Fin 302 Ch 6
ABC Co. issued 1 million 6 percent annual coupon bonds that mature in 10 years. The face value is $1,000 per bond. What are the expected cash flows from one of these bonds?
$60 in interest at the end of each year for 10 years and a $1,000 repayment of principal at the end of 10 years.
The model that precisely specifies the relationship between the nominal rate and the real rate is: R = the nominal rate r = the real rate h = the rate of inflation
(1 + R) = (1 + r)×(1 + h)
What are the two major forms of long-term debt?
- public issue - private issue
Which of the following is true of zero coupon bonds?
No coupon payments are made on the bonds
True or false: Investors require a premium for the risk that issuers other than the Treasury may not make all promised payments on the issued bonds.
True
True or false: Long-term debt has maturities greater than one year.
true
Which of the following terms apply to a bond?
- Coupon rate - Par value - Time to maturity
What four variables are required to calculate the value of a bond?
- Coupon rate - Time remaining to maturity - Par value - Yield to maturity
The sensitivity of a bond's price to interest rate changes is dependent on which of the following two variables?
- Coupon rate - Time to maturity
Which three components determine the shape of the term structure of interest rates?
- Interest rate risk premium - Inflation premium - Real interest rate
What is a real rate of return?
- It is a percentage change in buying power. - It is a rate of return that has been adjusted for inflation.
What is the bid price?
- It is the price at which a dealer is willing to buy securities. - It is the price an investor will receive if he sells a bond to a dealer.
What is the asked price?
- It is the price at which a dealer is willing to sell a particular security. - It is the price at which an investor can buy a particular security from a dealer.
Which of the following are true about a bond's face value?
- It is the principal amount repaid at maturity. - It is also known as the par value.
Which of the following may increase the yield on corporate bonds as compensation to investors but will not impact Treasury bond yields?
- Liquidity premium - Default risk premium
What are some features of the OTC market for bonds?
- OTC dealers are connected electronically. - The OTC has no designated physical location.
As a general rule, which of the following are true of debt and equity?
- The maximum reward for owning debt is fixed. - Equity represents an ownership interest.
What are the three components that influence the Treasury yield curve?
- The real rate of return - The interest rate risk premium - Expected future inflation
Which of the following are usually included in a bond's indenture?
- The total amount of bonds issued - The repayment arrangements
Which of the following are true of bonds?
- They are normally interest-only loans - They are issued by both corporations and governments
Which of these correctly identify differences between U.S. Treasury bonds and corporate bonds?
- Treasury bonds are issued by the US government while corporate bonds are issued by corporations. - Treasury bonds are considered free of default risk while corporate bonds are exposed to default risk. - Treasury bonds offer certain tax benefits to investors that corporate bonds cannot offer.
What are the two unique features of a U.S. federal government bond?
- U.S. Treasury issues are considered to be default-free. - U.S. Treasury issues are exempt from state income taxes.
What is a corporate bond's yield to maturity (YTM)?
- YTM is the expected return for an investor who buys the bond today and holds it to maturity. - YTM is the prevailing market interest rate for bonds with similar features.
Which of the following are bonds that have actually been issued?
- a CoCo bond - a put bond - a convertible bond
A corporate bond's yield to maturity:
- changes over time - is usually not the same as a bond's coupon rate
A key difference between interest payments and dividend payments is?
- dividends are not tax deductible - interest is tax deductible
Which three of the following are common shapes for the term structure of interest rates?
- downward sloping - upward sloping - humped
The term structure of interest rates describes ________.
- the pure time value of money - the relationship between nominal rates and time to maturity
If you are holding a municipal bond that is trading at par to yield 6%, by how much will your after-tax yield change if your federal income tax bracket increases from 15% to 20%. Assume there are no state or local taxes
0%
If you are in the 20% federal income tax bracket, what is your after-tax yield on a municipal bond that is currently trading at par to yield 5%. Assume there are no state or local taxes.
5%
Crossover bonds can also be called _____ bonds.
5B
What is a premium bond?
A bond that sells for more than face value
What are municipal bonds?
Bonds that have been issued by state or local governments
What are crossover bonds?
Bonds that have both an investment grade and a junk bond rating
What are "fallen angel" bonds?
Bonds that have dropped from investment grade to junk bond status
What is a bond's current yield?
Current yield = Annual coupon payment/Price
What is a discount bond?
Discount bonds are bonds that sell for less than the face value.
Which of the following is not a difference between debt and equity?
Equity is publicly traded while debt is not
True or false: The dirty price does not include accrued interest.
False
What is a bond's accrued interest?
It is interest that has been earned but not yet received by the current bondholder
What is the nominal rate of return on an investment?
It is the actual percentage change in the dollar value of an investment unadjusted for inflation.
What is the inflation premium?
It is the additional return demanded by investors to compensate for expected inflation
What is the definition of a bond's time to maturity?
It is the number of years until the face value is paid off
What does a Treasury yield curve show?
It shows the yield for different maturities of Treasury notes and bonds
What will happen to a bond's time to maturity as the years go by?
It will decline
Why is the bond market less transparent than the stock market?
Many bond transactions are negotiated privately.
Which one of the following is the most important source of risk from owning bonds?
Market interest rate fluctuations
Which of the following variables is NOT required to calculate the value of a bond?
