Chapter 3 additional bond features and risks

What will not affect the marketability of a corporate bond? (A) Bond rating (B) Maturity (C) Bond denominations (D) Block size

(C) Bond denominations The higher rated a bond, the more marketable. The shorter the maturity, the more marketable it is. For corporate bonds, the most marketable blocks are 5 bonds up to 100 bonds. Under 5 is an odd lot, over 100 is a large block which is more difficult to trade. The bond denominations have no effect on marketability.

Bond Put Features

- A put gives the investor the right to sell the bond (the investor can put the bond) back to the issuer after a specified date, at a specified price (typically par). - A put option also is called a tender option. since the put option is a benefit to the investor, puttable bonds carry lower coupon rates than non-puttable issues. - The bondholder is likely to exercise the put option if interest rates rise. As interest rates rise, bond prices fall. If the bond's price drops below par, the bondholder can tender the bond to the issuer and receive the full par value. The bondholder can reinvest the principal into a bond with a higher coupon rate.

Which bonds are more volatile: bonds with higher coupon rates or bonds with lower coupon rates?

- Bonds with lower coupon rates are more volatile. Lower coupon bonds do not pay large interest payments, and therefore do not provide as much of a cushion.

Variable rate bonds

- Have an interest rate that is periodically reset to a market index. This causes the coupon rate to move in the same direction as the interest rate. As market interest rates move up, so will the interest rate on the bond; and as market interest rates move down, so will the interest rate on the bond. The price for variable rate bonds usually stays close to par because their interest rates move with the market rates. as a result, variable rate bonds do not have interest rate risk.

Volatility summary points

- Long-maturity bonds are more volatile - Short-maturity bonds are less volatile - Low-coupon (discount) bonds are more volatile - High-coupon (premium) bonds are less volatile

The Yield to Call relation to a Yield to Maturity for a discount bond.

- The YTC is typically higher than the YTM for a discount bond. This is because the investor is receiving the gain between the discounted price paid and the amount received prior to maturity.

The Yield to Call relation to Yield to Maturity for a premium Bond

- The YTC on a premium bond is typically lower than the YTM. calls on premium bonds are usually bad for the investors because they are being forced to redeem the bond prior to maturity. The investor paid more for the bond, a premium, because of the issue's attractive, higher coupon. The investor loses the higher coupon payments earlier when the bond is called and now must find a new bond at the current, lower interest rate.

YTM/YTC test taking tips

- The YTC will be higher than the YTM for a bond trading at a discount - The YTC will be lower than the YTM for a bond trading at a premium - The YTW for a bond trading at discount will be the YTM - The YTW for a bond trading at a premium will be the YTC. - YTW means Yield To Worst

Marketability risk

- The risk that the security will be difficult to sell in the future. Many factors affect marketability including: > The issue's size > The number of traders in the market Marketability risk is virtually nonexistent for Treasury bonds, but it is a major concern in the municipal bond market

Duration

- The term used to express a bond's overall sensitivity to interest rate swings. - A long-duration bond (long maturity, low coupon) is a very price-sensitive bond - A short-duration bond (short maturity, high coupon) is a very price-stable bond Long-term zero-coupon issues are most volatile of all bond issues

Purchasing power risk (inflation risk)

Is the risk that the investor will be able to buy fewer goods and services when the bond matures if inflation has caused prices to rise since the bond was issued. The only bond that gives protection against purchasing power risk is a Treasury Inflation-Protected Security (TIPS), which is issued by the U.S. government specifically for this purpose. Other forms of securities such as equities hedge against this risk since these assets often grow at rates that exceed the inflation rate

When interest rates rise:

Puttable bonds are likely to be redeemed

Prepayment risk

Risk that an investor's principal will be repaid prior to maturity. This risk applies primarily to mortgage-backed securities (MBSs) and occurs when interest rates fall. As rates fall, mortgage holders refinance their homes at a lower rate, causing the MBS investor to receive their principal back sooner than expected. When the investor tries to reinvest the principal, they can't get as high a rate.

Currency risk

Risk that the value of the foreign currency in which the investment is denominated weakens, causing the value of security to fall. Only applies to investments in foreign securities. Note that when the value of foreign currency weakens against the U.S. dollar, it is the same as the U.S. dollar strengthening against the foreign currency.

Nonsystematic risks

Risks that are unique to individual securities, industries, or countries. If a bond portfolio is not properly diversified, a decline in a single bond's value may have a greater impact on a portfolio's overall return. Business risk and credit risk are good examples of nonsystematic risk. This risk can be lessened and even eliminated by diversifying the portfolio.

