Ch.2
Bond trading at premium
-NY(coupon)>CY>YTM>YTC
Refunding
-Retiring an outstanding bond issue at maturity by using money from the sale of a new offering -issuer calls bonds with a high coupon and reissues new bonds with a lower coupon
Low call premium
-attractive to issuers -allows issuer to call the bond away from investors for a lower price
investment grade
-below=speculative -Moody's= at/above Baa - S&P bonds =at/above BBB
YTC (yield to call)
-calc use First call date and any call premium
longer maturity
-more risky -have higher interest rates - less marketable
An investor purchasing 2 GMAC ZR 12's at 53 1/2 would receive annual interest of
0 The ZR in the quote indicates that this bond is a zero, it does not make semi-annual interest payments. Zero's sell at a deep discount and mature at par. The difference between the purchase price and the cash received at maturity is interest income
For a bond that Moody's rates Aa1, what is the corresponding S&P rating?
AA+ Moody's ratings use upper and lower case letters (Aa), while S&P uses all caps. Remember that "The poor wear caps." Moody's uses a 1 to indicate higher quality within a given rating. S&P uses a +.
If Standard & Poor's assigns an AAA rating to a foreign country, what rating will it usually give to the foreign country's sovereign bonds?
AAA
book entry form
All Treasury securities are issued in book entry form, which reduces printing costs for the U.S. government and supplies increased protection and ease of transfer for investors and the securities firms they do business with.
bonds are not callable
Federal government
Central depository
In a book-entry format, ownership of the security is recorded
When a bond is trading at par
Its nominal yield, current yield, and yield-to-maturity will all be equal
put feature
Requires the issuer to return an investor's principal should the investor decide to sell his bond prior to maturity.
Gov securities
T+1 settlement (next business day following trade)
A 4% municipal bond is trading in the secondary market for 96
The bond's current yield is 4.17% III. The bond's CY is less than its YTM
ABC Law Firm has just changed the rating of the Friendly School District bonds from BBB+ to AA-.
The price of these bonds would increase while their yields would fall
Trading flat
When coupons from previous interest payments are attached, the interest has not been paid. Such bonds are termed "trading flat
An investor purchases a 5% bond for 90. Rank the yields for this bond from lowest to highest
When trading at a discount the lowest yield of a bond is the nominal yield (i.e. coupon), followed by the current yield, the yield to maturity, and the yield to call. You may want to note that the yield-to-worst is always the lower of the yield to maturity or yield to call.
bond trades "flat,"
buyer is not responsible for paying interest that has accrued since the last interest payment.
Interest
difference between the discounted purchase price and par value
Zero-coupon bonds
generally long-term bonds that are purchased at a deep discount and mature to their face value. Because of the deep discount, their prices generally fluctuate more than prices of other bonds that are traded in the secondary market. They pay interest only at maturity, although imputed interest must be reported for tax purposes each year.
marketable.
if it can be traded in the market at competitive bid-ask prices.
LT v ST
long-term bonds generally have less liquidity than short-term bonds. Short-term bonds have less price change than long-term bonds when interest rates are changing. Long-term bonds are subject to greater market risk, interest-rate risk, and purchasing-power risk than short term bond.
An investor has purchased 5 ABC 3% Corporate convertible debentures with a maturity date of 20XX. This investor can expect to receive a total of $150 of interest from these bonds
once per year Corporate bonds pay interest twice per year, and together these two payments will provide the total stated coupon indicated by the issuer. In this case, the total stated coupon is 3%, which translates to $30 per year of interest income. The investor here has purchased 5 bonds, each paying $30 per year. The total interest income earned for the year on these 5 bonds is $150.
Interest rate risk
risk that rising interest rates will diminish the value of a bond
Bond in default
trade flat, meaning they do not trade with accrued interest.
A corporate bond valued at "300 over" comparable treasury securities
yielding 300 basis points more than treasury securities
If a municipal issue is quoted as "Orange County, LA, General Obligation bonds: 6.25% of 2035 at 6.45%, the bonds are selling
-discount 6.25% represents that nominal yield, or coupon rate, and 6.45% represents the yield-to-maturity. When the YTM is greater than the NY, the bond is trading at a discount as the investor will earn a capital gain upon maturity, thus yielding a higher rate than just the 6.25% coupon payments.
