FI 311 - Chapter 6 Review

True or False: YTM is ALWAYS expressed on an Annual Basis

True

True or False: When it comes to the majority of Bonds, the Coupon Payment never changes, regardless of what the price of the Bond does

True - In this course, the Coupon Rate never changes

True or False: If a Bond has attractive features, you are willing to accept a lower yield

True - Similarly, you will demand a higher yield if the bond has unattractive features

What does it mean if there is a Capital Loss on the purchase of a Bond?

When Current Price - Amount Paid (Par Value) is Negative

What does it mean if there is a Capital Gain on the purchase of a Bond?

When Current Price - Amount Paid (Par Value) is Positive

When a Bond is sold at Par Value, what can be said of the YTM and Coupon Rate?

When a Bond is sold at Par, the Coupon Rate is the same as the yield an investor receives by holding the bond to maturity - Coupon Rate = YTM

What does it mean for a Bond to be considered Illiquid? What is the main issue with a Bond being considered Illiquid?

When a much smaller market, or no market at all, exists for a certain bond, they are considered to be Illiquid - Because the bondholder of such bonds has limited options to sell them, Bond Dealers may offer to buy bonds for extremely low prices

State if the following will have a Lower Yield or a Higher Yield: A Bond with a Protective Covenant

Lower Yield

What is the price of a bond that pays $25 semi-annually in coupons, has a Par Value of $1000, has a YTM of 6.2%, and has 13.5 years until maturity?

$891.33

A company is contemplating a long-term bond issue. It is debating between including a call provision in the bond or not. What are the benefits and costs associated with including a call provision in a bond?

- Benefits: If the Bond is callable, it can be used to refinance the company's debt by buying back the bond and re-issuing it at a lower interest rate - Costs: If the Bond is callable, investors will demand a higher yield. If a bond contains a call provision, it is an unfavorable aspect of a bond for investors. Because of this, they will demand a higher yield on the bond.

What is the Coupon Rate of a bond with a Par Value of $1000, pays $60 annually in Coupon Payments that are made semiannually, has 21 years left to maturity, sells at par, and has a YTM of 6%? What is the Coupon Rate if YTM drops to 5%?

- Coupon Rate at YTM of 6%: 6% - Coupon Rate at YTM 5%: 6%

Explain the difference between the Coupon Rate and the Required Rate of Return on a Bond

- Coupon Rate: The interest rate as a percentage of the par value of the bond - Required Rate of Return: What investors are requiring when looking at the Total Return of a Bond

What are the 2 ways in which Cash Flow can be generated by a Bond?

- Income (Coupon Payments) - Capital Appreciation (Capital Gain or Capital Loss)

Example Problem: A Bond sells at Par Value with an 8% Coupon Rate. Describe the Cash Flows generated by this Bond

- Income: $80 per year (8% of Par Value) - Capital Appreciation: $0 (The Bond was purchased at Par, and the holder will receive Par at Maturity)

Example Problem: Investors are not impressed with the bond's issuer, and feel there is an increased level of risk that Coupon Payments will not be made on time, or that the issuer will not be able to completely pay back the Par Value of the bond to the bondholders at Maturity. There is less selling pressure on the bond and investors will be willing to pay less for it. The price of the bond decreases from $1000 to $900. The Coupon Rate of this Bond is 8%. Describe the Cash Flows generated by this Bond

- Income: $80 per year (8% of Par Value) - Capital Gain: $100 (The Bond was purchased below Par ($900), and the holder will receive $1000 at Maturity) - Assuming that all of the Coupon Payments are paid on time, the investor will make *more than 8%* on their investment - The price has gone down, and the YTM has gone up - This Bond was a Discount Bond

Example Problem: Investors look favorably on the terms of the Bond and are impressed with the issuer and its likelihood to make all of its Bond Payments on time, so buying pressure causes the price to rise. The price of the Bond has increased from $1000 to $1100. The Coupon Rate of this Bond is 8%. Describe the Cash Flows generated by this Bond

- Income: $80 per year (8% of Par Value) - Capital Loss: -$100 (The Bond was purchased above Par ($1100), but the holder will only receive $1000 at Maturity) - In this case, the bondholder's overall return is *less than 8%* because of the $100 loss on the price of the Bond - The price has gone up, but the YTM has gone down - This Bond was a Premium Bond

What is the difference between a Bond's Value and a Bond's Price?

- Like any Financial Asset, a Bond's Value is the Present Value of all expected future cash flows - A Bond's Price is whatever the investors are buying and selling for at the moment in the bond market

What is the difference between Senior Bonds and Subordinated Bonds?

- Senior Bonds place highly on the Liquidation List (are likely to receive liquidated assets) - Subordinated Bonds place low on the Liquidation List (are less likely to receive liquidated assets)

What information is typically contained in a Bond Indenture?