Original issue price of bond
What are the cash flows involved in the purchase of a 5-year zero-coupon bond that has a par value of $1,000 if the current price is $800? Assume the market rate of interest is 5 percent.
Pay $800 today and receive $1,000 at the end of 5 years
What is the equation for approximating the nominal rate of return? R = the nominal rate of interest r = the real rate of interest h = the inflation rate
R = r + h
What does historical data suggest about the nature of short-term and long-term interest rates?
Sometimes short-term rates are higher and sometimes long-term rates are higher.
If you are holding two identical bonds, except that one matures in 10 years and the other matures in 5 years, which bond's price will be more sensitive to interest rate risk?
The 10-year bond
What does a bond's rating reflect?
The ability of the firm to repay its debt and interest on time
If you are holding two bonds - one with a 5% coupon rate and the other with an 8% coupon rate - which one is more sensitive to interest rate risk, all other things being equal?
The bond with a 5% coupon rate
What does the AAA rating assigned by S&P mean?
The firm is in a strong position to meet its debt obligations
What does the clean price for a bond represent?
The quoted price excluding accrued interest
Junk bonds have the following features:
They are rated below investment grade bonds
The US government borrows money by issuing:
Treasury bonds, and treasury notes.
True or false: A put bond allows the holder to force the issuer to buy the bond back at a stated price.
True
True or false: All else being equal, a one-year bond's price is less sensitive to interest rate changes as compared to that of a ten-year bond's price.
True
True or false: In general, the price that is paid for a bond will exceed its quoted price.
True
True or false: Longer-term bonds have greater interest rate sensitivity because a large portion of a bond's value comes from the face amount.
True
True or false: The government sells Treasury notes and bonds to the public every month.
True
True or false: The price you actually pay to purchase a bond will generally exceed the clean price.
True
True or false: Zero coupon bond calculations use semiannual periods to be consistent with coupon bond calculations.
True
When long-term rates are higher than short-term rates, which of the following shapes will the term structure of interest rates usually have?
Upward sloping
A bond's coupon payment is:
a fixed amount of interest that is paid annually or semiannually by the issuer to its bondholders
The coupon payments on floating-rate bonds are _____.
adjustable
To find the total bond value, add the present value of the amount paid at maturity to the _____ of the annual coupon payments.
annuity present value
If bonds for AT&T are quoted at 115, they can be purchased:
at 115% of par value plus accrued interest
If a $1,000 face value U.S. Treasury bond is quoted at 99.5, then the bond can be purchased _____.
at 99.5 percent of face value plus any accrued interest
A provision in the bond indenture giving the issuing company the option to repurchase the bonds before maturity is termed a _________________.
call provision
A bond's _____ payment is a fixed amount of interest that is paid annually or semiannually by the issuer to its bondholders
coupon
When interest rates in the market rise, we can expect the price of bonds to ____.
decrease
The _____ price is also called the "full" or "invoice" price.
dirty
Debt cannot be subordinated to _____.
equity
True or false: A debenture is a bond secured with collateral.
false
True or false: Bond ratings are concerned only with the possibility of price changes.
false
True or false: Bonds that have dropped into junk territory are called "trash" bonds.
false
True or false: The higher the coupon rate, the greater the interest rate risk, all other things being equal.
false
A limitation of bond ratings is that they ____.
focus exclusively on default risk
If a bond is selling at a discount from its par value, the YTM must be _____ the coupon rate.
greater than
A bond with a BB rating has a ______ than a bond with an BBB rating.
higher risk of default
When interest rates in the market fall, bond values will increase because the present value of the bond's remaining cash flows ____.
increases
The nominal rate is found by adding the _____ and the real rate of return.
inflation
What does the dirty price represent?
it includes the quoted price and accrued interest
The bonds of a firm in financial distress may have a market value that is _____ than the face value at maturity.
less
If a $1,000 par value bond is trading at a discount, it means that the market value of the bond is ______$1,000.
less than
The interest rate risk premium is the additional compensation demanded by investors for holding ____ bonds.
longer-term
When using trial and error to compute the yield to maturity (YTM) for a 6 percent coupon bond that trades at a premium, the process can be shortened if the initial guess is ____ 6 percent.
lower than
A zero-coupon bond is a bond that ____.
makes no interest payments
Bonds issued by state and local governments are called _______ ______.
municipal bonds
Equity represents a(n) _____ interest of a firm.
ownership or owner's
A part of the indenture limiting certain actions during the term of the loan are termed ________.
protective covenants
The term structure of interest rates examines the ____.
relationship between short-term and long-term interest rates
Which type of debt is given preference in the event of default?
senior
The relationship between nominal rates, real rates and inflation is called ________ .
the Fisher Effect
Bond ratings are based on the probability of default risk, which is the risk that ___.
the bond's issuer may not be able make all the required payments
The degree of interest rate risk depends on ____.
the sensitivity of the bond's price to interest rate changes
If a $1,000 par value bond is trading at a premium, the bond is:
trading for more than $1,000 in the market
True or false: Current yield = Annual coupon payment/Price
true
True or false: Low-grade bonds may not be rated by major rating agencies.
true
A debenture is a(n) _____ bond, for which no specific pledge of property is made.
unsecured
Most of the time, a floating-rate bond's coupon adjusts ____.
with a lag to some base rate