0 coupon bond
-interest income taxed annually -interest not paid until maturity -suitable for investors that would like to plan for a lump sum to be available at a defined date in the future.
LT bonds
-more vulnerable to interest rate risk than short term bonds -highest degree of purchasing power risk because the interest and principal received does not appreciate in value as inflation causes prices to increase. -purchasing power of the semi-annual interest payments decreases over time.
inflationary environment
-prices of goods are increasing=lower purchasing power for fixed income securities -higher interest rates, which will lead to a fall in price for bonds
LIBOR
-used as the benchmark to set a new coupon rate on a bond -variable rate bonds, unlike fixed
relationship between interest rates and bonds prices
A bond trades at a discount when its coupon rate is lower than prevailing interest rates.
affect a debt obligation's coupon
I. Ratings II. Maturity III. Covenants IV. Security Coupon refers to the annual interest rate ("pricing") paid on a debt obligation's principal amount outstanding. It can be based on either a floating rate (typical for bank debt) or a fixed rate (typical for bonds). Bank debt generally pays interest on a quarterly basis, while bonds generally pay interest on a semiannual basis. There are a number of factors that affect a debt obligation's coupon, including the type of debt (and its investor class), ratings, security, seniority, maturity, covenants, and prevailing market conditions.
Debt securities
Investors that purchase bonds are creditors of the corporation, because the corporation owes them principal and periodic interest for the use of their money. Bonds are usually issued with a par value of $1,000. The stated rate of interest is a percentage of the bond's par value.
accrued interest calculation for a government bond
based on actual day years and months. It is added to the price the seller receives at settlement and included in the total price. The calculation includes interest on the prior coupon date up to, but not including, the settlement date.
A customer purchased a 5% U.S. government bond yielding 6%. A year before the bond matures, new U.S. government bonds are being issued at 4%, and the customer sells the 5% bond.
bought it at a discount sold it at a premium When the customer purchased the bond the YTM was greater than the nominal yield. This means that the bond was purchased at a discount as the investor will realize a capital gain upon maturity. Interest rates and bond prices move in opposite directions, so when interest rates decrease to 4% the price of the 5% bond will increase as it has a higher coupon and is more attractive to investors. The customer will then be able to sell the bond at a premium.
corporate bond that has a sinking fund provision
can be offered at a lower interest rate than other bonds -Bonds that are retired through a sinking fund have less default risk, because the issuer is making payments in advance to a trustee to buy bonds in the open market. This reduction of principal risk allows the issuer to offer these bonds at a lower interest rate.
interest on a new municipal issue will begin accruing
dated date
bearer bonds
have interest coupons attached. The interest is payable to the individual who presents the appropriate coupon.
price of a bond decreases, what will happen to its current yield
incr If the price of a bond decreases, which means that the bond is trading at a discount to par, its current yield will increase. For example, if a bond with a 7.5% coupon that is issued at par trades down to a price of 98, its current yield will be 7.653%. This is calculated as $75/$980. Even though the price has decreased, the investor still receives the 7.5% coupon on the par amount.
Pre-refunding or advance refunding
issuers sells the new bonds in advance of the first available call date, typically to lock in a lower interest rate.
credit rating
measure the issuer's ability to pay interest and principal (default risk). -high=More likely to receive interest and principal payments
Municipal bonds, in addition to corporate bonds and treasury notes and bonds
pay interest semiannually. MBS:monthly
Interest rate change (ST v LT bond)
price of a long-term bond will fluctuate more than the price of a short- term bond.
Current yield
sum of annual coupon (interest) payments divided by bond market price
Non-IG bond
usually carry a higher degree of risk and pay more interest, and thus are often referred to as high yield bonds (formerly junk bonds). The markets for these bonds is typically not as liquid, so the costs associated with trading them are generally higher than those associated with trading investment grade debt.
