Chapter 7 - Bonds
When valuing a semiannual coupon bond, the time period variable(N) used to calculate the price of a bond reflects the number of _____________ periods remaining in the bond's life.
6-month
long-term debt issued by private corporations typically paying semiannual coupons and returning the face value of the bond at maturity - Default risk is measured by credit rating - Higher risk means higher rate of return demanded by investors - Much riskier
Corporate bonds
Bonds issued by state and local governments - Interest is federal, tax-free, state tax-free for residents of that state
Municipal bonds
What are the 4 types of bonds?
US treasury bills, notes, and bonds Corporate bonds Municipal bonds Foreign bonds
the most secure bonds and the most secured investment, and they are backed by the "full faith and credit" of the U.S. Government - Free of default risk - Up to 1 year maturity - bills - Notes have 2 - 10 years maturity - Bond 10 year maturity or longer
US treasury bonds
Assume that a $1,000,000 par value, semiannual coupon US Treasury note with four years to maturity has a coupon rate of 5%. The yield to maturity (YTM) of the bond is 11.00%. Using this information and ignoring the other costs involved, calculate the value of the Treasury note: $809,963.02 $688,468.57 $971,955.62 $510,276.70
a
Butcher Company plans to issue bonds to raise $10 million to finance expansion. It could use 10-year mortgage bonds backed by the firm's fixed assets, 10-year debentures that are not backed by any specific assets but are backed by the firm's general earning power, or 10-year subordinated debentures that would be subordinated to all of the firm's other debt. If it uses mortgage bonds, they would be rated A by Moody's and S&P, and their market interest rate would be 7.5%. Given this information, which of the following statements is most correct? a. Given the 7.5% interest rate on the mortgage bonds, the plain debentures might carry an interest rate of 8.0% and the subordinated debentures a rate of 8.5%. b. Given the 7.5% interest rate on the mortgage bonds, the subordinated debentures might carry an interest rate of 8.0% and the plain debentures a rate of 8.5%. c. The subordinated debentures would be rated highest, probably AA. d. The debentures would be rated highest, probably AA. e. Since bond ratings are highly subjective, information about the rating and interest rate on the A-rated bond tells us nothing about how the two types of debentures would be rated, or about their likely interest rates.
a
Coupon payments in finance refer to: a. Interest payment from owning a bond. b. Discounts paid to buyers. c. Admissions into a financial market. d. Dividends paid by stocks or equities.
a
Delta Corporation has a bond issue outstanding with an annual coupon rate of 7% and 20 years remaining until maturity. The par value of the bond is $1,000 and present market conditions justify a 14% nominal annual required rate of return. What is the bond's current yield? 13.05% 13.75% 12.20% 14.50% 14.00%
a
If interest rates fall, the risk with a fixed rate instrument is that: a. It will be paid off before maturity. b. The real interest rate may increase very rapidly. c. Default risk will become counter cyclical. d. Price of the financial instrument will fall rapidly.
a
In July 2009, Hungary successfully issued 1 billion euros in bonds. The transaction was managed by Citigroup. Who is the issuer of the bonds? The Hungarian government Hungary Bank Citigroup
a
Wald Inc.'s bonds currently sell for $1,120 and have a par value of $1,000. They pay an $85 annual coupon and have a 20-year maturity, but they can be called in 5 years at $1,050. What is their YTC? a. 6.49% b. 7.08% c. 7.34% d. 6.71% e. 5.95%
a
Which of the following statements about sinking funds is CORRECT? Sinking fund provisions sometimes turn out to adversely affect bondholders, and this is most likely to occur if interest rates decline after the bond was issued. Sinking fund provisions only establish "targets" for the company to reduce its debt over time, not to retire their debt entirely. If interest rates increase after a company has issued bonds with a sinking fund, the company will be less likely to buy bonds on the open market to meet its sinking fund obligation and more likely to call them in at the sinking fund call price. Most sinking funds require the issuer to provide funds to a trustee, who holds the money so that it will be available to pay off bondholders when the bonds mature. A sinking fund provision makes a bond more risky to investors at the time of issuance.
