Fin 322: Chapter 10 -- Bond Prices And Yields

Front 1

Bond

Back 1

A security that obligates the issuer to make specified payments to the holder over a period of time.

Front 2

Face value, par value

Back 2

The payment to the bondholder at the maturity of the bond.

Front 3

Coupon rate

Back 3

A bond's annual interest payment per dollar of par value.

Front 4

Zero-coupon bond

Back 4

A bond paying no coupons that sells at a discount and provides only a payment of par value at maturity.

Front 5

Callable bonds

Back 5

Bonds that may be repurchased by the issuer at a specified call price during the call period.

Front 6

Callable bonds

Back 6

Bonds that may be repurchased by the issuer at a specified call price during the call period.

Front 7

Convertible bond

Back 7

A bond with an option allowing the bondholder to exchange the bond for a specified number of shares of common stock in the firm.

Front 8

Put bond

Back 8

A bond that the holder may choose either to exchange for par value at some date or to extend for a given number of years.

Front 9

Floating-rate bonds

Back 9

Bonds with coupon rates periodically reset according to a specified market rate.

Front 10

Yield to maturity (YTM)

Back 10

The discount rate that makes the present value of a bond's payments equal to its price.

Front 11

Current yield

Back 11

Annual coupon divided by bond price.

Front 12

Premium bonds

Back 12

Bonds selling above par value.

Front 13

Discount bonds

Back 13

Bonds selling below par value.

Front 14

Realized compound return

Back 14

Compound rate of return on a bond with all coupons reinvested until maturity.

Front 15

Horizon analysis

Back 15

Analysis of bond returns over multiyear horizon, based on forecasts of bonds yield to maturity and reinvestment rate of coupons.

Front 16

Reinvestment rate risk

Back 16

Uncertainty surrounding the cumulative future value of reinvested bond coupon payments.

Front 17

Investment grade bond

Back 17

A bond rated BBB and above by Standard & Poor's, or Baa and above by Moody's.

Front 18

Speculative grade or junk bond

Back 18

A bond rated BB or lower by Standard & Poor's, or Ba or lower by Moody's, or an unrated bond.

Front 19

Indenture

Back 19

The document defining the contract between the bond issuer and the bondholder.

Front 20

Sinking Fund

Back 20

A bond indenture that calls for the issuer to periodically repurchase some proportion of the outstanding bonds prior to maturity.

Front 21

Subordination clauses

Back 21

Restrictions on additional borrowing that stipulate that senior bondholders will be paid first in the event of bankruptcy.

Front 22

Collateral

Back 22

A specific asset pledged against possible default on a bond.

Front 23

Debenture

Back 23

A bond not backed by specific collateral.

Front 24

Default Premium

Back 24

The increment to promised yield that compensates the investor for default risk.

Front 25

Credit default swap

Back 25

An insurance policy on the default risk of a corporate bond or loan.

Front 26

Yield curve

Back 26

A graph of yield to maturity as a function of term to maturity.

Front 27

Term structure of interest rates

Back 27

The relationship between yields to maturity and terms to maturity across bonds.

Front 28

Expectations hypothesis

Back 28

The theory that yields to maturity are determined solely by expectations of future short-term interest rates.

Front 29

Forward rate

Back 29

The inferred short-term rate of interest for a future period that makes the expected total return of a long-term bond equal to that of rolling over short-term bonds.

Front 30

Liquidity preference theory

Back 30

The theory that investors demand a risk premium on long-term bonds.

Front 31

Liquidity premium

Back 31

The extra expected return demanded by investors as compensation for the greater risk of longer term bonds.

Front 32

Accrued Interest

Back 32

= (Annual coupon payment/2) x (Days since last coupon payment/Days separating coupon payments)

Front 33

Treasury notes are issued with original maturities of…

Back 33

1 and 10 years

Front 34

Treasury bonds are issued with maturities ranging from...

Back 34

10 to 30 years

Front 35

Bonds and notes may be purchased directly from the ___ in denominations of only ___, but denominations of ___ are far more common. Both make semiannual coupon payments.

Back 35

Treasury, $100, $1000

Front 36

Debt securities are distinguished by

Back 36

Their promise to pay a fixed or specific stream of income to their holders.

