ch. 5 -13ed bonds - master
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1
Chapter 5
Bonds, Bond Valuation, and
Interest Rates
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Topics in Chapter Key features of bonds
Bond valuation
Measuring yield
Assessing risk
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Value = + + +FCF1 FCF2 FCF
∞
(1 + WACC)1 (1 + WACC)∞ (1 + WACC)2
Free cash flow(FCF)
Market interest rates
Firm’s business risk Market risk aversion
Firm’s debt/equity mix Cost of debt
Cost of equity
Weighted average
cost of capital(WACC)
Net operatingprofit after taxes
Required investmentsin operating capital
−
=
Determinants of Intrinsic Value: The Cost of Debt
...
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Interest Rates & Interest-
Bearing Securities Interest rates:
Based on supply & demand for money
Driven by risk factors
Role of Federal Reserve
Basis Point
.01% or .00014
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5
Risk & Term Structure of
Interest Ratesrd = r* + IP + DRP + LP + MRP
rd = Required rate of return on a debt security.
r* = Real risk-free rate.
IP = Inflation premium.
DRP = Default risk premium.LP = Liquidity premium.
MRP = Maturity risk premium.
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Risk & Term Structure r = r* + IP + DRP + LP + MRP
r = nominal interest rate of a particular security (or
required rate of return) r* = real risk-free interest rate
typically 1-4% depending on monetary policyassumes expected inflation = zero
IP = Inflation premium Ave. inflation over life of bond
DRP = Default risk premiumCompensation for possible defaultFunction of bond ratings
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Risk & Term Structure
r = r* + IP + DRP + LP + MRP
LP = Liquidity Premium
Compensation for possible difficulty sellingbond quickly at fair market value
MRP = Maturity Risk PremiumCompensation for possible loss in value dueto increase in interest rates over maturity ofbond.
Affects longer maturities more than shorter.
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Premiums Added to r* (real risk-free
rate) for Different Types of Debt ST Treasury:
only IP for ST inflation
LT Treasury: IP for LT inflation, MRP
ST corporate: ST IP, DRP, LP
LT corporate: IP, DRP, MRP, LP
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Inflation & Interest Rates
Nominal Interest= 12%
- Inflation -1%
= Real Int. % =11%
If inflation =
& req’d real return =
Then Nominal rate =? =
12%
- 8%
=4%
9
8%
11%
=19%
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Relationship b/w Nominal &
Real Interest Rates, & Inflation Nom = Real + Inflation
But, inflation not additive, it grows or
compounds, so multiply
Nom = (Real) x (Infl)
And (1+Nom) = (1 + real) x (1 + infl) Is better determinant; known as Fisher effect
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Estimating Inflation Premium (IP)
Treasury Inflation-Protected Securities(TIPS) are indexed to inflation.
IP for a particular length maturity canbe approximated as the differencebetween the yield on a non-indexed
Treasury security of that maturity minusthe yield on a TIPS of that maturity.
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Bond Spreads, the DRP, and
the LP A “bond spread” is often calculated as the
difference between a corporate bond’s yield
and a Treasury security’s yield of the samematurity. Therefore:
Spread = DRP + LP.
Bond’s of large, strong companies often have
very small LPs. Bond’s of small companiesoften have LPs as high as 2%.
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Term Structure Yield Curve Term structure of interest rates: the
relationship between interest rates (or
yields) and maturities. A graph of the term structure is called
the yield curve.
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Hypothetical Treasury Yield
Curve
0%
2%
4%
6%
8%
10%
12%
14%
1 3 5 7 9 1 1 1 3 1 5 1 7 1 9
Years to Maturity
I n t e r e s t R a
t e
MRP
IP
r*
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What factors can explain
shape of this yield curve? Upward slope due to:
Increasing expected inflation
Increasing maturity risk premium
What about liquidity & default risk?
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Treasury vs. Corporate YieldCurves relationships
Corp yield curves are higher thanTreasuries, but not necessarily parallel.
Spread b/w the two yield curves widens ascorporate bond rating decreases due to:
DRP & LP
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Computing Yields
Estimate the inflation premium (IP) foreach future year. This is the estimated
average inflation over that time period. Step 2: Estimate the maturity risk
premium (MRP) for each future year.