a
Which of the following statements is CORRECT? a. There are 2 different ways to calculate a bond's return. The main difference is with the life-span of the bond. If an issuer can call its bonds early, the relevant return calculation is the yield to call. However, if an issuer cannot call its bonds, the relevant return calculation is the yield to maturity. b. The main difference between the yield to call and the yield to maturity calculations is that the dollar coupon payment differs on a callable bond than on a non-callable bond. c. The yield to maturity is the return calculated on a bond that is held until it is called, which is a shorter period than the bond's original life. d. The yield to call is the return calculated on a bond that is held to maturity.
a
Which of the following statements is correct? a. Other things held constant, a 10-year bond has more reinvestment risk than a 30-year bond. b. If you need a specific amount of money at a specific future date, you could invest in a number of different kinds of bonds, but the one type of bond that you should avoid is a zero coupon bond, because such bonds do not pay any interest. c. If you need a specific amount of money at a specific future date, you should be concerned about price risk, but you do not need to be concerned about reinvestment risk.
a
Who, generally, benefits for a fixed interest rate bond if market interest rates are falling? a. Lenders or holders of bonds. b. Equity holders. c. Governments because it collects more in tax revenue. d. Borrowers or bond issuers.
a
A bond that matures in 6 years sells for $950. The bond has a face value of $1,000 and a 5.5% annual coupon. What is the bond's current yield? 6.25% 5.79% 6.50% 5.50% 6.00%
b
Based on your understanding of bond ratings and bond-rating criteria, which of the following statements is true? During a period of economic growth and in an optimistic environment, the yield spread between US government bonds and corporate bonds could be higher than during an economic recession and a pessimistic environment. During an economic recession and in a pessimistic environment, the yield spread between US government bonds and corporate bonds could be higher than during good economic times.
b
If all interest rates in the economy fall by 1%, which of the following bonds would have the greatest percentage increase in value? 1-year, 10% coupon bond. 20-year, zero coupon bond. 10-year, zero coupon bond. 20-year, 10% coupon bond. 20-year, 5% coupon bond.
b
The coupon rate refers to: a. The rate at which a bond price changes. b. The interest rate a bond pays. c. The true market price of bond. d. The rate at which investors buy a bond.
b
The key difference between investment grade bonds and junk bonds are: a. Length to maturity. b. Default risk. c. Prepayment risk. d. Liquidity risk.
b
Under what circumstances would a firm be more likely to buy the required number of bonds in the open market as opposed to using one of the other procedures? When interest rates are lower than they were when the bonds were issued When interest rates are higher than they were when the bonds were issued
b
Wald Inc.'s bonds currently sell for $1,120 and have a par value of $1,000. They pay an $85 annual coupon and have a 20-year maturity, but they can be called in 5 years at $1,050. What return would an investor most likely earn, if interest rates remain at current levels for the foreseeable future? a. 5.95% b. 6.49% c. 7.08% d. 6.71% e. 7.34%
b
When are issuers more likely to call an outstanding bond issue? When interest rates are higher than they were when the bonds were issued When interest rates are lower than they were when the bonds were issued
b
a long-term debt security that a borrower an a company agree to making payments on specific dates to the holders of th e bond - a loan, liability of the company - contractual relationship
bond
the difference between the selling price and par when the bond is sold for less than par
bond discount
the difference between the selling price and par when the bond is sold for more than par
bond premium
similar to convertibles, but instead of giving the investor an option to exchange the bonds for stock, warrants give the holder an option to buy stock for a stated price, thereby providing a capital gain if the stock's price rises. - carry lower coupon rates than otherwise similar nonconvertible bonds.
