Chapter 7
Which one of these statements is correct?
Bonds often provide tax benefits to issuers.
If YTM > Coupon Rate
then Bond Price < Par Value Why? Coupon is below current market conditions, so bond is traded at a discount
If YTM < Coupon Rate
then Bond Price > Par Value Why? Coupon is above current market conditions, so bond is traded at a premium
If YTM = Coupon Rate
then Par Value = Bond Price Why? because coupon is at current market conditions, so bond is traded at par
The interest rate risk premium increases as the ___________ increases.
time to maturity
A Treasury yield curve plots Treasury interest rates relative to:
time to maturity.
A floating rate bond's coupon payment may have a "collar", which means...
the rate cannot go above a specified "ceiling" or below a specified "floor"
The real rate of return has minimal, if any, effect on?
the slope of the term structure of interest rates.
Typical issuers of bonds:
-Federal Government: Treasury Bonds -Corporations: Corporate Bonds -States & Cities: Municipal Bonds -Foreign Governments & Corporations: Foreign Bonds
Which one of the following bonds is the least sensitive to interest rate risk?
3-year; 6 percent coupon **look for the bond with the lowest maturity date and highest coupon rate
Al is retired and his sole source of income is his bond portfolio. Although he has sufficient principal to live on, he only wants to spend the interest income and thus is concerned about the purchasing power of that income. Which one of the following bonds should best ease Al's concerns?
5-year TIPS
Nadine is a retired widow who is financially dependent upon the interest income produced by her bond portfolio. Which one of the following bonds is the least suitable for her to own?
7-year income bond
Current Yield (CY)
= annual coupon / market price **not to be confused with YTM
Medium Grade
A: susceptible to impairment given adverse economic changes
Lowest Investment Grade
BBB: adequate capacity to pay principal and interest; weakened payment capacity could exist if adverse economic conditions exist
A bond that can be paid off early at the issuer's discretion is referred to as being which type of bond?
Callable
You are trying to compare the present values of two separate streams of cash flows that have equivalent risks. One stream is expressed in nominal values and the other stream is expressed in real values. You decide to discount the nominal cash flows using a nominal annual rate of 8 percent. What rate should you use to discount the real cash flows?
Comparable real rate
Allison just received the semiannual payment of $35 on a bond she owns. Which term refers to this payment?
Coupon
Jason's Paints just issued 20-year, 7.25 percent, unsecured bonds at par. These bonds fit the definition of which one of the following terms?
Debenture
A sinking fund is managed by a trustee for which one of the following purposes?
Early bond redemption
Bert owns a bond that will pay him $45 each year in interest plus $1,000 as a principal payment at maturity. What is the $1,000 called?
Face value ***Face Value = Par Value = FV
The Fisher effect is defined as the relationship between which of the following variables?
Real rates, inflation rates, and nominal rates
Real rates are defined as nominal rates that have been adjusted for which of the following?
Inflation
Which one of the following risks would a floating-rate bond tend to have less of as compared to a fixed-rate coupon bond?
Interest rate risk *floating rate notes are bonds that have a variable coupon
Which one of the following risk premiums compensates for the inability to easily resell a bond prior to maturity?
Liquidity
Which one of these is most apt to be included in a bond's indenture one year after the bond has been issued?
List of collateral used as bond security
Which bond would you generally expect to have the highest yield?
Long-term, taxable junk bond
You expect interest rates to decline in the near future even though the bond market is not indicating any sign of this change. Which one of the following bonds should you purchase now to maximize your gains if the rate decline does occur?
Long-term; zero coupon **if interest rates drop, the PV of the bond will increase and you can sell at a premium.
Last year, you purchased a TIPS at par. Since that time, both market interest rates and the inflation rate have increased by .25 percent. Your bond has most likely done which one of the following since last year?
Maintained a fixed real rate of return
Can a zero coupon bond sell for more than par value?
No! Why? otherwise, the lender would be paying an interest to the borrower
Last year, Lexington Homes issued $1 million in unsecured, noncallable debt. This debt pays an annual interest payment of $55 and matures six years from now. The face value is $1,000 and the market price is $1,020. Which one of these terms correctly describes a feature of this debt?
Note
What determines the YTM of a bond?
TVOM and the Risk of Default
If Bond interest rates increase
The PV of cash flows decrease the Bond value
If Bond interest rates decrease
The PV of cash flows increase the Bond value
What is the difference between "current yield" and "Yield to Maturity (YTM)"?
The Yield to Maturity is the yield when a bond becomes mature, while the current yield is the yield of a bond at the present moment. . The current yield is the actual yield an investor would get. The YTM can be called as the rate of return a person will receive for the bond until its maturity.
Which one of these equations applies to a bond that currently has a market price that exceeds par value?
Yield to maturity < Coupon rate (premium bond)
Which one of the following statements is correct?
