
-Riskier and higher YTM than secured bonds
-Advantage is no property has to be secured by them, which allows the firm to issue debt and still preserve some future borrowing power.
-BH creditors for unpaid portion of d
Subordinated Debentures
claims of sub debentures are honored only after the claims of secured debt and unsubordinated debentures have been satisfied
Mortgage Bonds
-Bonds secured by a lien on real property.
-Property value > bond value
-BH become creditors for the unpaid portion of debt
Eurobonds
-Issued in dif country than whose currencey the bond is denominated
Zero coupon and very low coupon bonds
-No or very low coupon int payments
-BH receives all or most of their return at maturity
-Must sell at a deep discount
-STRIPS (gov zero coupon bonds)
-like a US savings bond
Junk (high-yield) bonds
High-risk debt that has below investment-grade bond rating
Issued by fallen angels
Floating rate bonds
-coupon rate fluctuates according to the level of current market interest rates.
-uncommon with corps
-common with municipalities and foreign governments
Convertible bonds
debt securities that can be converted into a firm's stock at a pre-specified price
Priority of claims
place in line where the BH stand in securing repayment out of the dissolution of the firm's assets.
Secured bonds first, then unsubordinated debentures, and then subordinated debentures
Amortizing bonds
home mortgage loan, include both the interest and a portion of the principal.
Nominal (or quoted) interest rates
interest rates unadjusted for inflation
Real rate of interest
adjusts for the expected effects of inflation
EX: If you have $100 today, you can buy 25 lattes priced at $4.00. If you lend a friend your $100 for one year, and the price of lattes are expected to rise by 5% to $4.20, you will then need how much to maintain purchase power?
$105. And since you would want to be compensated for lending your money with the ability to buy two more lattes next year you would demand another $113 of repayment.
Components of interest rates for a bond:
1. Real rate of interest
2. Inflation premium
3. Default premium (reflects default risk)
4. Maturity premium
Nominal Rate of Interest =
has not been adjusted for the rate of inflation
real + inflation + (real x inflation)
Fisher Effect
Relationship between nominal rates of interest, the anticipated rate of inflation, and the real rate of interest
(1+nominal) = (1+real)(1+inflation)
Default Premium
Interest rate must account for risk of default
Term structure of interest rates (or the yield curve)
the relationship between interest rates and time to maturity with default risk held constant
rises for longer maturities
upward sloping