Fixed-rate debt

In Chapter 8, we described several models to measure the term structure of credit spread and we introduced the model proposed by Longstaff and Schwartz (1995) for pricing fixed-rate debt. The authors propose also a model to valuing floating-rate notes. The equation derived for pricing floating-rate bonds is given by (10.2) ... 

Longstaff, F.A., Schwartz, E.S., 1995. A simple approach to valuing risky fixed and floating rate debt. J. Financ. 50 (3), 789-819. 

A fixed-rate bond pays fixed coupons during the bond s life known with certainty. Conversely, a floating-rate note ox floater pays variable coupons linked to a reference rate. This makes the coupon payments uncertain. The main pim-pose of this debt instrument is to hedge the risk of rising interest rates. Although the financial crisis and liquidity provided by central banks have decreased the level of interest rates, they will at some point of course rise in future years. 

Despite our focus on the public debt markets, banks still provide the bulk of corporate Europe s credit needs. Bank loans to commercial and industrial borrowers in Europe total 3,000 billion, compared to 651 billion of public fixed-rate investment grade debt. 

The interest-rate equivalent of the cash discounts is 2 percent per month, since this discount could he obtained every month if payment were to he made at the beginning of the month rather than, as at present, at its end. Since the hills are settled monthly, the notional interest is paid monthly and should not he compounded. The discount is equivalent to 12 monthly simple-interest payments per year. Hence, from Eq. (9-31) the effective annual interest rate on discounts = (12)(0.02) = 0.24 = 24 percent. It would, therefore, he a good use of surplus cash to reduce this debt as quickly as possible. This would require cash equivalent to one-sixth of the annual hills due, or 16,700, to he avadahle. It can, therefore, he assumed that this level of liquidity is not available for capital projects, either as working capital to reduce the debt or for fixed-capital projects. Further, since the new project will not increase sales, it cannot generate further debt of this kind. Hence, this source is not available to capitahze the new project. 

Required revenues are the sum of operation and maintenance expenses, depreciation, taxes, and a return on rate base. The rate base is the total amount of fixed capital used by the utility in producing, transmitting, and delivering electricity. The return on rate base IS the weighted average cost of capital, including debt and equity sources. 

Many companies make substantial profits by gathering and distributing information about products and companies (Klein 1997). They bear the fixed costs of learning about the relevant basic research and then sell that knowledge to others at a lower marginal cost. The A.M. Best Company rates life insurance companies actuarial and investment practices. Moody s rates the repayment risk of debt. 

Under the secured loan structure, the trustee might find it necessary under certain circumstances to enforce the fixed and floating charges. Such circumstances could include unremedied events of default under the issuer-borrower loan, or if third-party creditors were to attempt to put the company into administration. In this case, the trustee would seek to have an administrative receiver appointed on behalf of the secured creditors. However, the process could disrupt the receipt and payment of cash flows. The ratings of the notes are based on timely payment of interest (and sometimes principal) so the transaction will include some form of liquidity support, which is typically sized to enable the issuer to cover one year s debt service. 

This discussion covers the main factors affecting bond returns in the European fixed income market, namely, the random fluctuations of interest rates and bond yield spreads, the risk of an obligor defaulting on its debt, or issuer-specific risk, and currency risk. There are also other, more subtle sources of risk. Some bonds such as mortgage-backed and asset-backed securities are exposed to prepayment risk, but such instruments still represent a small fraction of the total outstanding European debt. Bonds with embedded options are exposed to volatility risk. However, it is not apparent that this risk is significant outside derivatives markets. 

The equity, Ql, is paid back to the investors at the end of operations, z3, but after first deducting the decommissioning costs, which are assumed to be 10 % of Q2. At this point, the project capital is reduced to zero. Interest on outstanding debt is charged to the project at the rate of p per cent per accounting period, but repayment is by means of a fixed sum per accounting period, starting at the start of operations, z2. 

If stocks are the building blocks of a portfolio, then so-called fixed income securities are the mortar that holds them together. While the words fixed income securities have a rather technical ring to them, conceptually, they are easy to understand. Simply put, fixed income securities simply refer to debts, or lOUs from businesses or governments. More commonly they are referred to as bonds where investors lend a certain sum, usually in 1,000 increments, in return for a quarterly or annual interest payment, and repayment of the 1,000 loan or principal at a stated future date. The name fixed income derives its origin from the fact that bonds, corporate or government, offer investors a rate of return which is usually stated and fixed. 

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