On February 1st a customer purchases a municipal bond for settlement on February 3rd. The bond pays semi-annual interest on January 15 and July 15. How many days of accrued interest are added to the buyer's price?
18 The calculation of accrued interest includes interest on the prior payment date up to, but not including the settlement date. Municipal bond accrued interest is calculated based on 30-day months. If you start counting on the 15th of a 30 day month, there are 16 days of interest. There are 2 additional days in February for a total of 18 days of interest.
A bond would "trade flat" for all of the following reasons
A bond "trading flat" does not make a regular interest payment. This happens for a variety of reasons, including any trade involving a zero-coupon bond. When the settlement date and an interest payment date are different, there will be accrued interest involved in the trade.
A bond that was issued at par to yield 7.5% is now trading at $105. What is the bond's current yield?
A bond issued at par to yield 7.5 has a coupon of 7.5% because for a bond trading at par, the NY, CY and YTM are the same. If a bond with a 7.5% coupon is trading at $105, then the current yield = $75/$1050 = 7.143%.
A bond is trading for 102 ¾. To purchase this bond an investor will pay
A bond point is $10, and 1/8 of a bond point = $1.25. $1,020 + 7.50 = $1,027.50
A bond has annual coupons totaling $60. What is the highest price that can be paid for the bond to generate at least a 5% current yield?
Current yield is calculated as the annual coupons divided by current price. One way to solve this problem is to divide $60 by 5% = $1,200 current price. Alternatively, a 5% current yield means an investor can afford to pay up to 20 times total annual coupons = $60 X 20 = $1,200.
If a bond declines in price, which of the following results in yield will occur
Current yield will rise Coupon yield, or nominal yield, doesn't change over the life of the bond, so it isn't sensitive to price changes. Current yield is the sum of annual coupon (interest) payments divided by the bond's current price. It moves inversely with prices. As bond prices decline, the current yield rises; as bond prices increase, the current yield falls.
A 20-year U.S. Treasury bond was bought at a price of $945 in July. By the end of the year, its price had increased to $1,075. What most likely caused the price to rise?
Interest rates fell The most likely factor that caused a change in the trading value of a bond is a change in prevailing market interest rates. The inverse relationship between bond price and interest rates instructs that when interest rates go down, bond prices go up. Likewise, if rates go up, bond prices go down.
major factor in determining the price of long-term bonds
Interest rates have a significant impact on the prices of bonds because a bond's price changes as the bond's interest rate differs from prevailing market interest rate. When prevailing market interest rates are higher than a bond's interest rate the price of the bond will fall. If the bond's interest rate is higher than the prevailing market interest rate the price of the bond will increase. This relationship is called an "inverse relationship" because when one goes up, the other goes down.
Most beneficial call date
Investors prefer a longer call date in order to better protect themselves from call and reinvestment rate risk.
An investor should expect the greatest price increase in which of the following if interest rates decline?
Long-term bonds selling at a discount Because of the inverse relationship between price and yield, when interest rates fall, bond prices rise. Longer maturities have more market risk, so their prices rise more than shorter maturities. Bonds selling at a discount also rise more sharply than those selling at a premium.
On Friday September 1st a customer purchases a municipal bond for regular way settlement. The bond pays semi-annual interest on December 1 and June 1. How many days of accrued interest are added to the buyer's price?
Regular way settlement for municipal bonds is T+2 business days, and the accrued interest calculation is based on 30-day months. There are 30 days in June, 30 days in July, 30 days in August, and 4 in September due to the weekend (settlement date is Tuesday September 5th). The buyer's price includes interest that goes up to, but does not include the settlement date.
Two bonds have relatively equal credit quality and terms to maturity.
The bond with the higher coupon is more marketable. All other factors being equal, bonds with higher coupons are more marketable, and more attractive to investors than bonds with lower coupons. Investors will pay more for the bond with the higher coupon unless it is more risky. Bonds of equal credit quality and terms to maturity will likely have similar yields, but their coupon rates of interest may be very different
A bond that was yielding 3.65% yesterday is currently yielding 3.75%
The bond's price went down since yesterday -The bond's yield is 10 basis points more today. There is an inverse relationship between bond prices and bond yields. Because the bond's yield is more today, its price fell. Basis points measure the change in interest rate. Each basis point equals 1/100 of a percent. (A change of 1 percent = 100 basis points). A change from 3.65% to 3.75% is a change of 10 basis points.
