Chapter 6 questions
ABC CO. issued 1 million 6% annual coupon bonds that mature in 10 years. The face value is $1000 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 $1000 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 some features of the OTC market for bonds?
- OTC dealers are connected electronically - the OTC has no designated physical location
What are two unique features of a US federal government bond?
- US treasury issues are exempt from state income taxes - US treasury issues are considered to be default-free
A provision in the bond indenture giving the issuing company the option to repurchase the bonds before maturity is termed a _____.
call provision
As an investor in the bond market, why should you be concerned about changes in interest rates?
changes in interest rates cause changes in bond prices
What is a bond's current yield?
current yield = annual coupon payment / price
Debt cannot be subordinated to _____.
equity
T/F: Bond ratings are concerned only with the possibility of price changes.
false
T/F: The dirty price does not include accrued interest.
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
What is a corporate bond's yield to maturity (YTM)?
- YTM is the prevailing market interest rate for bonds with similar features - YTM is the expected return for an investor who buys the bond today and holds it to maturity
Which of the following are bonds that have actually been issued?
- a CoCo bond - a put bond - a convertible bond
What is a real rate of return?
- a percentage change in buying power - a rate of return that has been adjusted for inflation
The term structure of interest rates describes _____.
- the relationship between nominal rates and time to maturity - the pure time value of money
Which of the following are usually included in a bond's indenture?
- the repayment arrangements - the total amount of bonds issued
Which if the following are true of bonds?
- they are issued by both corporations and governments - they are normally interest-only loans
Which one of the following terms apply to a bond.
- time to maturity - par value - coupon rate
The US government borrows money by issuing:
- treasury notes -treasury bonds
If you are holding a municipal bond that is trading at par value 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 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 is a premium bond?
a bond that sells for more than face value
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 $1000 face value US treasury bond is quoted at 99.5, then the bond can be purchased _____.
at 99.5% of face value plus any accrued interest
What are crossover bonds?
bonds that have both an investment grade and a junk bond rating
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 will happen to a bond's time to maturity as the years go by?
it will decline
The bonds of a firm in financial distress may have a market value that is _____ than the face value at maturity.
less
If a $1000 par value bond is trading at a discount, it means that the market value of the bond is _____ $1000.
less than
When using trial and error to compute the yield to maturity (YTM) for a 6% coupon bond that trades at a premium, the process can be shortened if the initial guess is _____ 6%.
less than
The interest rate risk premium is the additional compensation demanded by investors for holding _____ bonds.
longer-term
A zero-coupon bond is a bond that _____.
makes no interest payments
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
Bonds issued by state and local governments are called _____.
municipal bonds
Which of the following is true of zero coupon bonds?
no coupon payments are made on the bonds
Which of the following variables is NOT required to calculate the value of a bond?
original issue price of a bond
Equity represents a(n) _____ interest of a firm.
ownership
What are the cash flows involved in the purchase of a 5-year zero-coupon bond that has a par value of $1000 if the current price is $800? Assume the market rate of interest is 5%.
pay $800 today and receives $1000 at the end of 5 years
A part of the indenture limiting certain actions during the term of the loan are termed
protective covenants
What are the two major forms of long-term debt?
public issue and private issue
Which type of debt is given preference in the event of default?
senior
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
The relationship between nominal rates, real rates and inflation is called _____.
the Fisher Effect
What does a bond's rating reflect?
the ability of the firm to repay its debt and interest on time
What is the nominal rate of return on an investment?
the actual percentage change in the dollar value of an investment adjusted for inflation
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
Bond ratings are based on the probability of default risk, which is the risk that _____.
the bond's issuer may not be able to make all the required payments
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
The degree of interest rate risk depends on _____.
the sensitivity of the bond's price to interest rate changes
What does a treasury yield curve show?
the yield for different maturities of treasury notes and bonds
Junk bonds have the following features:
they are rated below investment grade bonds
If a $1000 par value bond is trading at a premium, the bond is:
trading for more than $1000 in the market
T/F: A put bond allows the holder to force the issuer to buy the bond back at a stated price.
true
T/F: In general, the price that is paid for a bond will exceed its quoted price.
true
T/F: Investors require a premium for the risk that issuers other than the treasury may not make all promised payments on the issued bonds.
true
T/F: Long-term debt has maturities greater than one year.
true
T/F: Longer-term bonds have greater interest rate sensitivity because a large portion of a bond's value comes from the face amount.
true
T/F: Low-grade bonds may not be rated by major rating agencies.
true
What are "falling angel" bonds?
bonds that have dropped from investment grade to junk bond status
What is a discount bond?
bonds that sell for less than the face value
T/F: The government sells Treasury notes and bonds to the public every month.
true
T/F: Zero coupon bond calculations use semiannual periods to be consistent with coupon bond calculations.
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
What four variables are required to calculate the value of a bond?
- coupon rate - time remaining to maturity - par value - yield to maturity
A key difference between interest payments and dividend payments is?
- dividends are not tax deductible - interest is tax deductible
As a general rule, which of the following are true of debt and equity?
- equity represents an ownership interest - the maximum reward for owning debt is fixed
The bid-ask spread represents the _____.
dealer's profit
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
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
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
Which of the following are differences between debt and equity?
- equity represents ownership interest while debt does not - unlike dividend omissions to equity holders, unpaid debt obligations can lead to bankruptcy - a corporation's interest payments on debt are tax deductible, but the dividends it pays to equity holders are not
Which 3 of the following are common shapes for the term structure of interest rates?
- humped - downward sloping - upward sloping
A corporate bond's yield to maturity:
- is usually not the same as a bond's coupon rate - changes over time
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
The sensitivity of a bond's price to interest rate changes is dependent on which of the following two variables?
- time to maturity - coupon rate
Which of these correctly identify differences between US treasury bonds and corporate bonds?
- treasury bonds offer certain tax benefits to investors that corporate bonds cannot offer - treasury bonds are considered free of default risk while corporate bonds are exposed to default risk - treasury bonds are issued by the US government while corporate bonds are issued by corporatinos
Which of the following are features of municipal bonds?
- the interest on municipal bonds is, in some cases exempt from state taxes in the state of issue - they are issued by state and local governments - the interest on municipal bonds is exempt from federal taxes
What are the 3 components that influence the treasury yield curve?
- the interest rate risk premium - the real rate of return - expected future inflation
What is the bid price?
- the price at which a dealer is willing to buy securities - the price an investor will receive if he sells a bond to a dealer
What is the asked price?
- the price at which an investor can buy a particular security from a dealer - the price at which a dealer is willing to sell a particular security
Which of the following are true about a bond's face value?
- the principal amount is repaid at maturity - it is also known as the par value