How Standard & Poor and Moody differentiate ratings

Standard & Poor can adjust a rating slightly by adding a + or - to the rating Moody can adjust ratings by adding a 1, 2, or 3 ranking

Where does speculative Grade start

Standard and Poor's: BB (last investment grade is BBB) Moody's: Ba (last investment grade is Baa)

Liquidity risk

The inability to sell an investment quickly, at a competitive price, without any loss of principal. Liquidity risk assumes that the security is thinly traded and may be difficult to sell at the bond's actual value. Short-term high-quality issues are liquid. The longer the term and the lower the quality, the less liquidity.

Systematic risk

The risk that an investment's value will decline because the entire market declines. For bonds, interest rate risk is considered a systematic risk. As interest rates rise, the prices of all bonds will fall. Inflation risk is also a systematic risk: as inflation increases, all bondholders have a difficult time keeping up with the inflation. For stocks, market risk is a systematic risk. If the entire stock market declines, the value of individual stocks is pulled down with it. Systematic risk cannot be reduced or eliminated with additional diversification.

Reinvestment risk

The risk that interest rates will fall over the bond's life, leaving the bondholder with no choice but to reinvest the bond's interest payments at a lower rate. Zero-coupon bonds are not subject to reinvestment risk because they don't pay interest payments that need to be reinvested. ??

Political risk

The risk that investing in foreign countries that have weak political and legal systems- typically less developed countries

Capital risk

The risk that investors lose money. The risk is most prevalent in high-yield (junk) bonds as well as speculative stocks and speculative option strategies

Legislative risk

The risk that new laws could reduce the value of a security. An example would be change in the tax laws that increases the taxes on interest received from debt investments. A related idea is regulatory risk which is the result of changing rules as opposed to changing laws.

Call risk

The risk that the bonds may be redeemed prior to maturity, forcing the investor to reinvent the principal at a lower interest rate. Call risk increase as interest rates fall because issuers can call in existing higher rate issues and refund them at lower current market rates. This means the investor cannot replace their income since current issues pay lower coupon rates. The bonds most susceptible to call risk are those with high coupon rates and low premiums. Bonds with low coupon rates and high call premiums are the least likely to be called.

Business risk

The unique risk associated with a specific investment. The primary source of this risk is a company that underperforms investor expectations. This underperformance may be caused by poor management, change in technology, etc. Largest business risk is the risk that the company will go out of business and the investment will cease to exist. Business risk can be evaluated by examining a company's financial statements. Remember that business risk can be reduced by diversification. The more different securities there are in an investor's portfolio, the less impact a poorly performing one will have.

If a bond is purchased at a discount, what is true of the relationship of yield to call to the yield to maturity?

The yield to call is higher than the yield to maturity

If a customer buys debenture, M '32 at 85 which satement is true if bond is called prior to maturity?

The yield to call will be higher than the yield to maturity.

Which of the following is not true of MBSs? (A) They are subject to prepayment risk, which is more likely when interest rates rise (B) They pay varying monthly interest payments (C) They are known as pass-through securities (D) They are subject to extension risk, which means investor gets his money back slower than expected

A. Its more likely when intererst rates fall not rise

Interest rate risk

Also known as market risk - The risk that rising interest rates will cause bond prices to fall. Bonds with long-term maturities or low coupon rates, and those sold at a deep discount, are most susceptible to interest rate risk. - Interest rate risk only exists for fixed income securities, which include bonds with fixed coupon rates and preferred stock with fixed dividend rates. As market rates rise, the prices of these securities fall. This inverse relationship does not exist for variable rate bonds.

Price volatility

_ Based on the inverse relationship between price and yield, which is affected by two features: - Time to maturity - coupon rate Bonds with a shorter maturity are less volatile Bonds with a longer maturity are more volatile

Yield to Call

rem- It is a measure of how the call affects an investor's return. It is important for investors who are considering buying a callable bond to understand what happens to their return if the issuer decides to call the bond - Yield to worst : When a recommendation is made, the lesser of the yield to maturity (YTM) or YTC must be disclosed to the client so that they understand the lowest potential yield (return).

Credit risk is most highly associated with which of the following types of investments? (A) Treasuries (B) Corporate bonds (C) REITs (D) Common stocks

B. Corporate bonds Generally, credit risk, also known as default risk, is risk that a debtor will not pay a lender what it owes. Credit risk is significant to bondholders because bonds are debt securities. Credit has two parts. First, it is the risk that an issuer's perceived or actual creditworthiness will drop, causing the issuer's bonds to lose value. Second, it is the risk that the issuer will default on a bond issue and, therefore, not pay bondholders owed interest or principal. Treasury securities have practically no credit risk. Real Estate Investment Trusts (REITs) are a form equity in real estate industry so no credit risk, and common stocks are equity ownership so no credit risk.

Moody's lowest investment grade

Baa

When interest rates fall:

Callable bonds are likely to be called

Moody's rating measure:

Default risk of debt issues

Call premium

From investor's perspective, the increase over pal value they receive when the bond is called