Front 37

Treasury notes an bonds have original maturities

Back 37

greater than one year

Front 38

T notes and bonds are issued ___ or ___ par value, with their prices quoted net of accrued interest.

Back 38

at, near

Front 39

Callable bonds should offer ___ promised yields to maturity to compensate investor for the fact they will not realize full capital gains should the interest rate fall and the bonds be called away from them at the stipulated call price.

Back 39

Higher

Front 40

Bonds often are issued with a ____

Back 40

period of call protection

Front 41

Discount bond selling significantly below their call price offer ____

Back 41

implicit call protection

Front 42

Put bonds give the ____ rather than the ___ the choice to terminate or extend the life of the bond.

Back 42

bondholder, issuer

Front 43

Convertible bonds may be exchanged, at the ____ discretion, for a specified number of shares of stock

Back 43

bondholder's. They often "pay" for this option by accepting a lower coupon rate on the security.

Front 44

Floating-bonds pay a ____ over a referenced short-term interest rate.

Back 44

fixed premium. Risk is limited because the rate paid is tied to current market conditions.

Front 45

Yield to maturity

Back 45

The single discount rate the equates the present value of a security's cash flows to its price.

Front 46

Bond prices and yields are ____ related.

Back 46

inversely

Front 47

For premium bonds, the coupon rate is ____ than the current yield, which is greater than the ____.

Back 47

greater, YTM. These inequalities are reversed for discount bonds.

Front 48

YTM is often interpreted as

Back 48

An estimate of the average rate of return to an investor who purchases a bond and holds it until maturity. This interpretation is subject to error.

Front 49

Related measures to YTM are ____, ___, and ____

Back 49

yield to call, realized compound yield, and expected (vs. promised) yield to maturity.

Front 50

Treasury bills

Back 50

US government-issued zero-coupon bonds with original maturities of up to one year.

Front 51

Treasury STRIPS

Back 51

Longer term default-free zero-coupon bonds.

Front 52

Prices of zero-coupon bonds rise ___ over time.

Back 52

higher. This provides a rate of appreciation equal to the interest rate.

Front 53

The IRS treats ____ price appreciation as imputed taxable interest income to the investor.

Back 53

zero-coupon bond

Front 54

When bonds are subject to potential default, the stated YTM is ___.

Back 54

the maximum possible YTM that can be realized by the bondholder. (This happens when?)

Front 55

To compensate bond investors for default risk, bonds must offer ___, that is, promised yields in excess of those offered by default-free government securities.

Back 55

default premiums. Otherwise, the returns may be lower.

Front 56

Bond safety often is measured using ___.

Back 56

financial ratio analysis

Front 57

Bond indentures offer _____ to protect the claims of bond holders.

Back 57

safeguards (What part of a bond offers this?)

Front 58

Common indentures specify ___, ___, ___, and ____ of future debt.

Back 58

sinking fund requirements, collateralization, dividend restrictions, subordination (These characteristics specify what part of a bond?)

Front 59

What are credit default swaps?

Back 59

This provides insurance against the default of a bond or loan.

Front 60

How does a credit default swap work?

Back 60

The swap buyer pays an annual premium to the swap seller but collects a payment equal to lost value if the loan later goes into default. (What type of insurance does this describe?)

Front 61

Term structure of interest rate

Back 61

The relationship between time to maturity and term to maturity.

Front 62

Yield curve

Back 62

Graphical depiction of the term structure.

Front 63

Forward rate

Back 63

The break-even interest rate that would equate the total return on a rollover strategy to that of a longer-term zero-coupon bond.

Front 64

Expectations hypothesis

Back 64

This hypothesis holds that forward interest rates are unbiased forecasts of future interest rates.

Front 65

Liquidity preference theory

Back 65

This theory argues that long-term bonds will carry a risk premium known as a liquidity premium.

Front 66

A positive premium can cause the yield curve to slope ____.

Back 66

Upward. This happens even if no increase in short rates is anticipated. (What type of premium can cause this?)

Front 67

Bond value = ____ (formula)

Back 67

___ = Present value of coupons + Present value of par value

Front 68

Present value of $1 annuity that lasts for T periods when interest rate equals r = ____ (formula)

Back 68

1/r [1- 1/(1+r)^t]

Expression is called the T-period "annuity factor" for an interest rate of r^4. Similarly, we call 1/(1+r)^T the PV factor, the present value of a single payment of $1 to be received in T periods.

