Chapter 6
three types of corporate bonds
Zero-coupon bonds Floating-rate bonds Convertible bonds
Measure of an issuer's credit quality
Bond ratings
can be exchanged for a specified number of shares of the issuing corporation's common stock.
Convertible bonds
The interest payments made to the bondholder
Coupon
Annual interest payment, as a percentage of face value
Coupon Rate
Annual coupon payments divided by bond price
Current Yield
______________ measure the portion of total return that is due to the coupon interest payments It ignores the portion of return due to price changes, or capital gains
Current yield
The risk that a bond issuer may default on its bonds
Default or Credit Risk
The additional yield on a bond that investors require for bearing credit risk
Default premium
Payment at the maturity of the bond
Face Value (Par Value or Principal Value)
T/F "The current yield is less than the yield to maturity whenever the bond price is greater than the face value." State whether the statement is true or false?
False. The current yield exceeds the yield to maturity on the bond because the bond is selling at a premium. At maturity the holder of the bond will receive only the $1,000 face value, reducing the total return on investment.
have coupon payments that are not fixed but fluctuate with short-term interest rates.
Floating-rate bonds
Bonds rated Baa or above by Moody's or BBB or above by Standard & Poor's
Investment grade
Bond with a rating below Baa or BBB
Junk bonds
Timeline for zero-coupon bond
No interest payments Pays par value at maturity
How did the calculation change, given semi- annual coupons versus annual coupon payments? time periods
Paying coupons twice a year, instead of once, doubles the total number of cash flows to be discounted in the PV formula.
How did the calculation change, given semi- annual coupons versus annual coupon payments? discount rate
Since the time periods are now half years, the discount rate is also changed from the annual rate to the half year rate.
A listing of bond maturity dates and the interest rates that correspond with each date
Term Structure of Interest Rates
If you need to value a bond with many years to run before maturity, it is usually easiest to value the coupon payments as an annuity and then
add on the present value of the final payment.
For the issuer, the _____ is a loan that requires regular interest payments and repayment of the borrowed principal
bond
Security that obligates the issuer to make specified payments to the bondholder
bond
The U.S. _____ market is over twice the size of the U.S. ______ market - Total outstanding debt in 2007: $29.2 trillion - Total market value of common stock: $14.2 trillion
bond stock
As interest rates change, so do
bond prices
Governments and corporations borrow money by selling
bonds
The yield to maturity is a measure of a bond's total return, including both
coupon income and capital gain.
For bonds priced at face value the answer is easy. The rate of return is the
coupon rate
The ____________ merely tells us what cash flow the bond will produce
coupon rate
The bond's interest rate is called a __________
coupon rate
is the chance the issuer will not be able to repay on a timely basis
credit risk
Bonds are ______ obligations
debt
The difference between the promised yield on a corporate bond and the yield on a U.S. Treasury bond with the same coupon and maturity is called the
default premium
The greater the chance that the company will get into trouble, the higher the __________- demanded by investors.
default premium
A bond priced below face value sells at a
discount
the coupon rate is NOT the _______ _____ used in PV calc
discount rate
The coupon rate is listed on the bond as a percentage of par value and determines the
dollar amount of interest paid to bondholders
When the interest rate rises, the present value of the payments to be received by the bondholder ______ and bond prices ______. Conversely, a decline in the interest rate _________ the present value of those payments and the price of bonds.
fall falls increases
Amount and timing of cash flows are known
fixed-income securities
Bonds are also known as
fixed-income securities
Investors in discount bonds receive a capital gain over the life of the bond; the return on these bonds is _________ than the current yield: Because it focuses only on current income and ignores prospective price increases or decreases, the current yield does not measure the bond's total rate of return. It ___________ the return of premium bonds and____________ that of discount bonds.
greater overstates understates
Yield is affected by credit risk - Lower quality bonds offer __________ yields - Higher quality bonds offer _______ yields
higher lower
Bond prices change as ______________ and __________
interest rates firm risk change
Bonds rated Baa and above are called ________________, while those with a rating of Ba or below are referred to as speculative grade, high yield, or ________
investment grade junk bonds
In the presence of inflation, an investor's real interest rate is always _______ than the nominal interest rate
less
Investors who buy a bond at a premium must absorb a capital loss over the life of the bond, so the return on these bonds is always ______ than the bond's current yield.
less
When the market interest rate exceeds the coupon rate, bonds sell for_______ than face value. When the market interest rate is below the coupon rate, bonds sell for _______ than face value.
less more
__________ bond prices are more sensitive to shifting interest rates.
long-term
First, the prices of ________ bonds fluctuate much more than prices of ________ bonds
long-term short-term
A change in interest rates has only a modest impact on the present value of near-term cash flows but a much greater impact on the value of distant cash flows. Therefore, any change has a greater impact on the price of ______________ than the price of _______________
long-term bonds short-term bonds.
Therefore, in periods of high and variable inflation, we would expect to see much more variation in the ________ rate than the ______ rate.
nominal real
Zero coupon bonds sell at a substantial discount to
par
When first issued, bonds sell at
par value
Corporate bond prices are quoted in terms of
percent of par a bond worth $1,150 would be listed at 115, while a bond worth $870 is quoted as 87
A bond that is priced above its face value is said to sell at a
premium
However, the interest rate changes from day to day. These changes affect the _______________ of the coupon payments but not the payments themselves.
present value
Total income per period per dollar invested
rate of return
The price of a bond is the present value of all cash flows generated by the bond (i.e. coupons and face value) discounted at the
required rate of return
When the bonds trade among investors in the _________ _______, the price will likely differ from par value
secondary market
Corporate debt can be dependable or as risky as a dizzy tightrope walker—it depends on the value and the risk of the firm's assets. Bondholders can never eliminate default risk, but they can take steps to minimize it. Here are some of the ways that they do so:
seniority security protective covenants
If investors don't like price fluctuations, they will invest their funds in ___________ unless they receive a higher yield to maturity on long-term bonds.
short-term bonds
In finance, "plain vanilla" means
simple, standard, and common.
in general, bonds are less risky than ______
stocks - But, like all assets, high-yield bonds have higher risk
If the bond's yield to maturity remains unchanged during the period, the bond price changes with time so that the total return on the bond is equal to ___________ The rate of return will be less than the yield to maturity if interest rates _____, and it will be greater than the yield to maturity if interest rates _____.
the yield to maturity. rise fall
Is there any connection between the yield to maturity and the rate of return during a particular period?
yes
Bonds are debt obligations for (3)
• Corporations • Federal government and federal agencies • States and local governments
Credit rating agencies
• Investment-grade bonds are AAA to BBB rated • Junk bond (high-yield) are rated below BB
Bond rating agencies, such as Moody's and Standard & Poor's, monitor debt and report their findings as a grade, or rating shows what (3) things
• Issuers' financial condition • General economic conditions • Economic value of underlying collateral
Plot of relationship between bond yields to maturity and time to maturity
Yield Curve
Discount rate for which the present value of the bond's payments equals the price
Yield To Maturity
measures the total return to the bondholder if the bond is held to maturity It takes into account both the price paid for the bond and the amount of coupon interest
Yield To Maturity
repay principal at maturity but do not have coupon payments along the way. (Zero-coupon Treasuries are called "strips" because coupons are stripped away from the bonds and sold separately.)
Zero-coupon bonds
Because the inflation rate is uncertain, so is the real rate of interest on the
Treasury bonds.