FIN-2Lecture 9-The Term Structure of Interest Rates and Yield Derivation

Liquidity risk the risk that investors may have

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Unformatted text preview: d prices fall (rise); The longer the time to a bond’s maturity, the greater its interest rate risk. § Liquidity risk: The risk that investors may have difficulty finding a buyer when they want to sell and may be forced to sell at a significant discount to market value. § Market risk: The risk that the bond market as a whole would decline § Default risk: The possibility that a bond issuer will be unable to make interest or principal payments when they are due. § Inflation risk: purchasing power risk of a bond investor’s future Bond Ratings § Bond ratings are letter grades that designate investment quality § Private bond rating agencies assign ratings based upon financial analysis of the bond issuer § Investment grade ratings are received by financially strong companies § Junk bond ratings are received by companies making payments, but default risk is high § Higher rated bonds have less default risk and pay lower interest rates Bond Ratings Determinants of Bond Safety § § § § § Coverage Ratio – ratio of company earnings to Fixed Costs (examples: times interest earned and fixed charge coverage ratio). Low or falling coverage ratios indicate possible CF difficulties. Leverage Ratio – Debt-to-Equity ratio – too high ratio indicate excessive indebtedness, signaling possible default. Liquidity Ratios – current ratio, acid-test ratio – these measure the firm’s ability to pay bills coming due with its most liquid assets. Profitability Ratios – return on assets (ROA) is the most popular ratio in this category. Firms with high ROA should be better able to raise money in security markets because they offer prospects for better returns on the firm’s investments. Cash flow-to-debt Ratio – this is a ratio of total CF to Major Bond Sectors § Bond market is comprised of a series of different market sectors: § § § § Government Treasury issues Municipal bond issues (issued by local Governments) Corporate bond issues (issued by private companies) Differences in interest rates between the various market sectors are called yield spreads Bond Yields and Interest Rates Inflation Inflation goes G , interest rates go G Inflation goes G , interest rates go G Interest Rate Sensitivity § § § § § § Bond prices and yields are inversely related: as yields increase, bond prices fall; as yields fall, bond prices rise An increase in a bond’...
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