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Assume investors expect inflation to be 5% next
year, 6% the following year, and 8% per year
thereafter.
Step 1: Find the average expected
inflation rate over years 1 to n:
IP1 = 5%/1.0 = 5.00%.
IP10 = [5 + 6 + 8(8)]/10 = 7.5%.
IP20 = [5 + 6 + 8(18)]/20 = 7.75%. Must earn these IPs to break even versus inflation; thatis, these IPs would permit you to earn r* (beforetaxes).
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Step 2: Find MRP based onthis equation:
MRPt = 0.1%(t - 1).
MRP1 = 0.1% x 0 = 0.0%.
MRP10= 0.1% x 9 = 0.9%.
MRP20 = 0.1% x 19 = 1.9%.
Assume the MRP is zero for Year 1 and
increases by 0.1% each year.
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Step 3: Add the IPs and MRPs to r*:
r RFt = r* + IPt + MRPt .
r RF = Quoted market interestrate on treasury securities.
Assume r* = 3%:
r RF1 = 3% + 5% + 0.0% = 8.0%. r RF10 = 3% + 7.5% + 0.9% = 11.4%.
r RF20 = 3% + 7.75% + 1.9% = 12.65%.
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Upward vs. Downward slopingyield curves due to?
Real risk-free rate = 3%
Expected inflation for
Year 1 =7%, Yr 2 = 5%; Yr 3 = 3%
What are interest rates for 1, 2, & 3 yrborrowings?
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Interest Rates & MRP problem
Assume the real risk-free rate (r*) is 4% and
inflation is expected to be 7 percent in Year1;
4% in yr 2; and 3% thereafter. Assume allTreasury Bonds are highly liquid and free of
default risk. If 2-yr and 5-yr T-Bonds both
yield 11%, what is the difference in thematurity risk premiums (MRPs) on the two
bonds; that is, what is MRP5 – MRP2?
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Interest Rates & Inflation Problem
Due to the recession, the rate of inflation expectedfor the coming year is only 3.5%. However, the
rate of inflation in Yr 2 and thereafter is expected tobe constant at some level above 3.5%. Assume thereal risk-free rate (r*) = 2% for all maturities, andthere are no maturity premiums. If 3-year T-Bonds
yield 3% (0.03) more than the 1-year T-Bonds,what rate of inflation is expected after year 1?
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Coupon Bonds
Bond = Debt = Borrowing
Fixed Maturity (Maturity Date) = N
Par Value=Face Value=Maturity Value=$1000=FV
Coupon Rate=Stated Rate (locked in in bondcontract)
Coupon payment= Coupon rate x face value=PMT
Market Rate of interest = Yield to Maturity = rate
used to discount bond CF’s = I
**PV cash flow of bonds always opposite sign of PMT & FV!!!
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Bond Perspectives
Debt
Needs $
Borrower
Issuer or seller Debtholder
Cost of borrowing
Interest Paid (Expense) –
generates tax benefit (Svgs) Cost of Debt
= R d or K d;
After-tax cost = R d (1-t)
Asset
Has $
Lender
Buyer or Investor Bondholder
Creditor
Requires return to invest
$ in bonds based on risk Interest Received (earned)
(Revenue) - pay tax on it
Capital Appreciation
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Key Features of a Bond
Par value: Face amount; paid atmaturity. Assume $1,000.
Coupon interest rate: Stated interestrate. Multiply by par value to getdollars of interest. Generally fixed.
(More…)
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Key Features of a Bond
Maturity: Years until bond must berepaid. Declines.
Issue date: Date when bond wasissued.
Default risk: Risk that issuer will not
make interest or principal payments.
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Value of Financial Security
Value of any asset based on the net presentvalue of the expected future cash flows
discounted by the interest (discount) ratethat reflects risk factors
Discount (interest rate) depends on:
Riskiness of CFs reflected by DRP, MRP, LP General level of interest rates, which reflects
inflation, supply & demand for $, production
opportunities, time preferences for consumption 28
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Value of a 10-year, 10%coupon bond if r
d = 10%
VB
=$100 $1,000
. . .+
$100
100 100
0 1 2 10
10%
100 + 1,000V = ?
