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.