Investments Ch. 10

Zero-coupon bond

A bond paying no coupons that sells at a discount and provides only a payment of par value at maturity.

Convertible Bond

A bond with an option allowing the bondholder to exchange the bond for a specified number of shares of common stock in the firm.

Coupon rate

A bond's annual interest payment per dollar of par value

Bond

A debt instrument that promises a fixed stream of payments during its life and then a principal at the end

How do we determine the level of bond's default risk?

Bond default risk is measured by Moody's, Standard & Poors, and Fitch. All of these ratings agencies provide financial information on firms as well as the credit risk of large corporate and municipal bonds.

Discount bonds

Bonds selling below par value

Callable Bond

Bonds that may be repurchased by the issuer at a specified call pricing during the call period.

Floating rate Bonds

Bonds with coupon rates periodically reset according to a specified market rate.

Yield curve facts

Bonds with shorter maturities offer lower yields to maturity Rising yield curves are mot commonly observed

What is default risk and how does it impact bond prices (required yields on bonds)

CHECK Default Risk: The event in which companies or individuals will be unable to make the required payments on their debt obligations. Impact on bond prices: If company is at risk of default, bonds will sell at a low percentage of par value and in turn raising the yield to maturity on these bonds

Understand the factors that determine safety of the bond

Coverage ratios: Company earnings to fixed costs Leverage ratio: Debt to equity Liquidity ratios Current: Current assets to current liabilities Quick: Assets excluding inventories to liabilities Profitability ratios: Measures of RoR on assets or equity Cash flow-to-debt ratio: Total cash flow to outstanding debt

Maturity date

Date when bond expires, pays par value

Understand the difference between flat (quoted) price and invoice price

Flat price: Quoted prices that do not account for the accrued interest between coupon payments Invoice Price: what the investor actually pays. flat price+accrued interest.

Know how and why bond prices change

Interest rate fluctuations

Yield to maturity

Internal rate of return for the bond you will be able to reinvest coupon at YTM rate Yield to maturity measures average RoR if investment held until bond matures Assumes that all coupons are reinvested at YTM Is known at time of purchase

Holding Period Return for Bond

Practice set

Understand the basics of the expectations theory--- this stuff will be conceptual question on test

Read it over again, its actually pretty swaggy The theory states that the slope of the yield curve is attributable to expectations of changes in short-term rates. Relatively high yields on long-term bonds reflect expectations of future increases in rates, while relatively low yields on long-term bonds (a downward-sloping or inverted yield curve) reflect expectations of falling short term rates. check it out, if you were to roll up with a one year bond yielding 8% and then the next year you roll up with bond investing and shit and this bond gives you 10%, then a two year bonds gotta compete with this by throwing a 9% bond your way (average out the 8 and the 10). Hence, if a yield curve for a long term bond is up, thats because these long term bonds are compensating for interest rates to increase, can you dig it? Further, one of the implications of this theory is that expected holding-period returns on bonds of all maturites ought to be about equal. One more thing, inverted yield curves, which imply falling interest rates, turn out to be among the best indicators of a coming recession.

Know what a yield curve is

Read page 322 onward Yield Curve Graph of yield to maturity as function of term to maturity Term Structure of Interest Rates Relationship between yields to maturity and terms to maturity across bonds Expectations Hypothesis Yields to maturity determined solely by expectations of future short-term interest rates

Importance of yield to maturity to a bond

The higher the yield to maturity the lower the sensitivity of the bond. With a high YTM a lower proportion of the yield comes from that last pmt

face value, par value

The payment to the bondholder at the maturity of the bond

Understand the basics of the liquidity preference

This theory kinda goes against the other one. Its big thing is that risks of long and short term bonds are not equivalent. Like for example, longer term bonds are subject to greater interest rate risk. As a result, this theory states, investors in long term bonds might require a risk premium to compensate them for this risk. In this case, the yield curve will be up ward sloping even in the absence of any expectations of future increases in rates. The viewpoint in this theory is that shorter term bonds have more liquidity than long term bonds, in the sense that they offer greeter price certainty and trade in more active markets with lower bid ask spread. So investors demand a risk premium in long term bonds

how do we usually divide bonds in terms of their riskiness

Those rated BBB or above (S&P, Fitch) or Baa and above (Moody's) are considered investment grade bonds speculative grade or junk bonds are lated lower than what is listed above, duh. Speculative grade or junk bond Rated BB or lower by S&P, Ba or lower by Moody's, or unrated

Be able to price bonds

Will do

Premium bonds

bonds selling above par value

know definitions of investment and speculative grade bonds

investment grade bonds: A bond rated BBB and above by S&P, Fitch or Baa and above by Moody's. Speculative grade bonds: Also known as junk bonds, are also known as high-yield bonds. A bond rated BB or lower by S&P or Fitch OR Ba or lower by Moody's OR a straight up non rated bond.

know how to calculate accrued interest and invoice price

invoice price: Flat price + accrued interest Accrued interest= annual coupon pmt/2 + Days since last coupon pmt/days between coupon payments

Know the terminology and definitions related to bonds; be able to read bond quotes

p.294 and 295 for reading bond quotes terminology: Face value, par value, coupon rate, zero coupon bond, and maturity date

Know what zero-coupon bonds are and understand their changes

zero-coupon bonds: Only one payment which occurs at maturity UNDERSTAND THEIR CHANGES?