...
= $90.91 + . . . + $38.55 + $385.54= $1,000.
++(1 + rd)1 (1 + rd)N (1 + rd)N
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10 10 100 1000N I/YR PV PMT FV
-1,000
$ 614.46
385.54
$1,000.00
PV annuityPV maturity value
Value of bond
==
=
INPUTS
OUTPUT
The bond consists of a 10-year, 10%annuity of $100/year plus a $1,000 lumpsum at t = 10:
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When market interest rate (rd)rises abovecoupon rate, bond’s value (PV or price)falls below par, so sells @ discount.
10 13 100 1000
N I/YR PV PMT FV
-837.21
INPUTS
OUTPUT
What would happen if expected inflationrose by 3%, causing r = 13%?
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9 13 100 1000
N I/YR PV PMT FV
-846.05
INPUTS
OUTPUT
What happens if one year passes but themarket i stays at 13%?
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8 13 100 1000
N I/YR PV PMT FV
-856.04
INPUTS
OUTPUT
What happens if a second year passes butthe market i stays at 13%?
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1 13 100 1000
N I/YR PV PMT FV
-973.45
INPUTS
OUTPUT
What happens if 9 years pass but themarket i stays at 13%?
As a bond approaches maturity, it’s price
approaches the face or maturity value of $1000
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What would happen if inflationfell, and r
d declined to 7%?
If coupon rate > mrkt i% (rd), price risesabove par, and bond sells at a premium.
10 7 100 1000N I/YR PV PMT FV
-1,210.71
INPUTS
OUTPUT
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Bond Pricing in Excel
Years to Mat: 10
Coupon rate: 10%
Annual Pmt: $100
Par value = FV: $1,000
Going rate, rd: 7%
PV = ? $1210.71
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Summary of Bond price andinterest rate relationships
If market rate of interest increasesabove the stated (coupon) rate, then
bond’s price falls and sells at discount If market rate of interest drops below
the stated (coupon) rate, then bond’s
price increases and sells at a premium **INVERSE RELATIONSHIP b/w Market
i% and Bond’s PRICE!***
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Bond prices & changinginterest rates
Suppose the bond was issued 20 yearsago and now has 10 years to maturity.
What would happen to its value overtime if required rate of return remainedat 10%, or at 13%, or at 7%?
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M
1,372
1,211
1,000
837
775
30 25 20 15 10 5 0
r d = 7%.
r d = 13%.
r d = 10%.
Bond Value ($) vs Yearsremaining to Maturity
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Bond Price Movements over time
At maturity, value of any bond mustequal its par value.
Value of a premium bond decreases to$1,000.
Value of a discount bond increases to$1,000.
A par bond stays at $1,000 if mrkt i%(rd)remains constant.
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What’s market value of 10 year 10%coupon bond when market = 7%?
Bond sells at a premium::Price today = $1,210.71.
10 7 100 1000N I/YR PV PMT FV
?
INPUTS
OUTPUT
If you buy a 10% 10 year bond
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If you buy a 10%, 10 year bondtoday for $1,210.71, and hold it to
maturity, what’s your rate of return?
Solve for i% = 7% = Yield to maturity(YTM)
10 (1210.71) 100 1000N I/YR PV PMT FV
?
INPUTS
OUTPUT
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What’s “yield to maturity”?
YTM is rate of return earned on a bond held tomaturity. Also called “promised yield.”
It assumes bond will not default. Includes both interest pmt component & cap gains
over bond’s life
Interest rate equating bond’s price today to NPV of
PMTs & FV. (Think market rate of interest)
Vs. Annualized Return which reflects only a one-year holding period
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YTM on a 10-year, 9% annual coupon,$1,000 par value bond selling for $887
90 9090
0 1 9 10r d=?
1,000PV1 ..
.PV10 PVM
887 Find i % (rd) that “works”!
...
