Bonds and Interest Rates
If the stock market falls, what would you expect to happen to bond prices and yields?
When the stock market falls, investors flee to safer securities, like bonds, driving the demand for those securities up and therefore also increasing the price. Since prices and yields move inversely, if bond prices rise, yields will fall. The government may lower interest rates in an attempt to stimulate the economy.
If you believe interest rates will fall, should you buy or sell bonds?
If interest rates fall, bond prices will rise, so you should buy bonds.
What is the coupon payment?
The coupon payment is the amount that a company will pay to a bondholder normally on an annual or semi-annual basis. It is the coupon rate times the face value of the bond. For example, the coupon payment on an annual 10% bond with a 1000 dollar face value is 100 dollars.
Why is a firm's credit rating important?
The lower a firm's credit rating, the higher its risk of bankruptcy and therefore the higher the cost of borrowing capital.
What is a Callable Bond?
A Callable bond allows the issuer of the bond to redeem the bond prior to its maturity date, therefore ending coupon payments. However, a premium is usually paid by the issuer to redeem the bond early.
What is a Eurodollar bond?
A Eurodollar bond is a bond issued by a foreign company, but issued in U.S dollars rather than their home currency.
When should a company issue debt instead of issuing equity?
A company will normally prefer to issue debt since it is cheaper than issuing equity. In addition, interest payments are tax deductible and therefore provide interest tax shields. However a company needs to have a steady cash flow in order to be able to pay the coupon payments every year, whereas that is not necessary when issuing equity. It may also try to raise debt if it feels its stock is particularly undervalued and would not raise the capital needed from an equity offering.
What is a Convertible bond?
A convertible bond can be "converted" into equity over the course of the life of the bond. Therefore, a bondholder can decide that equity in the company is worth more to them than the bond, and the company can essentially buy back their debt by issuing new equity.
What is a Perpetual Bond?
A perpetual bond is a bond that simply pays a coupon payment indefinitely (or the company goes into default) and doesn't ever pay back a principle amount.
How would you value a perpetual bond that pays 1000 dollar coupon per year
A perpetual bond is one that pays coupon payments every period for eternity, with no repayment of principal. If it is a perpetual bond, then the value of the bond will be coupon payment divided by the current interest rate.
What is a Put bond?
A put bond is essentially the opposite of a callable bond. A put bond gives the owner of bond the right to force the issuer to buy back the security from them (usually at face value) prior to the maturity date.
Which is riskier, a 30 year coupon bond or a 30 year zero coupon bond?
A zero coupon bond will yield zero dollars until its date of maturity, while a coupon bond will pay out some cash every year. This makes the coupon bond less risky since even if the company defaults on its debt prior to its maturity date, you will have received some payments with the coupon bond.
What is the difference between an investment grade bond and a "junk bond"?
An investment grade bond is a bond issued by a company that has a relatively low risk of bankruptcy and therefore has a low interest payment. They are usually low risk, fundamentally sound companies with steady, reliable cash flows. A "junk bond" is one issued by a company that has a high risk of bankruptcy but is paying high interest premiums. These companies usually have less consistent cash flows, or may be in a relatively volatile industry.
How would the following scenario affect the interest rates: The president is impeached and convicted?
Any negative news about the country may lead to fears that the economy will decline, so the Fed would most likely lower interest rates to stimulate economic expansion
What are bond ratings?
Bond ratings are a grade given to a bond based on its risk of defaulting. These rating are issued by independent firms and are updated over the life of a bond. They range from AAA which are highly rated "investment grade" bonds with a low default risk, to C, which means the bond is "non-investment grade" or "junk" or even D which means the bond is actually in default and not making any payments. The three most well known and trusted ratings agencies are Standard and Poor's, Moody's, and Fitch
What are some ways to determine if a company poses a credit risk?
Determining the credit risk of a company takes an incredible amount of work and research. However, some quick things to look at would be their credit ratings from Moody's or Standard and Poor's, their current ratio, their quick ratio, their debt to equity ratio, and their interest coverage ratio, and compare those ratios to the ratios of similar companies.
What is Duration?
Duration is a measure of the sensitivity of the price of a bond to a change in interest rates. Duration is expressed as a number of years. When interest rates rise, bond prices fall, and falling interest rates mean rising bond prices. Formally, it is the "weighted average maturity of cash flows". In simple terms, it is the price sensitivity to changes in interest rates. If your cash flows occur faster or sooner your duration is lower and vice versa. In other words, a 4 year bond with semi-annual coupons will have a lower duration than a 10 year zero-coupon bond. The larger the duration number, the greater the impact of interest-rate fluctuations on bond prices.
What does X-economy event effect inflation/interest rates/bond prices? (5 items)
Event - Inflation - Interest Rates - Bond Prices Unemployment low - Up - Up - Down Dollars weakens against yen - up - up - down Consumer Confidence low - down - down - up Stock market drops - down - down - up Companies report healthy earnings - up - up - down
What is "face value"?
Face value or par value of a bond is the amount the bond issuer must pay back at the time of maturity. Bonds are usually issued with a 1000 dollar face value.
What will happen to the price of a bond if the fed raises interest rates?
If interest rates rise, newly issued bonds offer higher yields to keep pace. Therefore, exiting bonds with lower coupon payments are less attractive, and the price must fall to raise the yield to match the new bonds.
What would cause the price of a treasury note to rise?
If the stock market is extremely volatile, and investors are fearful of losing money, they will desire risk free securities, which are government bonds. The increase in demand for these securities will drive the price up, and therefore the yield will fall.