- The basic terms of the Bond - The number of Bonds being sold (or available to be sold) - A description of Property or other assets being set aside to cover bond payments - Provisions such as Call-ability - Protective Covenants

Explain how the Rating of a Bond is related to the yield of the Bond

- The higher the Bond's Rating, the lower the risk and the lower its yield - The lower the Bond's Rating, the higher the risk and the higher its yield

Describe the Cash Flows of a Bond that sells at its Par Value

- The only source of cash flows for this Bond are Coupon Payments (Income) - In this case, the investor will not make *any* Capital Gain or Loss on the price of the Bond at Maturity (The investor pays $1000 for the Bond and receives $1000 at Maturity)

Suppose a 10% coupon bond sells today at par. Two years from now, the required return on the same bond is 8%. What is the Coupon Rate on the bond then? The YTM?

- When the bond is issued at Par, the Coupon Rate and the YTM will be the same - When the Rate of Return changes to 8%, the YTM will also change to 8% - When the Rate of Return changes to 8%, the Coupon Rate will remain 10% (Coupon Rates don't change)

A bond with 20 years to maturity, a 10% Coupon Rate that pays coupons semi-annually, and is selling for $875 will have a YTM of what?

11.62%

Kaiba Corp wants to issue new 20 year bonds for an expansion project. The company currently has 6% coupon bonds with a Par Value of $1000 already on the market; these bonds currently sell for $1,083, make semiannual coupon payments, and have 20 years remaining until maturity. What Coupon Rate should the company set on its new bond issue if it wants to sell them at Par?

5.32%

What is the YTM of a bond selling at $1,150, has a Coupon Rate of 9% paid semiannually, a par value of $1000, and has 11 years left to maturity?

7.02%

A 15 year bond currently sells at Par. It offers semi-annual payments and the payment is $36. What is the YTM of this bond?

7.2%

What is the Coupon Rate of a Bond selling for $1,076.23, has a par value of $1000, makes semiannual payments, YTM is 8%, and has 12 years remaining until maturity?

9%

All else equal, which of the following Bonds will have the higher yield: A Bond rated AA or a Bond Rated A?

A Bond Rated A - Because the rating of this Bond is lower than the other, it is risker and means that there will likely be a higher yield

What does it mean for a Bond to be considered Liquid?

A Bond is liquid when there is a large market for them that contains many willing and able buyers and sellers that can exchange the bonds with relative ease

What is a Discount Bond?

A Discount Bond is a bond whose current price is *below* Par Value - Par Value is always $1000

What is a Premium Bond?

A Premium Bond is a bond whose current price is *above* Par Value - Par Value is always $1000

How is the Annual Coupon Payment Calculated?

Annual Coupon Payment = Coupon Rate * Par Value ($1000)

What are Municipal Securities?

Bonds issued by state and local governments - The coupon payments on these bonds are tax free at the federal level

How will Bonds of similar risk and maturity be priced?

Bonds of similar risk (and Maturity) will be priced to yield about the same total return, regardless of the Coupon Rate

What are Zero-Coupon Bonds?

Bonds that do not have Coupon Payments - Because these are backed by the government, they are generally considered to be "risk-free" and tend to have small yields - EX: Treasury Bills and Principal-Only Treasury Strips

What are Secured Bonds?

Bonds whose repayment is secured / reinforced by assets - These add security for investors and tend to have lower yields - EX: Asset-Backed Bonds and Mortgage-Backed Bonds

What are Debentures?

Bonds with no assets backing up repayment - These are unattractive features to investors and tend to have higher yields - AKA Unsecured Bonds

All else equal, which of the following Bonds will have the higher yield: A Callable Bond or a Non-Callable Bond?

Callable Bond - Because the bond can be called back by the Bond Issuer at any point, the risk involved means there will likely be a higher yield

How is Capital Appreciation Calculated?

Capital Appreciation is the amount the Bond was sold for (its current price) and the amount paid for the bond

All else equal, which of the following Bonds will have the higher yield: Secured Debt or a Debenture?

Debenture - Due to the high risk associated with the Debenture, it is likely to have a higher yield

True or False: Investors will pay less for Bonds with attractive features

False - Investors will pay *more* for Bonds with attractive features - Investors will pay *less* for Bonds with unattractive features

True or False: Premium Bonds are of higher quality than Discount Bonds

False - The word "Premium" refers to the price paid for a Bond, NOT its quality

How does a Bond Issuer decide on the appropriate Coupon Rate to set on its bonds?

Firms typically set the Coupon Rate to be equal to the YTM (they issue the bonds at Par)

State if the following will have a Lower Yield or a Higher Yield: A Bond with a Call Provision

Higher Yield

State if the following will have a Lower Yield or a Higher Yield: A Non-Investment Grade Bond

Higher Yield

State if the following will have a Lower Yield or a Higher Yield: An Illiquid Bond

Higher Yield

State if the following will have a Lower Yield or a Higher Yield: A Bond with a Higher Price

Lower Yield

Companies pay rating agencies to rate their bonds. Why would they do this?