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10 -887 90 1000
N I/YR PV PMT FV
10.91
VINT M
B =(1 + r
d)1 (1 + r
d)N
... +INT
887 90
(1 + rd)1
1,000
(1 + rd)N
= +90
(1 + rd)N
++
++
INPUTS
OUTPUT
...
Find YTM (i % or rd)
(1 + rd)N
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YTM in Excel
Years to Mat: 10
Coupon rate: 9%
Annual Pmt: $90.00
Current price: $887.00
Par value = FV: $1,000.00
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Bond Prices & Int. Rates
If coupon rate < mrkt i % (rd), bondsells at a discount.
If coupon rate = i %, bond sells at itspar value.
If coupon rate > i%, bond sells at apremium.
If market i% rises, price falls.
Price = par at maturity.
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Find YTM if price were$1,134.20.
Sells at a premium. Because
coupon = 9% > mrkt i% =7.08%, bond’s value > par.
10 -1134.2 90 1000
N I/YR PV PMT FV7.08
INPUTS
OUTPUT
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Definitions
Current yield = “Interest Yield”
Capital gains yield =Change in value
= YTM = +Exp totalreturn
ExpCurr yld
Exp capgains yld
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9% coupon, 10-year bond, P =$887, and YTM = 10.91%
Current yield =
= 0.1015 = 10.15%.
$90$887
C ld C l
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Cap gains yield = YTM - Current yield= 10.91% - 10.15%= 0.76%.
Could also find values in Years 1 and 2,get difference, and divide by value in
Year 1. Same answer.
YTM = Current yield + Capitalgains yield.
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Semiannual Bonds
1. Multiply years by 2 to get periods = 2N.
2. Divide nominal rate by 2 to get periodicrate = rd /2.
3. Divide annual INT by 2 to get PMT =
INT/2.2N r d /2 OK INT/2 OK
N I/YR PV PMT FV
INPUTS
OUTPUT
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2(10) 13/2 100/2
20 6.5 50 1000
N I/YR PV PMT FV
-834.72
INPUTS
OUTPUT
Value of 10-year, 10% coupon,semiannual bond if rd = 13%.
S d h t F ti
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Spreadsheet Functionsfor Bond Valuation
PRICE
YIELD
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Call Provision
Issuer can refund if rates decline. Thathelps the issuer but hurts the investor.
Therefore, borrowers are willing to paymore, and lenders require more, on callablebonds.
Most bonds have a deferred call and adeclining call premium
Yield to call: yearly rate of return earned on
a bond until it’s called
C ll bl B d d Yi ld t
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Callable Bonds and Yield toCall
A 10-year, 10% semiannual coupon,$1,000 par value bond is selling for
$1,135.90 with an 8% yield to maturity.It can be called after 5 years at $1,050.
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10 -1135.9 50 1050
N I/YR PV PMT FV
3.765 x 2 = 7.53%
INPUTS
OUTPUT
Nominal Yield to Call (YTC)
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If you bought bonds, would you bemore likely to earn YTM or YTC?
Coupon rate = 10% vs. YTC = rd =7.53%. Could raise money by selling
new bonds which pay 7.53%. Could thus replace bonds which pay
$100/year with bonds that pay only$75.30/year.
Investors should expect a call, hence YTC = 7.53%, not YTM = 8%.
I t t ll bl
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Investor returns on callablebonds
In general, if a bond sells at a premium,then coupon > market rate, so a call is
likely. So, investors expect to earn:
YTC on premium bonds.
YTM on par & discount bonds.
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What’s a sinking fund?
Provision to pay off a loan over its liferather than all at maturity.
Similar to amortization on a term loan. Reduces risk to investor, shortens
average maturity.
But not good for investors if ratesdecline after issuance.
Si ki f d ll
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Sinking funds are generallyhandled in 2 ways
Call x% at par per year for sinkingfund purposes.
Call if rd is below the coupon rate and bondsells at a premium.
Buy bonds on open market.
Use open market purchase if rd is abovecoupon rate and bond sells at a discount.