bonds issued with warrants
Kholdy Enterprises' outstanding bonds mature in 6 years, have a par value of $1,000, and make an annual coupon payment of $60. The market yield on the bond is currently 10%. What is the bond's price? a. $ 967.55 b. $1,125.00 c. $ 825.79 d. $1,089.93 e. $1,000.00
c
Question Workspace Check My Work Leggio Inc. issued bonds with a 30-year maturity one year ago. The bonds have a 6% coupon, make one payment per year, and sold at their $1,000 par value at issue because the going market rate at the time was 6%. Now, one year later, the market rate has declined from 6% to 5%. At what price should Leggio's bonds now sell? a. $1,209.10 b. $1,000.00 c. $1,151.41 d. $ 911.22 e. $1,067.54
c
View each of the below-listed provisions that are often contained in bond indentures alone. Which of these provisions would tend to REDUCE the yield to maturity that investors would otherwise require on a newly issued bond? Fixed assets are used as security for a bond. A given bond is subordinated to other classes of debt. The bond can be converted into the firm's common stock. The bond has a sinking fund. The bond has a call provision. The indenture contains covenants that restrict the use of additional debt. 1, 3, 4, 5, 6 1, 2, 3, 4, 6 1, 3, 4, 6 1, 4, 6 1, 2, 3, 4, 5, 6
c
Who tends to issue junk bonds? a. Foreign governments. b. The Federal Reserve. c. Financially troubled firms. d. Local governments in the United States.
c
A provision in a bond contract that gives the issuer the right to redeem the bonds under specified terms prior to the normal maturity date.
call provision
gives the issuer the right to call, or redeem, a bond at specific times and under specific conditions.
call provision
Which type of bonds offer a higher yield? Callable bonds Noncallable bonds
callable
a bond that the issuer has the right to pay off before its maturity date
callable bond
The percentage change in the market price of a bond over some period of time. the dividend growth rate, or the rate at which the value of an investment grows
capital gains yield
allows a bondholder or preferred stockholder to convert their bond or preferred share, respectively, into a specified number or value of common shares.
convertibility provision
Bonds that are exchangeable at the option of the holder for the issuing firm's common stock.
convertible bonds
bondholders (or sometimes issuers) may elect to convert their bonds to shares of common stock—subject to preset constraints—at some future date.
convertible provision
the stated annual interest rate on a bond
coupon interest rate
the amount of interest earned on a bond, expressed as a percentage of the bond's current market price a bond's annual coupon divided by its price
current yield
A bond will sell at a discount if which of the following happened? a. Taxes increased. b. The bond was redeemed. c. Market interest rates became negative. d. Interest rates rose above coupon rate
d
A bond will sell at a premium if which of the following happened? a. Tax rates increased. b. The borrower defaulted. c. The stock market increased. d. Interest rates fell below coupon rate.
d
Delta Corporation has a bond issue outstanding with an annual coupon rate of 7% and 20 years remaining until maturity. The par value of the bond is $1,000 and present market conditions justify a 14% nominal annual required rate of return. What is the bond's current yield? 14.50% 13.75% 12.20% 13.05% 14.00%
d
Of the following, identify the CORRECT statement. A discount bond's price declines each year until it matures, when its value equals its par value. Assume that two bonds have equal maturities and are of equal risk, but one bond sells at par while the other sells at a premium above par. The premium bond must have a lower current yield and a higher capital gains yield than the par bond. If a bond sells at par, then its current yield will be less than its yield to maturity. A bond's current yield must always be either equal to its yield to maturity or between its yield to maturity and its coupon rate. A discount bond's price declines each year until it matures, when its value equals its par value.
d
Wald Inc.'s bonds currently sell for $1,120 and have a par value of $1,000. They pay an $85 annual coupon and have a 20-year maturity, but they can be called in 5 years at $1,050. What is their YTM? a. 6.71% b. 5.95% c. 7.08% d. 7.34% e. 6.49%
d
A long-term bond that is not secured by a mortgage on specific property.