If Bonds are rated highly, investors will be more willing to pay the prices set by the company issuing them - If bonds are poorly rated or not rated at all, investors will demand a higher yield to compensate for the risk and uncertainty involved - Investors prefer Bonds with high risk / low rating to a Bond with no rating at all

Explain the general trade-off between Risk and Yield

If an Investor takes on a high level of risk, they expect a high level of reward (higher returns on their investments) - A Riskier Bond will have lower prices, but higher yields - A Low-Risk Bond will have higher prices, but lower yields

Suppose you buy a 7% coupon, 20 year bond today when its first issued. If the YTM rises to 15%, what has happened to the price of the bond?

If the YTM has increased, the price of the bond has decreased - There is an inverse relationship between Bond Price and YTM on Bonds

State if the following will have a Lower Yield or a Higher Yield: A Bond with Higher Seniority

Lower Yield

State if the following will have a Lower Yield or a Higher Yield: A Bond with a High Rating

Lower Yield

Is the YTM the same as the Coupon Rate?

No - YTM refers to the total return of a Bond - Coupon Rate determines the Coupon Payments made by the Bond Issuer to the Bond Holder

If YTM < Coupon Rate, describe the relationship between Par Value and Bond Price

Par Value < Bond Price - The higher Coupon Rate causes value above Par - Price above Par Value, called a Premium Bond

If YTM = Coupon Rate, describe the relationship between Par Value and Bond Price

Par Value = Bond Price

If YTM > Coupon Rate, describe the relationship between Par Value and Bond Price

Par Value > Bond Price - The discount provides yield above Coupon Rate - This is known as a Discount Bond

How is the Periodic Coupon Payment Calculated?

Periodic Coupon Payment = Annual Coupon Payment / Number of Payments per Year

What are Treasury Bills?

Pure Discount Bonds (zero coupon) with original maturity of one year or less

Regarding Bonds, what is Seniority?

Refers to the position Bondholders are in when it comes to receiving Assets following a Liquidation or Declaration of Bankruptcy

What are Default Risk Premiums?

Represents compensation (additional yield) for the possibility of default - As the risk increases, you want a higher yield to compensate for these risks

What are Liquidity Premiums?

Represents compensation for lack of liquidity - Bonds that have more frequent trading will generally have lower required returns (Liquid) - Bonds that have less frequent trading will generally have higher returns (Illiquid)

What are Taxability Premiums?

Represents compensation for unfavorable tax status

Describe the Cash Flows generated by Zero-Coupon Bonds

Since there is no income from these bonds, investors' returns come solely from Capital Gains - Zero-Coupon Bonds are sold below their Par Value, and the difference between the purchase Price and Par is the only source of profit for investors

All else equal, which of the following Bonds will have the higher yield: A Subordinated Debenture or Senior Debt?

Subordinated Debenture - Due to the high risk associated with the Debenture, it is likely to have a higher yield

When using Excel to calculate YTM, what does the "PMT" element of the Time Value of Money Model represent?

The Actual Coupon Payment - Coupon Payment = Coupon Rate * Par Value - To find the semiannual Coupon Payment, divide this answer by 2

What is a Bond Indenture?

The Bond Indenture can be described as the contract between the borrower (the Issuer of the Bond) and the lender (The Bondholder)

When using Excel to calculate YTM, what does the "PV" element of the Time Value of Money Model represent?

The Current Price of the Bond - This is whatever the bond is selling for on the market - Expressed as a Negative (Cash Outflow)

When using Excel to calculate YTM, what does the "FV" element of the Time Value of Money Model represent?

The Par Value / Face Value of the Bond - In this course, this will always be $1000

When using Excel to calculate YTM, what does the "RATE" element of the Time Value of Money Model represent?

The Yield-to-Maturity (YTM) - If you are calculating the YTM using semiannual data, multiply your answer by 2

What is Yield to Maturity (YTM)? What does this definition mean?

The interest rate that makes the Present Value of all future cash flows equal to its current price - The YTM is the yield an investor will receive on his or her investment if the bond is purchased now and held to Maturity

When using Excel to calculate YTM, what does the "NPER" element of the Time Value of Money Model represent?

The number of Coupon Payments remaining until Maturity - For semiannual payments, multiply the number of annual Coupon Payments by 2

Describe the relationship between Bond Prices and Bond Yields

There is an *inverse* relationship between Bond Prices and YTM - If a Bond's Price goes up, YTM decreases - If a Bond's Price goes down, the YTM increases

What does it mean if a Bond is "Callable" or contains a "Call Provision"?

These are Bonds that may be repurchased by the Bond Issuer before they Mature - Since Bondholders are obligated to give up the Bond they are holding when they are called, this is an unattractive feature for investors - While most Bonds are not Callable, those that are will tend to have to compensate investors with a higher yield

What are Asset-Backed Bonds?

When the issuer of the Bond sets aside certain assets and keeps them available to sell if they become unable to make Bond Payments (Coupon Payments and Par Value Payments at Maturity) on time

Is it true that Treasury Bills are a risk-free asset?

Yes - The risk associated with these Treasury-Bills are considered risk-free - Their risk is as close to zero as you could find in the investment world

Is the YTM on a bond the same thing as the Required Rate of Return?

Yes - They are essentially the SAME THING - If the YTM is not equal to the Required Rate of Return, market forces will change the price of the bond so that the YTM = Required Rate of Return