Chapter 2 Debt Securities

A bond's nominal yield is always

equal to it's coupon - nominal yield is fixed and does not change over the life of the bond

default

failure to pay back a loan - if an interest payment is missed on an outstanding debt obligation, the bond will default

A bond that includes accrued interest in its price trades "with" or "and" interest. A bond without accrued interest trades _____

flat

For a bond trading at a premium, YTC is ____than YTM because

lower the investor loses the premium paid for the bond more quickly

what features make a bond more sensitive to interest rate risk?

1. low coupon 2. long maturity - longer duration - a measure of how long a bond's price is likely to change when interest rates move

Bond quotations

price at which a bond is trading - typically expressed as a percentage of their par value - bond quote above 100 means bond is trading at premium to par - bond quote at 105 is trading at 105% of par, or 1050

When a bond matures, investors receive

principal (usually 1000) + their final semiannual coupon payment

accrued interest formula

(interest rate * par value * number of days )/360

after one year of holding the bond, the new cost basis will be? Jane buys a bond for $1,100 with five years until maturity.

1080 The annual adjustment is calculated as the $100 premium divided by five years to maturity, which equals $20. Therefore, the cost basis of the bond will be adjusted downward by $20 each year.

For corporate, municipal, and agency bonds, a year is assumed to have _____ days, with 30 days in each month. Regular way settlement is_____, which is _____ business days after the trade date. For T-notes and T-bonds?

360 T+2 two For T-notes and T-bonds, a year is assumed to have 365 days, with actual-day months. US government securities settle regular way on the next business day following the trade, or T + 1.

An investor buys a 10 year, $1000 par value bond with a 6% coupon. How much interest will the investor receive if the bond is held until maturity

6%*1000 = 60 each year 60*10 years = 600

John purchased an 8% XYZ bond for $900. The bond is now trading for 980. The bond's current yield is

8.2% current yield is annual interest payable/current market price 80/980

A 10% March & September corporate bond is traded on Monday, June 2 How many days of interest accrued?

93 days - 30 days for march April and may = 90 need to add t+1 for June so 3 days in june = 90+3=93

call risk leads to

reinvestment rate risk

zero coupon bonds do not have ______risk

reinvestment rate risk - since they do not pay a coupon, there is no interest to reinvest

trade flat

A bond that does not pay interest.

When can you call a bond?

A callable bond is usually callable anytime after the call date. For example, a 20-year bond callable after 10 years could be called anytime from year 10 through maturity, not only in year 10.

Put feature

A feature on a bond that allows the investor to redeem the bond at its face value before it matures - if the bond rating falls or interest rates increase above a certain level, the investor has the right to sell back the bond to the issuer - beneficial to investors, so they pay less interest than similar straight or non-cuttable bonds

Imputed Interest/phantom interest

An interest rate applied by the IRS when the note or contract either does not state, or contains an unreasonably low interest rate.

inflationary risk/purchasing power risk

risk that an investment's returns will be adversely impacted because of inflation

A bond has a current yield of 4.5% and a nominal yield of 4.7%. This must be what kind of bond? A. Discount B. Premium C. TermD. Callable

B

A corporate bond issued by Total Co. pays an investor interest of $25 per bond, twice per year. What is its nominal yield? A. 2.5% B. 5% C. Nominal yield will fluctuate with the bond's price. D. Nominal yield will gradually increase as the bond nears maturity.

B

reinvestment rate risk

risk that no available investments will be able to provide similar return as a bond that has been called

non-investment grade bonds

Bonds rated BB+ or lower by Standard & Poor's and Fitch and Ba1 or lower by Moody's. Also called high-yield bonds or junk bonds.

investment grade bonds

Bonds rated triple-B or higher; many banks and other institutional investors are permitted by law to hold only investment-grade bonds - lower chance of default

What determines the amount of interest paid by a floating-rate bond? A. The market value of the bond B. The general health of the company C. The value of a widely accepted bond benchmark D. The supply and demand characteristics of the bond issue

C

A corporate bond has nominal yield of 6%. Howard owns eight of these bonds. At their maturity, how much will he receive? A. 8000 B. 8048 C. 8240 D. 8480

C At maturity, the bondholder receives par value plus the final coupon interest payment. Each semiannual coupon payment is $30, and two such payments per year create the 6% yield. $1,000 Par Value + $30 Interest per Bond. $1,030 × 8 Bonds = $8,240.

Bond yield

the return an investor would receive on a bond if it were purchased and held to maturity

A corporate bond is marked M&S 15. It is now July 1. When will the next interest payment be made? A. August 1 B. September 1 C. August 15 D. September 15

D - months of payment (M&S) are March and September - 15 indicates payment will be made on the 15th

interest rate risk

the risk of capital losses to which investors are exposed because of changing interest rates - inverse relationship between price and yield - when interest rates fall, bond prices rise

call risk

the risk to bondholders that a bond may be called away from them before maturity - when interest rate are falling

Does US gov debt have default risk?

Debt issued by the US government has little risk of default due to the government's ability to raise money through taxation. For this reason, US government securities are considered risk-free from a credit perspective. They still are susceptible to other risks, however, such as interest rate and inflationary risk.

fixed income securities

Securities such as bonds, notes, and preferred stocks that offer purchasers fixed periodic income.