Front 69

Price of a bond = ____ (formula).

Back 69

Price = Coupon x 1/r [1 - 1/(1+r)^T] + Par vale x 1/(1+r)^T

= Coupon x Annuity factor(r,T) + Par value x PV factor (r,T)

Front 70

Corporate bonds are typically issued at ____, meaning the underwriters of the bond issue (the firms that market the bonds to the public for the issuing corporation) must choose a coupon rate that very closely approximates market yields.

Back 70

par value (What type of corporate security is usually issued at this price?)

Front 71

Primary issue of bonds

Back 71

When underwriters attempt to sell the newly issued bonds directly to their customers. If the coupon rate is inadequate, investors will not pay par value for the bonds.

Front 72

What happens after bonds are issued?

Back 72

Bondholders may then buy or sell bonds in secondary markets. In these markets, bond prices fluctuate inversely with the market interest rate.

Front 73

Keeping all other factors the same, the longer the maturity of the bond, the ____ to fluctuations in the interest market.

Back 73

the greater the sensitivity of its price (What is this related to? Hint: It's a general rule of bonds, keeping all other factors the same)

Front 74

Invoice price = ___ + ____

Back 74

___ = Flat price + Accrued Interest

Front 75

Bond Pricing in Excel

Back 75

=PRICE (settlement date, maturity date, annual coupon rate, yield to maturity, redemption value as percent of par value, number of coupon payments per year)

Given 1.125 coupon January 2012 maturity bond, from a book example:
=PRICE(DATE(2009,1,15), DATE(2012,1,15), .01125, .0101, 100, 2)

Front 76

Yields annualized using simple interest are also called ____. Therefore, the semiannual yield would be double and reported in the newspaper as a bond equivalent yield of 6%. The ___ annual yield of the bond, however, accounts for compound interest.

Back 76

bond equivalent yields, effective. (What yields would be called this? What about for effective annual yields?)

Front 77

The bond's yield to maturity is the ____ on an investment in the bond.

Back 77

Internal rate of return. Yield to maturity therefore is widely accepted as a proxy for average return.

Front 78

Yield to maturity is calculated on the assumption that ____

Back 78

The bond will be held until maturity. (When is this assumed?)

Front 79

Coverage ratios, #1 Key Ratio used as a determinant of Bond Safety

Back 79

ratios of company earnings to fixed costs. For example, "times-interest-earned ratio" is the ratio of earnings before interest payments and taxes to interest obligations. The "fixed-charge coverage ratio" includes lease payments and sinking fund payments with interest obligations to arrive at the ratio of earnings to all fixed cash obligations. Low or falling coverage ratios signal possible cash flow difficulties.

Front 80

Leverage ratio, #2 Key Ratio used as a determinant of Bond Safety

Back 80

Debt-to-equity ratio. A too-high leverage ratio indicates excessive indebtedness, signaling the possibility the firm will be unable to earn enough to satisfy the obligations on its bonds.

Front 81

Liquidity ratios, #3 Key Ratio used as a determinant of Bond Safety

Back 81

The two common liquidity ratios are the current ratio (current assets divided by current liabilities) and the quick ratio (current assts excluding inventories/current liabilities). These ratios measure the firm's ability to pay bills coming due with its most liquid assets.

Front 82

Profitability ratios, #4 Key Ratio used as a determinant of Bond Safety

Back 82

Measures of rates of return on assets or equity. Profitability ratios are indicators of a firm's overall performance. The ROA (earnings before interest and taxes divided by total assets) or ROE(net income/equity) are the most popular of these measures. Firms with higher return on assets or equity should be better able to raise money in security markets because they offer prospects for better returns on the firm's investments.

Front 83

Cash flow-to-debt ratio, #5 Key Ratio used as a determinant of Bond Safety

Back 83

This is the ratio of total cash flow to outstanding debt.

Front 84

Bond indentures

Back 84

Sinking funds, subordination of further debt, dividend restrictions, collateral

Front 85

Yield to Maturity and Default Risk

Back 85

The state yield is the maximum possible yield to maturity of the bond. The expected yield to maturity must take into account the possibility of a default.