An investor purchased 10 State of Nevada bonds at 104 5/8. The total price of the bonds is
The price of one bond is $1,040. + 6.25, or $1,046.25. The price of 10 bonds is $10,462.50.
An investor would most likely buy a floating rate security issued by the U.S. Treasury for which of the following reasons
To protect against interest rate volatility Floating rate securities feature an interest rate that varies or "floats" based on the performance of an underlying benchmark rate. Investors purchase them to protect against volatile interest rates, as these securities can help reduce the risk of locking in a low rate for a long period of time.
A customer purchased a Treasury bond in a regular way transaction on Monday, April 4th. The bond is a J&J bond. How many days of accrued interest will the seller receive?
Treasury bonds accrue interest on an actual days basis and use a 365 day year. They settle T+1, in this case on Tuesday, April 5th. Interest accrues from the last interest payment date (January 1st), up to, but not including the settlement date: January - 31 days February - 28 days March - 31 days April - 4 days 94 days
An investor owns a 9% coupon bond with par value of $1,000. The bond can be called after 5 years for a call premium of 104.5. Assuming the bond is called away at the earliest possible date, how much money will the investor receive upon redemption?
When a bond is called away, an investor receives the call premium (104.5 percent of par, or $1,045) plus the final semi-annual coupon payment: 9% x $1,000 par / 2 = $45. Therefore, $1,045 call premium + $45 interest = $1,090
accrued interest
ex.An investor purchases a $10,000 5% municipal bond. The trade settles regular way on March 13th. The bond pays interest on January 1 and July 1. How much accrued interest is added to the price the seller receives? A $10,000 5% municipal bond pays $500 of interest each year. The number of days of interest is 72 (30 + 30 + 12), so the amount of interest is $500 x 72/360 or $100.
Nominal yield
sum of annual coupon (interest) payments divided by the face amount of the bond
Current yield
sum of the annual coupons (the numerator) divided by current price (the denominator).
Sinking fund
-retire corporate debt -Issuers set aside money each year by making payments to a trustee who retires part of the issue by purchasing the bonds in the open market.
price of the bond as maturity approaches
-trend towards par -ex.bond has a coupon of 6.0% and a yield-to-maturity of 6.1%, trading at discount, price will increase to arrive at par value by maturity
On March 15, 2011, an investor buys a $1,000 par value 6% J&J 15 bond that can be called away at 103.75. If the bond is called on July 15, 2016, how much would the investor receive at redemption?
1067.5 When a bond is called away the investor receives a call premium along with any interest accrued since the previous coupon date. In this case, the investor would receive 103.75% of par ($1,037.50) along with the final semi-annual coupon payment of 3% ($30).
On Monday, March 1st a customer purchases a Treasury bond for regular way settlement. The bond pays semi-annual interest on January 1 and July 1. How many days of accrued interest are added to the buyer's price?
60 Regular way settlement for government bonds is T+1, and the accrued interest calculation is based on actual day months. There are 31 days in January, 28 in February, and 1 day in March (the buyer's price includes interest that goes up to, but does not include the settlement date).
redemption of a bond
If a bond is called away prior to maturity the investor may receive a call premium. If a bond is called away prior to maturity the investor receives the final interest upon redemption.
In interest-bearing bonds, accrued interest that is due the seller must be included in settlement. According to industry rules, the accrued interest must be calculated up to what date?
T+1 For interest-bearing fixed income securities, interest is accrues up to (but not including) the settlement date, which is the second business day following the trade date (T+2). Put differently, accrued interest includes the trade date and T+1, but not on T+2 (settlement). On T+2, the interest accrues to the buyer of the bond.
Which of the following statements is true about a callable bond that is trading at a premium?