debenture
These bonds are traded in the bond markets based on investors' belief that the issuer will not default on the repayment. These bonds have no collateral and usually offer higher yields.
debentures
A bond issuer is said to be ____________ if it does not pay the interest or the principal in accordance with the terms of the indenture agreement or if it violates one or more of the issue's restrictive covenants.
default
prevents the issuer from calling a portion or the entire issue for several years during the early years of the bond issue. Because most bond investors do not want to have their bonds called, the inclusion of a deferred call provision provides value and protection to the buyer by extending the length of time over which the investor will receive the bond's coupons.
deferred call provision
The coupon rate is less than the yield to maturity on what type of bond?
discount
the opportunity cost of capital, and is the rate that could be earned on alternative investments of equal risk
discount rate
Hooper Printing, Inc. has a bond issue outstanding with 14 years left to maturity. The bond issue has a 7% annual coupon rate and a par value of $1,000, but due to changes in interest rates, each bond's value has fallen to $749.04. The capital gains yield earned by investors over the last year was -25.10%. What is the expected current yield for the next year on this bond issue? 10.50% 10.00% 8.75% 8.24% 9.35%
e
Lei Corporation's bonds have a 30-year maturity, a 10% semiannual coupon ($50 coupon payments are made every six months), a face value of $1,000, and cannot be called. The going nominal annual interest rate (rd) for similar semiannual payment bonds of equivalent risk is 7%. What is the bond's price? a. $1,146.33 b. $1,000.00 c. $1,454.06 d. $ 957.49 e. $1,374.17
e
Of the following statements about default risk, which one is CORRECT? Secured debt is more risky than unsecured debt, all else being equal. A company's bond rating is affected by its financial ratios but not by provisions in its indenture. Under Chapter 13 of the Bankruptcy Act, the assets of a firm that declares bankruptcy must be liquidated, and the sale proceeds must be used to pay off claims against it according to the priority of the claims as spelled out in the Bankruptcy Act. Senior debt has more default risk than subordinated debt, all else being equal. Under Chapter 7 of the Bankruptcy Act, the assets of a firm that declares bankruptcy must be liquidated, and the sale proceeds must be used to pay off claims against it according to the priority of the claims as spelled out in the Bankruptcy Act.
e
Select one of the choices below that best completes the following sentence: If an investor sold long-term bonds and used the proceeds to purchase short-term bonds, this would increase the investor's exposure to ________ risk and decrease the investor's exposure to ________ risk. a. price; reinvestment b. price; default c. default; reinvestment d. liquidity; reinvestment e. reinvestment; pric
e
The differences in rates are most probably caused by: Inflation differences. Maturity risk differences. Real risk-free rate differences. Tax effects. Default and liquidity risk differences.
e
Which of the following statements about bond price risk is CORRECT, assuming that all else is equal? Low-coupon bonds have less price risk than high-coupon bonds. Long-term bonds have less price risk than short-term bonds. Short-term bonds have less reinvestment risk than long-term bonds. High-coupon bonds have less reinvestment risk than low-coupon bonds. Long-term bonds have less reinvestment risk than short-term bonds.
e
Which of the following statements is NOT CORRECT? a. Bonds are basically loans, so they usually make regular interest payments to the bondholders. The percentage of this interest payment relative to the bond's face value is called the coupon interest rate. b. For a fixed-rate bond, the coupon interest rate is set for the life of the bond. Unlike a fixed-rate bond's coupon interest rate, the market interest rate changes throughout the life of the bond and has a huge impact on the bond's price. c. When a bond's coupon interest rate is less than the market interest rate, the bond will sell at a value less than its par value and is known as a discount bond. d. When a bond's coupon rate is equal to the market interest rate, the bond will sell for its face value, or what is known as selling at par. e. When the market interest rate is higher than the coupon interest rate, the bond price rises above the par value and is called a premium bond.
