FIN 427 Exam #1

Why do bond prices go down when interest rates go up? Don't lenders like high interest rates?

A bond's coupon interest payments and principal repayment are not affected by changes in market rates. Consequently, if market rates increase, bond investors in the secondary markets are not willing to pay as much for a claim on a given bond's fixed interest and principal payments are they would if market rates were lower. This relationship is apparent from the inverse relationship between interest rates and PV. An increase in the discount rate (i.e., the market rate) decreases the PV of future cash flows

What is a callable bond? Why would a firm make a bond callable? How is the yield that investors demand affected by the callability feature?

A callable bond grants the issues the right to retire the debt fully or partially, before the scheduled maturity date. Investors demand a higher yield because of a call provision

What is a convertible bond? How is the yield that investors demand affected by the convertibility feature?

A convertible bond provides the bondholder the right to convert the bond into a fixed # shares of common stock The yield demand is lower because of the options to convert

Speculative grade (junk, high yield) bonds

BB - D

Investment grade bonds

BBB - AAA

Amortization reduces

Balloon risk

Corporate bonds are typically classified as "Investment Grade" or "Speculative Grade". Who classifies the bonds? Do issuing corporations pay to have their bonds classified or receive money to allow classification of their bonds?

Credit rating agencies such as Moody's and S&P. Corporations pay rating agencies to have their bonds rated

Credit risk

Default risk: Issuer fails to pay in full on time. Downgrade risk: Bonds are downgraded from BBB to BB. Credit spread risk: Credit spreads change over time.

What interest rate conditions do we have under the "Pure Expectations Hypothesis"?

Future spot rates are current forward rates

Which risk is the most important risk factor faced by a bond investor?

Interest rate risk

Securitization

Issuing bonds against receivables

Liquidity Risk

Liquidity risk or marketability risk depends on the ease with which an issue can be sold at or near its value.

How does the coupon rate vs. yield to maturity relate to the bond trading at a premium or a discount?

Premium: CR > YTM Discount: CR < YTM

Interest rate risk

Refers to the bond price uncertainty due to changes in bond yield. An increase in bond yield decreases bond price, creating a loss to a bond investor

Suppose an "Investment Grade" and a "Speculative Grade" bond have the same promised future cash-flows (same face value, annual coupon rate, and maturity) and the same protective covenants. Which one commands a higher price in the marketplace today? Which one commands a higher YTM? Why?

The IG bond commands a higher price and therefore a lower YTM (lower credit spread). Investors are more likely to get the promised bond payments promptly if they buy IG bonds if compared to SG bonds. The market typically agrees with the assessment of the rating agencies

Describe one advantage and one disadvantage of including callable bonds in a portfolio

The advantage of a callable bond is the higher coupon (and higher promised yield to maturity) when the bond is issued. If the bond is never called, then an investor earns a higher realized compound yield on a callable bond issued at par than a noncallable bond issued at par on the same date. The disadvantage of the callable bond is the risk of call. If rates fall and the bond is called, then the investor receives the call price and then must reinvest the proceeds at interest rates that are lower than the yield to maturity at which the bond originally was issued. In this event, the firm's savings in interest payments is the investor's loss.

Two bonds have identical times to maturity and coupon rates. One is callable at 105, the other at 110. Which should have the higher yield to maturity? Why?

The bond callable at 105 should sell at a lower price because the call provision is more valuable to thee firm. Therefore its YTM should be higher

Consider a bond with a 10% coupon and with yield to maturity = 8%. If the bond's yield to maturity remains constant, then in 1 year, will the bond price be higher, lower, or unchanged? Why?

The bond will be priced lower. As time passes, the bond price, which is now above par value, will approach par.

Explain the impact on the bond's expected life of adding a call feature to a proposed bond issue

The call feature reduces the expected life of the bond. If interest rates fall substantially. so that the likelihood of a call increases, investors will treat the bond as if it will "mature" and be paid off at the call date, not the stated maturity date. On the other hand, if rates rise, the bond must be paid off at the maturity date, not later. This asymmetry means that the expected life of the bond is less than the stated maturity

What will happen to a premium bond's quoted price over time if its yield-to-maturity remains constant? What about a discount bond?

The price will decrease over time and approach par. A discount's will increase over time and approach par

Inflation risk

The uncertainty in the purchase power of the cash flows of a bond due to changes in inflation rates during the life of the bond.

