Bonds and Interest Rates

What does the government do when there is a fear of hyperinflation?

increases taxes and decreases government spending to slow down economic growth. Raising key interest rates will slow the economy; reduce the money supply and slow inflation

What is the default premium?

the default premium is the difference between the yield on a corporate bond and the yield on a government bond with the same time to maturity to compensate the investor for the default risk of the corporation, compared with the "risk-free" comparable government security

What is the default risk?

the default risk is the risk of a given company going bankrupt

What is the yield to maturity on a bond?

the yield to maturity is the rate of return on bond if it is purchased today for its current price, coupon payments, face value and maturity date.

If the price of a bond goes up, what happens to the yield.

they are inversely related. when the price of a bond goes up, yield goes down

Let's say a report release today showed that inflation last month was very low. However, the 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 an investment grade bond and a "junk bond"?

-an investment grade bond is one that has a good credit rating, a low risk of bankruptcy and therefore pays a low interest rate -a "junk" bond that has a poor credit rating and a high risk of bankruptcy and therefore has to pay investors a higher interest rate

What is the current yield on the 10-year Treasury note?

1.313%

What is a Eurodollar bond?

A Eurodollar bond is one issued by a foreign company but in U.S. Dollars rather than the home currency.

Why could two bonds with the same maturity, same coupon, from the same issuer 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 is a callable bond?

A callable bond allows the issuer of the bond to redeem the bond prior to its maturity date, thus ending coupon payments. However, a premium is usually paid by the issuer to redeem the bond early.

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 if the company goes into default) and doesn't ever pay back a principle amount.

What is 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 (usually at face value) prior to maturity.

Which is riskier: a 30 year coupon bond or a 30 year zero coupon bond?

A zero coupon bond will yield 0 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 are bond ratings?

Bond ratings are a grade given to a bond based on its risk of defaulting. These ratings are issued by independent firms and are updated over the life of the 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 payments.

Why can inflation hurt creditors?

Creditors assign their interest rates based on the risk of default as well as the expected inflation rate. If a creditor lends a 7% and inflation is expected at 2% they are expecting to make 5%. But if inflation increases to 4%, they are only making 3%.

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 companie

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, duration is the "weighted average maturity of cash flows". In simple terms, it is the price sensitivity to changes in interest rates. If cash flows occur faster or sooner, 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 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 typically issued with 1,000$ face value

If you believe interest rates will fall, should you buy bonds or sell bonds?

If interest rates fall, bond prices will rise, so you should buy bonds.

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, existing 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 very volatile, and investors are fearful of losing money, they will desire free securities, which are government bonds. the increase in demand for these securities will drive price up, and therefore yield will fall.

What is the order of creditor preference in the event of a company's bankruptcy?

In this order: Senior debt holders, subordinated debt, preferred stock, common stock

When should a company issue debt instead of issuing equity?

It is cheaper than issuing equity. Interest payments are tax deductible and provide interest tax shields. If they think their share price is undervalued.

What steps can the fed take to influence the economy?

Open market operations (buying and selling securities to change the money supply), raise or lower interest rates, manipulate the reserve requirements (the amount of cash a bank must keep on hand to cover its deposits)

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 a zero-coupon perpetual bond is zero because it will pay out nothing.

If you believe interest rates will fall, which should you buy: a 10-year coupon bond or a 10-year zero coupon bond?

Since a zero-coupon bond is more sensitive to fluctuations in interest rates, when the interest rates fall, the price of the zero-coupon bond will rise more than the price of the coupon bond. Therefore, if they believe interest rates will fall, they should purchase the zero-coupon bond.

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 prices move inversely to interest rates, if you believe interest rates will fall, bond prices will rise, and therefore 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 x the face value of the bond. If 10% on a 1,000 face value then the coupon payment is 100.

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 U.S. Bonds, and the amount of current debt outstanding.

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 the difference between a bond and a loan?

The main difference between a bond and a 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.

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.

How would you value a perpetual bond that pays a $1,000 coupon per year?

Value of Perpetual Bond = (Coupon Payment) / (Current interest rate on comparable bonds)

If the stock market falls, what would you expect to happen to bond prices and interest rates?

bond prices will rise, and yields will fall.