e
generally $1,000 and represents the amount borrowed from the bond's first purchaser.
face or maturity value
A zero coupon bond pays no interest. It is offered at par value, which is where it sells initially. These bonds provide compensation to investors in the form of capital appreciation. True False
false
If the appropriate rate of interest on a bond is greater than its coupon rate, the market value of that bond will be above par value. True False
false
T or F: Price risk is lower on bonds that have long maturities than on bonds that will mature in the near future.
false
Most bonds are owned by and traded among large financial institutions, and it is relatively easy for bond dealers to arrange the transfer of large blocks of bonds among the millions of large and small bondholders on the exchanges rather than the over-the counter market. True or false?
false; among few holders of bonds
Bonds whose interest rate is fixed for their entire life.
fixed-rate bonds
Bonds whose interest rate fluctuates with shifts in the general level of interest rates.
floating-rate bonds
Bonds issued by foreign governments or by foreign corporations
foreign bonds
These bonds have currency risk, in addition to default risk and price risk
foreign bonds
The coupon rate is _________ the yield to maturity on a premium bond (priced above $1000)
greater than
When the coupon rate is greater than the yield to maturity on a bond, the bond price is then ________________________ the par value.
greater than
The contract that describes the terms of a borrowing arrangement between a firm that sells a bond issue and the investors who purchase the bonds is called the
indenture
a contract that describes the terms (obligations and responsibilities) of a borrowing arrangement between a firm that sells a bond issue and the investors who purchase the bonds. This document is a legally binding contract between the issuer and each bondholder. Among the terms specified in this is the issue's maturity date, the timing and method of calculating its interest payments, and any covenants and provisions affecting the interests of the issuing company and its bondholders.
indenture
a written bond contract
indenture
Bonds rated triple-B or higher; many banks and other institutional investors are permitted by law to hold only these bonds
investment-grade bonds
when the bond was issued
issue date
High-risk, high-yield bonds.
junk bonds
The coupon rate is _________ the yield to maturity on a discount bond (priced below $1000)
less than
When the bond's coupon rate is greater than the bondholder's required return, the bond's intrinsic value will be ________________ its par value, and the bond will trade at a premium.
less than
Do longer bonds or shorter bonds have more interest rate risk?
longer bonds
Do lower or higher coupon rates have more on less interest rate risk than shorter coupon bonds?
lower
the exact date the issuer of a bond must pay the principal to the bondholder - annual or semiannually
maturity date
a corporate bond secured by various assets of the issuing firm
mortgage bond
Any bond originally offered at a price below its par value.
original issue discount
Bonds are typically traded in what market?
over the counter market
At maturity, the value of any bond must be equal to...
par value
a bond's stated value, to be paid to the bondholder at maturity
par value
the risk that an asset's sale price will be lower than its purchase price
price risk
the risk that an asset's sale price will be lower than its purchase price - If market yields go up, prices go down and vice versa
price risk
All bonds face what type of risk?
price risk or interest rate risk
A bond that has interest payments based on an inflation index so as to protect the holder from inflation.
purchasing power bond
Bonds with a provision that allows investors to sell them back to the company prior to maturity at a prearranged price.
putable bonds
The risk that a decline in interest rates will lead to a decline in income from a bond portfolio
reinvestment risk
A bond that has just been issued is known as a new issue. Once it has been issued, it is an outstanding bond, also called a
seasoned issue
These bonds are backed by real estate holdings and equipment, and if a company goes bankrupt, the collateral can be sold off to compensate for the default. These bonds, more so than other collateralized securities, have prior claims over assets.
senior mortgage bonds
A reserve account in which the issuer of a bond periodically retires some part of the bond principal prior to maturity so that enough capital will be accumulated by the maturity date to pay off the bond.
sinking fund
A provision in a bond contract that requires the issuer to retire a portion of the bond issue each year.