Serial Bonds (vs Term Bonds)

Serial bonds are outstanding bonds that mature at different intervals with a portion of the issue maturing each year - term bonds means entire issuance matures in one date in the future

cost basis

The cost used to determine a capital gain or loss on an investment - represents the value of an asset for tax purposes

dated date

The date on which interest on a new bond issue begins to accrue.

call feature

a bond feature that allows the issuer to retire the security prior to maturity - typically an issuer will pay investors a call premium - an amount above par to compensate for the early redemption - earlier the call, higher the premium

refunding

The replacement of an existing bond issue with a new one. - calling bonds when interest rates have fallen

call protection

The time during which the issuer of the bond is not allowed to exercise the call option.

when an investor received accrued interest, it is taxed...

When an investor receives accrued interest, it is taxed for them as interest income based on their ordinary income tax rate, which is the rate they pay on their salary. Because it is interest income, accrued interest does not impact the bond's cost basis, which will be discussed shortly.

When will issuer call a bond?

When the interest rates are declining - it is paying higher coupon than the current market interest rates - the company can then issue near bonds at a lower interest rate, saving money on coupon payments

does holding a zero-coupon bond to maturity help eliminate interest rate risk?

Yes, when zero-coupon bonds are held to maturity, they have no interest rate risk as the investor will receive the full principal at maturity

zero coupon bond

a bond that makes no coupon payments and is thus initially priced at a deep discount -usually long term with matures of 10 or more years - good for retirement/tuition - still have to pay taxes - prices fluctuate more than other types of bonds in secondary market

fixed rate bond

a bond that pays a fixed amount of interest to the investor each year

current yield

a bond's annual interest divided by its price - represents a bond's return based on current market price rather than its par value

duration

a mathematical formula that measures how sensitive a bond is to changing interest rates

sinking fund provision

a requirement that the firm retire a certain amount of the bond issue each year - for bonds with longer maturities so that the issuer is prepared for future redemption - set aside money in a special account called sinking fund

when a bond is purchased for a discount, the cost basis must be

accreted

As rates change... outstanding bond prices

adjust so their yield is similar to what new bonds are paying

par value/face value or principal

amount of money a bondholder will receive at maturity

escrow account

an account where money is held in trust until it can be delivered to a designated party - typically with a bank

Bond issuers engage in debt financing

as they borrow money from investors

Until 1983, bonds were commonly issued in bearer form

bearer bonds included physical certificates and interest coupons - today its registered form

floating rate bonds/adjustable rate bonds/variable rate bonds

bonds whose interest rate fluctuates with shifts in the general level of interest rates - based on specific benchmark such as Treasury Bill rate. when T-bill rate increase/decrease, so will coupon rate

what's riskier? Callable or noncallable bonds

callable bonds are risker - callable bonds will pay a higher rate than non-callable - this feature is attractive to borrower (issuer) but not so great for bond holder, who will lose the higher rate of interest the bond is paying

accretion

cost basis of the bond must be adjusted upward toward par each year so that at maturity the investor's cost basis will equal par at $1000

a bond with longer maturity and a lower (or zero) coupon will have ________ interest rate risk for the investor

greater - long term bonds are more volatile, and low-coupon are more volatile

For a discount bond, the current yield is _________ than the nominal yield

greater assuming nominal yield is 5%

For a bond trading at a discount, YTC is ____than YTM because

higher - the investor receives his discount bucket an accelerated rate

accrued interest

interest revenue or expense that is recognized before cash has been exchanged - Accrued interest is added to the purchase price of the bond. It is paid by the buyer of the bond to the seller so that the seller receives their share of the upcoming coupon when the bond is sold between coupon dates.

Long term bonds compared to short term

long term bonds pay more interest than short term bonds because of the greater uncertainty over the long term - LT bond will fluctuate in price more than a short term as interest changes

As a bond reaches maturity, its price will

move toward par - for ex, a 10 year bond trading at a discount for 93 ($930) will move toward part ($1000) as it approaches maturity

For a bond trading at a discount, which of the following yields is lowest? A. Nominal yield B. Current yield C. Yield to maturity D. Yield to call

nominal yield

Basis Point (bps)

one-hundredth of a percentage point - there are 100 bps in 1%

Interest rates and bond prices move in _____ direction

opposite

bonds are accreted on a

straight line basis To calculate the annual accretion, divide the discount off par by the number of years until maturity.

when a bond is purchased for a premium

the cost basis must be amortized

Nominal Yield

the interest rate, also known as the "coupon rate" which is named on the bond certificate - percentage of the par value - a bond that pays a coupon of 10% pays 10% of 1000 or $100 of interest per year

credit risk

the probability that the borrower will fail to pay some of the interest or principal - to attract investors, issuers that are less creditworthy must issue bonds with higher interest rates than issuers that are more creditworthy

yield to maturity

the rate of return a bondholder will receive if the bond is held to maturity

Yield to call

the rate of return earned on a bond when it is called before its maturity date

amortization

the reduction of a loan balance through payments made over a period of time