Bond Features

K. Stephen Haggard, Ph.D.

 More on Bond Features
• Debt is NOT an ownership claim.
• The company’s payment of interest is considered a
cost of doing business – tax deductible (dividends
are NOT).
• Unpaid debt is a liability of the firm. Failure to pay
gives lenders right to take control of assets.
• Short-term debt – original issue maturity =< 1 yr.
• Long-term debt – original issue maturity > 1 yr.
– Notes: 1 yr < original issue maturity =< 10 years.
– Bonds: original issue maturity > 10 years
 The Bond Indenture A contract

• An agreement between borrower and lender

• Contains information about the bond issue.
– Terms
in a bond the borrower writes the contract.
– Security because theres one borrower and many lenders

– Seniority
– Repayment
– Call provision
 Terms of the Bond Issue
• Face value assume its $1000.

• Coupon rate the amount % paid and the frequency- annual or semi annual

• Maturity date
• Bond form: registered vs. bearer
bearer bonds are paper forms of bonds; whomever has the bond can claim the coupoins. if stolen then the theif can take
the value

registered bonds are regitered to a specific person, only they can claim it. registered bonds are easier to track by the
governemnt and track for tax and security reasons. coupons are elctronically deposited into an account.
 Security wha the lender can take if
the borrower doesnt pay

on bonds, its the colllection of fincial secirities. we want this

• Collateral basekt to be safer than the borrower. the stock woulndt be the
collatoral for a bond.

• Mortgage securities houses, factories and any property used as backing for a
security. used to pay the secured lenders.

Debenture – unsecured (in the U.S.) non-secured

debentures are backed by the
• firms
assets of he

• Notes – unsecured bond with 1 year < original

issue maturity =< 10 years notes are unsecured

bonds are less risky because they are seucred and first in line to recieve. debentures and unsecured debt have a higher
YTM becuase they are riskier
 Seniority who gets paid first

• Senior senior bonds get paid coupons first, and first incase of bankrupcy

followed by junior bonds (they arent necessarilty smaller)

• Junior subordinated bonds only get paid after the first two are get paid everything

subordinated are riskiest and highest YTM

• Subordinated
house and car loan paments include bonds are more lileky to default at the end
the interest and principle in each of its life when the principle is to be paid.

Repayment
payment. amortized loans
one way to increase ts attractivness is to
bonds are different, interest only buy back bonds in the open market at he
loans market price known as Sinking Fund. this
gets rid of the principle of the bond

• Without repayment arrangements, no

principal is paid back until bond matures.
• Sinking fund allows bond issuer to set aside
funds to periodically repurchase a portion of
the bonds, allowing principal of issue to be
paid down over bond life. bought by the bond trustee
• Bonds repurchased in open market or called.
a call provision forces the bond holder to sell their bond back if its not on the open market

• Sinking fund reduces the risk of a bond issue

for bondholders. Why? reduces the prniciple owed to bond holders in smaller
oncreemnts over a period of time. a bond with a
sinking fund is less risky and therefore less YTM
calling bonds will be attractive during decreasin IR. decrease in IR will increase bond value, if the value of the bond at
market price is less than the call premium the buiness will borrow new money at a lower IR and buy back the bnd at a
price lower than the current market price

The Call Provision

call provision increase the risk
for the bond holder, re-
investment risk
YTM should be highr
Call provision gives the bond issuer the right, but not
the obligation, to repurchase the bond at a set amount
(call premium) above the face value.
• Deferred call provision provides time at beginning of
bond life where bond is “protected” from being
called.
• When is it advantageous for a bond issuer to call a
bond? during lower periods of IR.
• Why is this the worst possible time for the bond
the call premium may be lower than the current
holder to have their bond called?market price of the bond. reinvestment risk
means theyll reinvest that money in something
of lower yeild
• What do you think happens to required YTM as a
result?
promises made by the issuer to the lender, to decrease the risk and YTM and cost of borrowing money.

Protective Covenants
Clauses in the bond indenture meant to
protect bondholders (lenders) - lowers
required YTM due to reduction of risk
• Negative covenants say what the bond
issuer is NOT allowed to do.
• Positive covenants say what the bond
issuer MUST do.
 Negative Covenants (Examples)
reduces the amount of cash to pay for coupons and face value

• Firms must limit dividend payments

the security cant be pledged to others, the more pledged the less general assets available to unsecured debt
• Firms cannot pledge assets to other lenders
• Firms cannot merge with another firm
• Firms cannot sell/lease major assets without
lender approval
• Firms cannot issue additional long-term debt
most firms wont make this promise, they want to borrow more most of the times
 Positive Covenants (Examples)
Net Workng Capital ensures short term luquidity to pay day-to-day activity

• Firms must maintain NWC at or

above a stated minimum level.
• Firms must periodically furnish
audited financial statements to the
bondholders. to measure the financial halth of the company. should
be AUDITED by outside firm to ensure honesty

• Firms must maintain any collateral or

security in good condition.
incase of bankrupcy the condition of the collaterla will determine its value and the security
 Bond ratings (1)
• Supposedly represent a combination of
default risk and probability of recovery given
default. with collatoral probability of recovery is higher; investing in
R&D would have more risk due to lower proability of recovery

• Ratings issued by firms: S&P, Moody’s, Fitch

they may rate companies or countries even when not asked.

