Interest Rates and Bond Valuation

Trustee Responsibilities

1. Make sure the terms of the indenture are obeyed

2. Manage the sinking fund

3. Represent the bondholders in default

Provisions in a Bond Indenture

1. Basic terms of the bonds.

2. The total amount of bonds issued.

3. A description of property used as security.

4. The repayment arrangements.

5. The call provisions.

6. Details of the protective convenants.

1. Determining bond prices and yields is an application of basic discounted cash flow principles.

2. Bond values move in the direction opposite that of interest rates, leading to potential gains or losses for bond investors.

3. Bonds have a variety of features spelled out in a document called the indenture.

4. Bonds are rated based on their default risk. Some bonds, such as Treasury bonds, have no risk of default, whereas so-called junk bonds have substantial default risk.

5. A wide variety of bonds exist, many of which contain exotic, or unusual, features.

6. Almost all bond trading is OTC, with little or not market transparency. As a result, bond price and volume information can be difficult to find.

7. Bond yields reflect the effect of six different things: the real rate and five premiums that investors demand as compensation for inflation, interest rate risk, default risk, taxability, and lack of liquidity.

8. Bonds are a vital course of financing to governments and corporations of all types. Bond prices and yields are a rich subject, and our one chapter, necessarily, touches on only the most important concepts and ideas. There is a great deal more we could say, but instead we'll move on to stocks in our next chapter.

9. Securitization is the process of packaging a set of cash flows and then selling claims (such as bonds) against them.

10. A coupon is the stated interest payment made on a bond.

11. Face value is the principal amount of a bond that is repaid at the end of the term. Also called par value.

12. Coupon rate is the annual coupon divided by the face value of the bond.

13. Maturity is the date on which the principal amount of a bond is repaid.

14. A level coupon bond is simply one that has a constant payment amount every year.

15. The amount paid at the end of the loan is called face value, or par value.

16. YTM – yield to maturity – interest rate required in the market on a bond

17. A bond's present value is the annuity present value (for the coupon disbursements) plus the present face value that is paid at the end of the term. All you have to do is figure both, then add them together!

18. If a bond costs more than face value, it is considered to be selling at a premium. If it costs less than face value, it is considered to be selling at a discount.

19. Interest rate risk – the risk that arises from fluctuating interest rates. The amount of interest rate risk depends on how sensitive the price is to interest rate changes. This is determined by time to maturity and the coupon rate. The longer the time to maturity, the greater the interest rate risk. The lower the coupon rate, the greater the interest rate risk.

20. There are two types of securities: debt and equity. At the “crudest level,” a debt is something that must be repaid. Debt is not ownership in the firm. Creditors generally do not have voting power. The corporation's payment of interest on debt is considered a cost of doing business and is fully tax deductible. Dividends paid to stockholders are not tax deductible. Unpaid debt is a liability of the firm. If it is not paid, the creditors can legally claim the assets of the firm. This action can result in liquidation or reorganization, two of the possible consequences of bankruptcy. Thus, one of the costs of issuing debt is the possibility of financial failure. This possibility does not arise when equity is issued.

21. Short term debt is sometimes called unfunded debt. The word “funding” is part of the jargon of finance, and it generally refers to the long term. Thus, a firm planning to “fund” its debt requirements may be replacing short-term debt with long-term debt.

22. “Intermediate debt” is a newer term that generally refers to debt with a term of 1-5 years.

23. A bond indenture is a legal document. It is the written agreement between the corporation (borrower) and its creditors, and is sometimes called a deed of trust. A trustee (usually a bank or similar financial institution) is appointed by the corporation to represent the bondholders. The trust company must make sure the terms of the indenture are obeyed, manage the sinking fund, and represent the bondholders in default. The bond indenture can be as large as several hundred pages, and generally makes for tedious reading.

24. Registered form – The form of bond issue in which the registrar of the company records ownership of each bond; payment is made directly to the owner of record.

25. Bearer form – The form of bond issue in which the bond is issued without record of the owner's name. Payment is made to whomever holds the bond.

26. Debenture – An unsecured debt, usually with a maturity of 10 years or more.

27. Corporate bonds usually have a face value, also called the principal value and par value.

28. Collateral is a general term that frequently means securities (for example, bonds and stocks) that are pledged as security for payment of debt. For example, collateral trust bonds often involve a pledge of common stock held by the corporation. The term collateral is common used to refer to any asset pledged on a debt.

29. Mortgage securities are secured by a mortgage trust indenture or trust deed. Sometimes mortgages are on specific property, but more often blanket mortgages are used. A blanket mortgage pledges all the real property owned by the company.

30. Note – unsecured debt, usually with a maturity under 10 years.