sinking fund provision
A reserve account in which the issuer of a bond periodically retires some part of the bond principal prior to maturity so that enough capital will be accumulated by the maturity date to pay off the bond.
sinking funds
These bonds have a claim on assets only after senior debt has been paid in full.
subordinated debentures
bonds having a claim on assets only after the senior debt has been paid in full in the event of liquidation
subordinated debentures
High quality corporate bonds means they have what amount of risk attached to them?
the least amount of risk
If the coupon rate and the yield rate are equal on a bond, the bond price will be _____________ as the par value.
the same
Fixed assets used as security, having the ability to convert into common stock, having a sinking fund, and including covenants that restrict the use of additional debt would all tend to reduce ...
the yield to maturity
Which bond doesn't face default risk?
treasuries
A 20-year bond with a 6% coupon rate can have a par value of any amount that is a multiple of $1,000. The issuer will make payments of 6% of the par value each year, generally with one-half of the annual amount paid each 6 months. Bonds may include a sinking fund, which means that some of the bonds must be paid off each year rather than at maturity. Also, many bonds include a call provision, which gives the issuer the right to pay off the bonds prior to their stated maturity. True or false?
true
A 20-year, annual coupon bond with one year left to maturity has the same price risk as a 10-year, annual coupon bond with one year left to maturity. Both bonds are of equal risk, have the same coupon rate, and the prices of the two bonds are equal. True False
true
Assume Lei's bonds paid interest annually rather than semiannually. You could find the value of these bonds, in a market where the going nominal annual rate on semiannual payment bonds is 7%, by finding the effective annual rate, which is 7.1225%, and then discounting the annual bond's cash flows by this effective rate. The annual payment bonds would have a value of $1,352.72 versus $1,374.17. True or false?
true
Foreign bonds are issued by a foreign government or a foreign corporation. An additional risk exists when bonds are denominated in a currency other than that of the investor's home currency. True or false?
true
If the market interest rate remains at 5% for the next 29 years, and if Leggio's credit rating remains constant, then the price of its bonds will decrease gradually over time and be exactly $1,000 at maturity. True or false?
true
T or F: A long-term zero coupon bond will experience more price change than a shorter-term zero or a coupon bond.
true
T or F: Although all bonds have some common characteristics, different types of bonds can have different contractual features.
true
T or f: Over the long run, rating agencies have done a reasonably good job of measuring the average credit risk of bonds and of changing ratings whenever there is a significant change in credit quality.
true
The interest paid on a municipal bond, otherwise known as a muni, is generally exempt from federal income taxes. Therefore, the coupon rate on these bonds is considerably lower than a corporate bond of equivalent risk. True or false?
true
True or False: Assuming all else is equal, short-term securities are exposed to higher reinvestment risk than long-term securities. True False
true
Two key sections of the Bankruptcy Act are Chapter 7, which relates to liquidating firms and allocating the proceeds among its creditors, and Chapter 11, which deals with reorganizing businesses that are thought to be worth more as operating enterprises than they would bring in from liquidation of firms' assets. Troubled firms' managements generally try to reorganize, but if no feasible reorganization plan can be developed, then the bankruptcy judge will order liquidation. True or false?
true
Remember, a bond's coupon rate partially determines the interest-based return that a bond __________ pay, and a bondholder's required return reflects the return that a bondholder __________ to receive from a given investment.
will, would like to receive
If current interest rates are well below an outstanding bond's coupon rate, a callable bond is likely to be called, and investors will estimate its most likely rate of return as the
yield to call
the rate of return earned on a bond when it is called before its maturity date
yield to call
the rate of return a bondholder will receive if the bond is held to maturity
yield to maturity
How do you calculate capital gains yield?
ytm - current yield
If the price of the bond is initially discounted and offers no coupon payments, the bond is called a
zero coupon bond
Bonds that pay no annual interest but are sold at a discount below par, thus compensating investors in the form of capital appreciation.
zero coupon bonds