What happens to economic indicators at a positive/negative event? (6 items)
Indicator - Positive Event - Negative Event GDP - up - down Unemployment - down - up Inflation - down - up Interest Rate - down - up New Home Sales - up - down Existing Home Sale - up - down
Why can inflation hurt creditors?
Inflation can definitely hurt creditors. Creditors assign their interest rates based on the risk of default as well as the expected inflation rate. If a creditor lends at 7% and inflation is expected at 2%, they are expecting to make 5%. However, if inflation actually increases to 4%, they are only making 3%.
What is the current yield on the 10-year treasury note?
Information changes daily and is available in the Wall street journal or any financial website.
How would you value a zero-coupon perpetual bond?
Since a zero coupon bond doesn't have any interest payments, and a perpetual bond has no par value, the value of the bond is zero since it will pay out nothing.
How many basis points equal .5 percent?
Since one basis point is equal to one-hundredth of a percent, one-half of a percent is equal to fifty basis points.
If you believe interest rates will fall, and are looking to make money due to the capital appreciation on bonds, should you buy them or short sell them.
Since price moves inversely to interest rates, if you believe interest rates will fall, bond prices will rise and therefore you should buy bonds.
What is the default premium?
The Default Premium is the difference between the yield on a corporate bond with the same time to maturity to compensate the investor for the the default risk of the corporation, compared with the "risk-free" comparable government security.
What is the current ratio?
The current ratio is current assets divided by current liabilities. A lower number just above one means the company is managing inventory efficiently. Lower than that could imply they don't have the ability to pay their debts.
What is the default risk?
The default risk is the risk of a given company not being able to make its interest payments or pay back the principle amount of their debt. The higher a company's default risk, the higher the interest rate a lender will require them to pay.
How do you determine the discount rate on a bond?
The discount rate is determined by the company's default risk. Some of the factors that influence the discount rate include a company's credit rating, the volatility of their cash flows, the interest rate on comparable US bonds, and the amount of current debt outstanding.
What is the order of creditor preference in the event of a company's bankruptcy?
The first creditors to get paid in the event of liquidation would be the senior debt holders. These are usually banks, or senior bondholders. Usually they have some of the firm's assets as collateral. Then comes those holding subordinated debt, followed by preferred stockholders. Common stockholders have the absolute last right to any assets in the event of liquidation or bankruptcy.
What does the government do when there is fear of hyperinflation?
The government can do a number of things, including taxation and government spending to regulate economic activity. Increasing taxes and decreasing government spending slows down growth in the economy and fights inflation. Also, raising key interest rates will slow the economy, slowing inflation.
What is interest coverage ratio?
The interest coverage ratio is EBIT/Interest Expense which shows the company's ability to pay its interest expense with cash flows compared to industry average.
What is the difference between a corporate bond and a consumer loan?
The main difference between a corporate bond and a consumer loan is the market that it is traded on. A bond issuance is usually for a larger amount of capital, is sold in the public market, and can be traded. A loan is issued by a bank and is not traded on a public market.
If the price of the 10-year treasury note rises, what happens to the note's yield?
The price and yield are inversely related, so when price goes up, the yield go down.
If the price of a bond goes up, what happens to the yield?
The price and yield of a bond move inversely to one another. Therefore, when the price of a bond goes up the yield goes down.
How do you price a bond?
The price of a bond is the net present value of all future cash flows (coupon payments and par value) expected from the bond using the current interest rate.
If you believe interest rates will fall, which should you buy: a 10-year coupon bond or a 10-year zero coupon bond?
The price of a zero-coupon bond is more sensitive to fluctuations in interest rates and the price moves in the opposite direction of interest rates. So, when interest rates fall, the price of the zero-coupon bond will rise more than the price of the coupon bond. Therefore, if you believe interest rates will fall, you should purchase the zero-coupon bond.
What is the quick ratio?
The quick ratio is current assets minus inventories divided by current liabilities. This is similar to the current ratio, but more conservative since it assumes a company could not instantly liquidate inventory to pay off debt.
What is the yield to maturity on a bond?
The yield to maturity on a bond is the rate of return on a bond if it is held through its maturity date based on its current price, coupon payments, face value, and maturity date.
Why could two bonds with the same maturity, same coupon, from the same issuer be trading at different prices?
There are a few reasons why they could be trading at different prices. A bond that is putable or convertible demands a premium, and a callable bond will trade at a discount.
What steps can the Fed take to influence the economy?
There are three ways the fed can influence the economy. There is open market operations, which includes the fed buying and selling securities to change the money supply. Buying increases money supply and selling decreases the money supply. Raising or lowering interest rates is another way, where the fed can alter the discount rate, the interest rate the fed charges banks on short term loans, and the federal funds rate, the rate which banks charge each other short term loans. When the fed lowers rates, it signals expansionary monetary policy. Finally manipulating the reserve requirements, which is the amount of cash a bank must keep on hand to cover deposits. When this requirement is lowered, more money goes into the economy and it is therefore an expansionary policy.
Let's say a report released today showed that inflation last month was very low. However, bond prices closed lower. Why might this happen?
This would occur because bond prices are based on expectations of future inflation. Bond traders may expect future inflation to be higher, and therefore the demand for bonds today will be lower, increasing the yields to match the increased inflation expectations.
What is the difference between yield to maturity and yield to worst?
Yield to maturity assumes the debt holder will maintain their investment through its maturity date, collecting all interest payments and is repaid in full at the time of maturity. Yield to worst is the lowest potential yield an investor can earn on their debi investment without the issuer defaulting. This means that if a bond is callable, or has provisions, an investor could earn less than the yield to maturity if the company exercises a prepayment option to get out of the bond early.