The bond is most likely to be called to save interest expense. Bonds are most likely to be called to save interest expense. It is most advantageous to an issuer to call bonds that are paying more interest than bonds that are already outstanding. Such bonds would be trading at a premium. Bonds are called at par, although at times a call premium is paid. Interest is no longer paid after a call.
accrued interest for municipal bonds
based on 360 day years and 30 day months. It is added to the price paid to the seller, and includes interest payable up to the settlement date only. Bonds that trade flat do not include accrued interest.
New municipal bond accrued interest
calculation begins on the dated date, and includes interest up to, but not including the settlement date.
par value of a bond
fixed amount that is also known as its face or principal value. It is the amount of money that an investor will receive at maturity. Par value does not fluctuate based as interest rates change.
An investor purchased a 5 1/2% bond to yield 6 1/2%. If the company calls the bond at par before maturity, the investor's return would be
greater than 6 1/2% For this bond, NY = 5.5% and YTM = 6.5%. With YTM>NY, this indicates that the bond is sold at a discount, and for a discount bond, YTC > YTM.
accrued interest
is measured from the last interest payment date (coupon date) up to but not including the settlement date of the trade. Settlement date is not included in these accrued interest computations because legal ownership of the bond changes on settlement date and this is the date from which the new owner of the bond begins earning his own interest. is calculated based on 30-day months, and starts on the date of the prior interest payment. It does not include interest payable on the settlement date. The dated date is only relevant for the calculation of accrued interest on newly issued municipal bonds.
High sinking fund
issuer need maintain a large reserve of cash to maintain the bond.
An investor purchases a T-Bond in the open market, paying 3% interest. The next day, the fed increases the discount rate. In this scenario, the investor would be immediately concerned with
market risk When interest rates increase, the immediate impact will be a decline in bond prices. Interest rate risk is also referred to as market risk. It is possible that higher rates could also lead to higher inflation, but that would be a longer term concern.
yield to maturity (YTM
measures the total return of a bond, held from the current date through scheduled maturity. It includes both scheduled interest payments and any capital gain or loss - i.e., the difference, if any, between the current price and maturity value. The denominator in YTM is the current bond price. So, YTM changes as current bond prices change.
nominal yield
or coupon is the stated interest rate that the purchaser of a bond will be paid on the bond's par (face) value, expressed as a percentage. Hence, the nominal yield on a $1,000 par bond ($100 price) that pays a 7.5% coupon is simply 7.5%.
bearer bond
owner:bearer of the bond certificate ;not formally recorded new ones banned in 1982 -today=cash
payment at maturity
par value plus the final semi-annual coupon payment.
An investor buys an 8.0% coupon bond to yield 7.0%. What will most likely happen to the price of the bond as maturity approaches?
price decr toward par This bond has a coupon of 8.0% and a yield-to-maturity of 7.0%, indicating that the bond is trading at a premium. The price of a bond will always trend towards par as maturity approaches. Given that this bond is trading at a premium (e.g. 105% of par), the price would need to decrease to arrive at par value
transfer agent
reviews all information for accuracy and completeness. It checks to ensure signatures are authentic, but does not guarantee them. The guarantee of the signature is handled by the broker-dealer through the Medallion Stamp process.
Reinvestment rate risk
risk that is created by a downward trend in interest rates Downward trends in interest rates cause reinvestment risk because it may be difficult to find comparable yields for reinvestment of principal or interest payments. Interest rate risk occurs as interest rates increase, causing a subsequent decline in bond prices.
Purchasing power, or inflation risk
risk that the returns of an investment will be adversely impacted by inflation. major concern for investors who hold portfolios of fixed income investments for funding retirement income. As inflation increases, the purchasing power of their fixed coupon will fall.
variable rate bonds
they typically have greater price volatility than fixed rate bonds The price of a variable rate bond remains relatively stable because the interest rate adjusts to prevailing conditions. As the name implies, the rate of interest paid will vary over the life of the bond. The amount of interest is tied to an underlying index; LIBOR + a spread is frequently used as the base rate. Lenders take on the interest rate risk because the interest payments they receive are subject to fluctuation.
discount
when its coupon rate is lower than prevailing interest rates.