The real rate must be less than the nominal rate given a positive rate of inflation.
Which one of the following statements is false concerning the term structure of interest rates?
The term structure of interest rates and the time to maturity are always directly related.
A premium bond that pays $60 in interest annually matures in seven years. The bond was originally issued three years ago at par. Which one of the following statements is accurate in respect to this bond today?
The yield to maturity is less than the coupon rate.
Examples of Zero Coupon Bonds:
Treasury Bills and Strips
Annual Coupon
YTM = Period Rate = APR = EAR
You own a bond that pays an annual coupon of 6 percent that matures five years from now. You purchased this 10-year bond at par value when it was originally issued. Which one of the following statements applies to this bond if the relevant market interest rate is now 5.8 percent?
You will realize a capital gain on the bond if you sell it today. **the bond price will be higher, which means the bond will sell at a premium
A bond that has only one payment, which occurs at maturity, defines which one of these types of bonds?
Zero coupon
A type of fixed-income security
a bond
All else constant, a bond will sell at ________ when the coupon rate is ________ the yield to maturity.
a discount; less than
A bond is:
a security obligating the issuer (seller) to make specific payments of interest and principal to the bondholder at specified dates, over a period of time.
What are sinking fund provisions?
accounts managed by a trustee to repay the bond by buying the bond on the market or calling them.
(Deferred) call provisions
allow the company to repurchase the bond at par Call premium = value - par
A note is generally defined as:
an unsecured bond with an initial maturity of 10 years or less.
Bonds issued by the U.S. government:
are considered to be free of default risk.
Protective covenants:
are primarily designed to protect bondholders.
U. S. Treasury bonds:
are quoted as a percentage of par.
A bond that is payable to whomever has physical possession of the bond is said to be in:
bearer form.
Price risk of bonds is greater for
bonds with longer maturity or small coupon
The term structure of interest rates includes what?
both an inflation premium and an interest rate risk premium.
A $1,000 face value bond can be redeemed early at the issuer's discretion for $1,030, plus any accrued interest. The additional $30 is called the:
call premium.
An example of a negative covenant that might be found in a bond indenture is a statement that the company:
cannot lease any major assets without bondholder approval.
The interest rate risk premium is the:
compensation investors demand for accepting interest rate risk.
T-notes
coupon debt with original maturity between one and ten years
T-bonds
coupon debt with original maturity greater than ten years
The price sensitivity of a bond increases in response to a change in the market rate of interest as the:
coupon rate decreases and the time to maturity increases.
The collar of a floating-rate bond refers to the minimum and maximum:
coupon rates
Fisher Effect
defines the relationship between real rates, nominal rates, and inflation
A discount bond's coupon rate is equal to the annual interest divided by the:
face value
Treasury securities
federal government debt
Collateral (bond classifications)
financial assets as a security
Rating agencies (examples)
firms assessing the risk of default -moody's, standard & poor, duff & phelps, Fitch
Treasury bonds are:
generally issued as semiannual coupon bonds.
A newly issued bond has a coupon rate of 7 percent and semiannual interest payments. The bonds are currently priced at par. The effective annual rate provided by these bonds must be:
greater than 7 percent.
A zero coupon bond:
has more interest rate risk than a comparable coupon bond.
Callable bonds generally:
have a sinking fund provision.
Senior, junior, subordinated (bond classifications)
in case of default, the latter is paid only after senior and junior bondholders
Road Hazards has 12-year bonds outstanding. The interest payments on these bonds are sent directly to each of the individual bondholders. These direct payments are a clear indication that the bonds can accurately be defined as being issued:
in registered form.
As a bond's time to maturity increases, the bond's sensitivity to interest rate risk:
increases at a decreasing rate.
The Fisher effect primarily emphasizes the effects of ________ on an investor's rate of return.
inflation
Downward sloping yield curve
inflation is expected to decrease gradually
Upward sloping yield curve
inflation is expected to raise gradually
Fixed-income security
is a claim on a specified periodic stream of cash payments
What is a Bond Identure?
is a legal document or contract between the bond issuer and the bondholder that records the obligations of the bond issuer and benefits owed to the bondholder
What is a bond?
it is a borrowing arrangement under which the borrower agrees to make payments of interest and principal, on specific dates, to the holders of the bond
What is a noncallable security?
it's a financial security that cannot be redeemed early by the issuer except with the payment of a penalty
What is term structure mean?
it's the relationship between time to maturity and yields, all else equal. **we ignore the effect of default risk, different coupons, etc.
Expectations of lower inflation rates in the future tend to...
lower the slope of the term structure of interest rates.
Zero coupon bonds:
make no periodic interest payments coupon rate = 0%
DLQ Inc. bonds mature in 12 years and have a coupon rate of 6 percent. If the market rate of interest increases, then the:
market price of the bond will decrease.