• Some firms pay to have their bonds rated.

Why? Could this create a conflict of interest?
firms pay to be rated to increase the potential
• Ratings tiers: audience of the bonds to lower YTM and coupon
paymnets but youre not big enough to be rated
safe blue and green by the firms.
– Investment grade because you’re paying them this may lead to

– Junk (also called High Yield)

conflict of interest.
 to take over a healthy company buy the stocks.
to buy a sick company buy the bonds (they are the first in line to take over assets…… VULTURE CAPITALISM

Bond Ratings (2)

Moody’s S&P

Aaa AAA

Aa AA

A A

Baa BBB

each could have + and -‘s Ba; B highest rated junk bond BB; B

Caa CCC

Ca CC

already in default C C

D already in default

junk bonds in default due to incompentent managent are attractive because thye may be saved
 Different types of bonds (1)
Government
• Federal
e.g. 3 month and is pure discount bond
– Treasury bills – no coupons
– Treasury notes – semi-annual coupons difference between notes
and bonds is YTM
– Treasury bonds – semi-annual coupons
– All are free of state taxes, but not Federal taxes
• Municipal
– Issued by states, counties, cities, special districts
– Free of Federal tax, and sometimes state tax
 What does tax-free status do to
possibel for
municipal bond to
go go bankrupt

required YTM?
because they arent
risk free becuase
communities can
go bankrupt

• Investors are interested in after-tax return.

• Bonds which do not incur taxes do not have to
return as much as taxable bonds
how much a municipal
• im = it * (1 – T), where it = im / (1-T)
Taxable equivelant yeild
bond must pay to be as
attractive as a taxbale

– im = interest required on municipal bond bond

– it = interest required on otherwise identical taxable

bond
– T = marginal tax rate of investor
• Who would be most interested in municipal
bonds, low-income people or high-income people?
municipal bonds ar emostly tax free(federal and state), high income earners have higher marginal tax rate, higher T will
lower the value of the taxable bondso high income earners are more interested in it municipla bonds. Pension funds
arent interested because they dont pay taxes or parents that have child deductons.
 Different types of bonds (2)
• Zero coupon bonds assumed semi annually even of 0

– All principal and interest paid back at maturity

– Must always be a discount bond after the crisis people flooded their
money int the risk free like 0 bonds
and thus made them premium
– AKA ‘zeroes,’ ‘deep discount bonds’ bonds and pushed YTM to 0
Floating rate bonds
2. coupoun rates can float, at regular intervals in the contract the
• coupon rate changes at the same rate as the YTM. thus the bond
sells for face value becasue YTM=copoun rate taking away risk

Income bonds
thus lower YTM due to lower risk. issuer has to deal with the
• interest risk
can be converted from debt to equity, equity/stocks are exposed to risk.
• Convertible bonds with convertable bonds, you can convert the bond to stock especially
during the good times when stocks are doing well. the bond can be
converted into x numbr of stocks, when bond price rises above a certain
• Put bonds level you can convert to the higher valued stock. usually when you
convert you sell the stock and cash out. people “pay” for these bonds
with lower YTM

put bonds are the opposit of call bonds. the holder has the right but not the obligation to force the issuer to repurchase the
bond a t adiscount to face value. good when the bond falls in the value (IR down). in theory safer thus lower YTM
 Bond Markets
• Bonds are sold “over the counter” (OTC), which
means they are bought and sold through dealers,
not exchanges
• Dealers purchase bonds directly from issuers such
as corporations and governments and sell them
to individual investors and funds
• Dealers hold an inventory and stand ready to buy
at the ‘bid’ price or sell at the ‘ask’ price.
Difference is the bid-ask spread, how dealers get
paid.
dealer takes actual posession
• ‘Making a market’ they profit from commsions
current yeild= (annual coupiun)/(bond price)=
(coupon rate X face value)/(quoted price x face value)=

Bond Quotes
YTM
coupoun rate/quoted price
based on
the
to find current yeild (not same at YTM), cupoun/asked
change asked
of face price
% of face value
value

EXAM TIP:

Know the difference

between Bid and Ask
EXAM: all rates
observed in the
market are
nominal Inflation and Interest Rates
• Real returns represent an increase in purchasing
power
• Nominal returns represent an increase in the
number of dollars
• The two are related by inflation and the Fisher
Effect (1+R) = (1+r)*(1+h) the bigger the inflation the wider
the gap between R and r

where R is nominal return, r is real return and h is

inflation.
• Approximation only: R = r + h in exams
do no use
 low IR in short term, higher in long term
real is expected to stay constant.
if inflation is expected to increase the upward
sloping
if we expect intrest risk then itll be upward
sloping

Term structure of interest Term

Structure
of Interest
Rates
short term IR high due to inflation, the FED
will sell bonds to reduce inflation
 Determinants of Bond Yields
• Term structure of interest rates
– Real rate
– Inflation premium
– Interest rate risk premium
• Default risk premium
• Taxability premium
would increase on top pf the other chart; potenital for
deafault or tax or being illiquid (ease of selling) increases
the risk and therefore need to increase YTM

• (Il)liquidity premium