Front 86

When a bond becomes more subject to default risk, its price will ___, and therefore its promised yield to maturity will ___. Therefore, the default premium, the spread between the state yield to maturity and that on otherwise comparable Treasury bonds, will rise. However, its expected yield to maturity, which ultimately is tied to the systematic risk of the bond, will be far less affected.

Back 86

fall, rise.

Front 87

To compensate for the possibility of default, corporate bonds must offer a ___. It is the difference between the promised yield on a corporate bond and the yield of an otherwise identical government bond that is riskless in terms of default.

Back 87

default premium

Front 88

The pattern of default premiums offered on risk bonds is sometimes called the ____. The greater the default risk, the higher it is.

Back 88

Risk structure of interest rates

Front 89

Bond indentures

Back 89

Sinking funds, subordination of further debt, dividend restrictions, collateral

Front 90

Yield to Maturity and Default Risk

Back 90

The stated yield is the maximum possible yield to maturity of the bond. The expected yield to maturity must take into account the possibility of a default.

Front 91

When a bond becomes more subject to default risk, its price will ___, and therefore its promised yield to maturity will ___. Therefore, the default premium, the spread between the state yield to maturity and that on otherwise comparable Treasury bonds, will rise. However, its expected yield to maturity, which ultimately is tied to the systematic risk of the bond, will be far less affected.

Back 91

fall, rise.

Front 92

To compensate for the possibility of default, corporate bonds must offer a ___. It is the difference between the promised yield on a corporate bond and the yield of an otherwise identical government bond that is riskless in terms of default.

Back 92

default premium

Front 93

The pattern of default premiums offered on risk bonds is sometimes called the ____. The greater the default risk, the higher it is.

Back 93

Risk structure of interest rates

Front 94

Credit Default Swaps compensation can take two forms.

Back 94

The CDS buyer may deliver a defaulted bond to the seller in return for the bond's par value, called a physical settlement. The seller may also pay the buyer the difference between the par value of the bond and its market price (even in a default, the bond will still sell at a positive price because there is some recovery of value to creditors in a bankruptcy), called a cash settlement.

Front 95

CDS were originally designed to do what?

Back 95

The insurance were designed to allow lender to buy protection against losses on sizable loans. The natural buyers of CDSs would then be large bondholders or banks that had made large loans and wished to enhance the creditworthiness of those loans. Even if the borrowing firm had shaky credit standing, the "insured" debt would be as safe as the issuer of the CDS.

Front 96

Credit Default Swaps compensation can take two forms.

Back 96

The CDS buyer may deliver a defaulted bond to the seller in return for the bond's par value, called a physical settlement. The seller may also pay the buyer the difference between the par value of the bond and its market price (even in a default, the bond will still sell at a positive price because there is some recovery of value to creditors in a bankruptcy), called a cash settlement.

Front 97

CDS were originally designed to do what?

Back 97

The insurance were designed to allow lender to buy protection against losses on sizable loans. The natural buyers of CDSs would then be large bondholders or banks that had made large loans and wished to enhance the creditworthiness of those loans. Even if the borrowing firm had shaky credit standing, the "insured" debt would be as safe as the issuer of the CDS.

Front 98

Credit Default Swaps compensation can take two forms.

Back 98

The CDS buyer may deliver a defaulted bond to the seller in return for the bond's par value, called a physical settlement. The seller may also pay the buyer the difference between the par value of the bond and its market price (even in a default, the bond will still sell at a positive price because there is some recovery of value to creditors in a bankruptcy), called a cash settlement.

Front 99

CDS were originally designed to do what?

Back 99

The insurance were designed to allow lender to buy protection against losses on sizable loans. The natural buyers of CDSs would then be large bondholders or banks that had made large loans and wished to enhance the creditworthiness of those loans. Even if the borrowing firm had shaky credit standing, the "insured" debt would be as safe as the issuer of the CDS.

Front 100

The Expectations Theory (math formula)

Back 100

[1+y(subn)]^n = [1+y sub(n-1)]^n-1 x [1+f (subn)]

Front 101

The Liquidity Preference Theory (math formula)

Back 101

f (subn) = E[r(subn)] + Liquidity premium