A bond's principal is repaid on the ________ date.
maturity
in bearer form (bond classifications)
means the certificate itself is proof of ownership and the company pays to the bearer
in registered form (bond classifications)
means the company has a registrar tracking the bondholders
Convexity
means the risk increases at a decreasing rate with maturity
real interest rate
nominal rate adjusted for inflation -percentage change in the amount of goods and services you can actually buy with your money
Interest rates that include an inflation premium are referred to as:
nominal rates
The Yield-To-Maturity (or yield, or internal rate of return (IRR))
of a bond is the interest rate required in the market for that bond
Municipal bonds:
pay interest that is federally tax free.
Yield to Maturity (YTM) =
period rate * number of periods
In the market, bonds are quoted in
price (not YTM) -the YTM is the discount rate at which the formula's value of a bond is equal to its market price
A deferred call provision:
prohibits the bond issuer from redeeming callable bonds prior to a specified date.
The items included in an indenture that limit certain actions of the issuer in order to protect a bondholder's interests are referred to as the:
protective covenants.
T-bills
pure discount bonds with original maturity of up to one year
Nominal interest rate
rate of interest -percentage change in the amount of money you have
Who measures default risk?
rating agencies
The yields on a corporate bond differ from those on a comparable Treasury security primarily because of:
taxes and default risk.
The pure time value of money is known as the:
term structure of interest rates.
The entire YTM on a zero coupon bond comes from
the difference between the purchase price and the par value
Period Rate =
the discount rate for the bond
All income from Treasury securities is taxable at...
the federal level, but not taxable at the state and local level
Debenture (bond classifications)
unsecured bond usually has a term > 10 years
Basic Bond Theorems:
-Bond prices and market interest rates move in opposite directions -when a bond's coupon rate is greater than (equal to / less than) its YTM, the bond's market value is greater than (equal to / less than) its par value -given two bonds identical but for maturity, the price of the longer-term bond will change more than that of the shorter-term bond, for a given change in YTM -given two bonds identical but for coupon, the price of the lower-coupon bond will change more than that of the higher-coupon bond, for a given change in YTM
Reinvestment risk: at what interest rate can you reinvest your coupon, after it is paid to you?
-If YTM is lower, you can't reinvest it at a high rate -this risk is greater for bonds with shorter maturity
Floating Rate Bonds
-coupon rate is not fixed but floats depending on some index value Ex: adjustable rate mortgages and inflation-linked Treasuries
Risks of Zero-Coupon U.S. Treasury Bonds
-have incredibly high interest rate risk (sensitive to interest rate changes) -have no coupon payments to cushion a fall if the Fed raises interest rates
Why is there a term structure of interest rates?
1. Real rates of return are expected to change -if we expect growth rates to slow down, future rates could be lower 2. Expected future inflation -if inflation is exited to increase, long term rates in nominal terms must be higher 3. Price Risk -the price of bonds with greater maturity are more sensitive to fluctuations of interest rates
Factors affecting the YTM of a Bond:
1. The yield curve - (a) real rate of return, (b) inflation premium, (c) interest rate risk premium 2. Default risk premium - bond ratings & maturity 3. Taxability premium - municipal versus taxable bond 4. Liquidity premium - bonds that have more frequent trading will generally have lower required returns ***anything else affecting the risk of the cash flows to the bondholders affects the required returns
High Grade (bond rating)
AAA: highest quality; strong capacity to pay principal and interest AA: High quality; lower rating because of weaker margins of protection
Which one of the following relationships applies to a par value bond?
Coupon rate = Current yield = Yield to maturity
Which one of the following applies to a premium bond?
Coupon rate > Current yield > Yield to maturity
Which one of the following relationships is stated correctly?
Decreasing the time to maturity increases the price of a discount bond, all else constant.
Which one of the following premiums is compensation for the possibility that a bond issuer may not pay a bond's interest or principal payments as expected?
Default risk
Which one of the following rates represents the change, if any, in your purchasing power as a result of owning a bond?
Real rate
Round Dot Inns is preparing a bond offering with a coupon rate of 6 percent, paid semiannually, and a face value of $1,000. The bonds will mature in 10 years and will be sold at par. Given this, which one of the following statements is correct?
The bonds will sell at a premium if the market rate is 5.5 percent.
A $1,000 par value corporate bond that pays $60 annually in interest was issued last year. Which one of these would apply to this bond today if the current price of the bond is $996.20?
The current yield exceeds the coupon rate.
The bond market requires a return of 9.8 percent on the 5-year bonds issued by JW Industries. The 9.8 percent is referred to as the:
current yield.
Municipal Securities
debt of state and local governments -varying degrees of default risk, rated similar to corporate debt -interest received is tax-exempt at the federal level -sometimes referred to as tax-exempt bonds
mortgage security (bond classifications)
real estate as a security