The term “bond” refers to a variety of assets which offer a wide range of interest rate payments from fixed cash payments, to accruals without cash, to payments in the form of additional securities.
The bond indenture is a document that sets forth the obligation of the issuer & the rights of the bond holders.
Corporate trustee act in a fiduciary capacity on behalf of the bondholders. They authenticate the issue & monitor the corporate activities to make sure the issuer abides by the indenture’s covenants.
All corporate bonds offering over $5 million & sold in interstate commerce must have a corporate trustee as set forth in the Trust Indenture Act.
The maturity date of a bond is when the bond issuer’s obligations are fulfilled. At maturity, the issuer pays the principal & any accrued interest or premium. The contract may terminate prior to the maturity date if the corporation chooses to retire the bonds early.
* Participating bonds : Pays atleat the specified interest rate but may pay more if companies profit increase.
* Income bonds : Pays almost the specified interest but they may pay less if the companies income is not sufficient.
* Deferred interest bonds (DIB) : DIB will not pay cash interest for some number of years early in the life of the bond. That period is the deferred-interest period.
* Payment in kind bonds (PIK) : PIK bonds pay interest with additional bonds for the initial period, and then cash interest after that period ends.
* A zero-coupon bond’s interest rate is determined by the original-issue discount (OID):
original-issue discount (OID) = face value — offering price
There is a zero reinvestment risk in zero-coupon bonds.
* Fixed-price call : The firm can call back the bonds at specific prices that can vary over the life of the bonds as specified in the indenture.
* Make-whole call : In this case, market rates determine the call price, which is the present value of the bond’s remaining cash flows subject to a floor price equal to par value
Credit Default Risk Credit Spread Risk
A method commonly used to evaluate credit spread risk is spread duration. The duration of the spread is the approximate percentage change in a bond’s price for a 100 basis point change in the credit spread assuming that the Treasury rate is constant.
Event risk addresses the adverse consequences from possible events such as mergers, recapitalizations etc. Such events can drastically change the firm’s capital structure and reduce the creditworthiness of the bonds and their value. Investors can lobby for clauses in the indenture to activate a put option for a variety of reasons including a change in the bond’s rating.
High-yield bonds are those bonds rated below investment grade by ratings agencies. There are many types of high-yield bonds.
High-yield bonds can have several types of coupon structures. There are reset bonds, where designated investment banks periodically reset the coupon to reflect market rates and the creditworthiness of the issuer. There are also deferred-coupon structures, which include three types:
A default occurs if there are any missed or delayed disbursements of interest and/or principal.
The recovery rate is the amount received as a proportion of the total obligation after a bond defaults. The value of the total obligation requires computing the present value of the remaining cash flows at the time of the default.
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