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Bond Ratings and Bond
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Bond Ratings and BondSpreads (YahooFinance, March 2009)
Long-term Bonds Yield (%) Spread (%)
10-Year T-bond 2.68
AAA 5.50 2.82 AA 5.62 2.94
A 5.79 3.11
BBB 7.53 4.85BB 11.62 8.94
B 13.70 11.02
CCC 26.30 23.62
What factors affect default risk
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What factors affect default riskand bond ratings?
Financial ratios
Debt ratio
Coverage ratios, such as interest coverageratio or EBITDA coverage ratio
Profitability ratios
Current ratios
(More…)
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Bond Ratings Median Ratios(S&P)
Interestcoverage
Return oncapital
Debt tocapital
AAA 23.8 27.6% 12.4% AA 19.5 27.0% 28.3%
A 8.0 17.5% 37.5%
BBB 4.7 13.4% 42.5%BB 2.5 11.3% 53.7%
B 1.2 8.7% 75.9%
CCC 0.4 3.2% 113.5%
Other Factors that Affect Bond
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Other Factors that Affect BondRatings
Provisions in the bond contract
Secured versus unsecured debt
Senior versus subordinated debt Guarantee provisions
Sinking fund provisions
Debt maturity
(More…)
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Other factors
Earnings stability
Regulatory environment Potential product liability
Accounting policies
I t t t ( i ) i k f 1
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Interest rate (or price) risk for 1-year and 10-year 10% bonds
i % 1-year Change 10-year Change
5% $1,048 $1,386
10% 1,0004.8%
1,00038.6%
15% 9564.4%
74925.1%
Interest rate risk: Rising mrkt i %
(rd) causes bond’s price to fall.
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0
500
1,000
1,500
0% 5% 10% 15%
1-year
10-year
r d
Value
What is reinvestment rate
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What is reinvestment raterisk?
The risk that CFs will have to bereinvested at future lower rates,
reducing income. Illustration: Suppose you just won
$500,000 playing the lottery. You’ll
invest the money and live off interest. You buy a 1-year bond with a YTM of10%.
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Year 1 income = $50,000. At year-endget back $500,000 to reinvest.
If rates fall to 3%, income will dropfrom $50,000 to $15,000. Had youbought 30-year bonds, income would
have remained constant.
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The Maturity Risk Premium
Long-term bonds: High interest rate risk, lowreinvestment rate risk.
Short-term bonds: Low interest rate risk,high reinvestment rate risk.
Nothing is riskless!
Yields on longer term bonds usually are
greater than on shorter term bonds, so theMRP is more affected by interest rate riskthan by reinvestment rate risk.
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Other types of Bonds
Zero coupon:
Pays no coupon & sells @ disct below par
Convertible: To stock @fixed price @ bondholder’s option
Income:
Pays interest only if interest earned by issuer;won’t bankrupt co.
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Other types of Bonds
Revenue:
Interest paid from revenue generated by projectbeing financed by bonds
Floating rate:
Adjusts coupon rate periodically based onmarket interest rates
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Bankruptcy
Two main chapters of FederalBankruptcy Act:
Chapter 11, Reorganization Chapter 7, Liquidation
Typically, company wants Chapter 11,
creditors may prefer Chapter 7.
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If company can’t meet its obligations, it filesunder Chapter 11. That stops creditors fromforeclosing, taking assets, and shutting downthe business.
Company has 120 days to file areorganization plan.
Court appoints a “trustee” to supervisereorganization.
Management usually stays in control.
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Company must demonstrate in itsreorganization plan that it is “worth
more alive than dead.” Otherwise, judge will order liquidation
under Chapter 7.
If the company is liquidated
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If the company is liquidated,here’s the payment priority:
Past due property taxes Secured creditors from sales of secured assets. Trustee’s costs
Expenses incurred after bankruptcy filing Wages and unpaid benefit contributions, subject to
limits Unsecured customer deposits, subject to limits Taxes Unfunded pension liabilities Unsecured creditors Preferred stock Common stock
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In a liquidation, unsecured creditors generallyget zero. This makes them more willing toparticipate in reorganization even though
their claims are greatly scaled back. Various groups of creditors vote on the
reorganization plan. If both the majority ofthe creditors and the judge approve,
company “emerges” from bankruptcy withlower debts, reduced interest charges, and achance for success.