Call risk

The uncertainty that a callable bond is called during the life of the bond

Reinvestment risk

The uncertainty that interim cash flows during a bond's life are reinvested at a pre-set fixed rate. Reinvestment risk is greater for longer holding periods, as well as for bonds with large, early cash flows, such as high-coupon bonds and long time to maturities

Exchange-rate risk

The unexpected change in one currency compared to another currency.

The stated yield to maturity and realized compound yield to maturity of a (default-free) zero- coupon bond will always be equal. Why?

ZCB provide no coupons to be reinvested. Therefore, the investor's proceeds from the bond are independent of the rate at which coupons could be reinvested (if they were paid). There is no reinvestment rate uncertainty with zeros.

A firm needs to issue a 10-year fixed-rate bond. The CFO believes that interest rate volatility is high in the next 10 years. Which bond should the CFO recommend to issue: a) a callable bond at 97 b) a putable bond at 102 c) a straight bond at 100

a

Explain the impact on the offering yield of adding a call feature to a proposed bond issue

a call requires the firm to offer a higher coupon (or higher promised YTM) on the bond to compensate the investor the firm's option to call back the bond at a specified price if the interest rate falls sufficiently. Investors are willing to grant this valuable option to the issuer, but only for a price that reflects the possibility that the bond will be called. That price. is the higher promised yield at which they are willing to buy the bond

As interest rate volatility decreases, which of the following bond value would increase: a callable bond, a putable bond, a convertible bond and an exchangeable bond?

a callable bond

List one shortcoming of yield to maturity

assumes the bond is held until maturity and that all coupon income can be reinvested at a rate equal to the yield to maturity

To take advantage of today's low corporate rates, a firm decides to issue a 10-year fixed-rate bond. The CFO believes that interest rates will stay at the same low rates for the next 10 years. Which bond should the CFO recommend to issue: a) a callable bond at 97 b) a putable bond at 102 c) a straight bond at 100

b

A firm needs to issue a 10-year fixed-rate bond. The CFO believes that 1) future interest rates may hit a historical high within the next 10 years and 2) interest rates will not fall below today's rates in the nenxt 10 years. Which bond should the CFO recommend to issue: a) a callable bond at 97 b) a putable bond at 102 c) a straight bond at 100

c

Rank the following bond prices from the highest to lowest, if all the other terms of the bonds are the same except embedded options: a convertible bond, a callable bond, a straight bond

convertible > straight > callable

Invoice price synonyms

dirty price, full price

List one shortcoming of current yield

does not account for capital gains or losses on bonds bought at prices other than the par value. It also does not account for reinvestment income on coupon payments

Rank the following bonds based on their interest rate risk from lowest to highest if all of the terms are the same: inverse floater, floater, fixed-rate

floater < fixed-rate < inverse floater

Consider a 5-year bond with a 10% coupon that has a present yield to maturity of 8%. If inter- est rates remain constant, 1 year from now the price of this bond will be: i. Higher. ii. Lower. iii. The same. iv. Par.

ii

A bond with a call feature: i. Is attractive because the immediate receipt of principal plus premium produces a high return. ii. Is more apt to be called when interest rates are high because the interest savings will be greater. iii. Will usually have a higher yield to maturity than a similar noncallable bond. iv. None of the above.

iii

An investment in a coupon bond will provide the investor with a return equal to the bond's yield to maturity at the time of purchase if: i. The bond is not called for redemption at a price that exceeds its par value. ii. All sinking fund payments are made in a prompt and timely fashion over the life of the issue. iii. The reinvestment rate is the same as the bond's yield to maturity and the bond is held until maturity. iv. All of the above

iii

In which one of the following cases is the bond selling at a discount? i. Coupon rate is greater than current yield, which is greater than yield to maturity ii. Coupon rate, current yield, and yield to maturity are all the same. iii. Coupon rate is less than current yield, which is less than yield to maturity iv. Coupon rate is less than current yield, which is greater than yield to maturity.

iii

List one shortcoming of realized compound yield

is affected by the forecast of reinvestment rates, holding period, and yield of the bond at the end of the investor's holding period

A coupon bond is a

portfolio of ZCBs

Risk (Model) Risk

refers to not knowing the risk of a security. You don't know what you don't know.

Volatility risk

the uncertain impact of a change in interest rate volatility on the price of a bond.