273: M2 - Bond Valuation

Question 1

Bond

Answer 1

A bond is a very simple form of debt contract. The borrower (referred to as the issuer) borrows a predetermined amount and pays periodic interest on the loan. At maturity, the borrower repays the loan to the lender (referred to as the buyer) along with the final interest payment.

Question 2

Striped Bond

Answer 2

a “striped bond” is a bond from which all the coupons have been removed and sold separately so that only the face value payment remains

Question 3

Zero Coupon Bond

Answer 3

A bond with no coupons is referred to as a zero coupon bond.

Question 4

Bond terminology:
Issuer
Investor
Face Value/Par Value (F)
Coupon Rate (r)
Maturity
Yield to Maturity

Answer 4

Issuer : borrower (corporations or government)

Investor : lender = bondholder = buyer

Face Value/Par Value (F) : the amount being lent per bond certificate, typically $1000

Coupon Rate (r) :the rate of interest being paid on the face value quoted as an APR

Maturity: the date on which the loan is repaid

Yield to Maturity (YTM): the discount rate for the bond

Question 5

The value of a bond is …

Answer 5

the value of a bond is simply the present value of all future cash flows (i.e. the present value of all remaining interest payments and the final face value payment).

Question 6

What happens if you buy a bond after it is issued

Answer 6

If you buy a bond after it is issued, you are purchasing the right to all the remaining interest payments and the face value payment. Interest payments that have already been made to the previous bond owner don’t factor into the bond’s current value.

Question 7

Bond coupon payments are the same as an …

Answer 7

Bond coupon payments are the same as an annuity

Question 8

At the time a bond is issued, the coupon rate is typically set …

Answer 8

At the time a bond is issued, the coupon rate is typically set equal to the discount rate so that the bond is sold at par value..

Question 9

Is the coupon rate for a bond locked in?

Answer 9

The coupon rate for the bond is locked in, it doesn’t change and it defines the rate of interest the bond holder receives.

Question 10

In bond valuation, what it is the discount rate typically referred to as?

Answer 10

when we are talking about bonds, the discount rate is typically referred to as the yield to maturity

Question 11

When is a bond at par? When is a bond at discount? When is a bond at a premium?

Answer 11

Par: Yield to Maturity/Discount Rate = Coupon Rate

Discount: Yield to Maturity/Discount Rate > Coupon Rate

Premium: Yield to Maturity/Discount Rate < Coupon Rate

Question 12

Given that most bonds are issued at par value, how do they then end up trading at a premium or discount?

Answer 12

After the bond is issued the discount rate will change over time as inflation expectations, opportunity costs and default likelihood change. This means that the discount rate (yield to maturity) of bonds changes over time but the compensation for bearing risk (coupon payments) doesn’t change.

Question 13

As bond value increases what happens to YTM? What about when bond value decreases?

Answer 13

When bond value increases the YTM decreases
When bond value decreases the YTM increases

Question 14

Interest Rate Risk

Answer 14

Interest rates capture the inflation risk and opportunity cost portions of the yield to maturity. Most countries have a central bank which sets short-term interest rates to ensure stability in the economy. Ex. Bank of Canada

When inflation rises, the bank of Canada typically reacts by increasing interest rates to reduce job growth and overall growth in the economy

Ventral banks lower interest rates to encourage investment which creates jobs, encourages investment, and stimulates the economy

Question 15

What is the relationship between bond value and interest rates

Answer 15

The relationship is non-linear, the relation is non-linear because the cash flows associated with a bond are not evenly distributed over time. Small coupon payments are received first with the largest cash flow, the face value payment, received at maturity. The later in time a cash flow is received, the more heavily it is discounted.

Question 16

What is the relationship between bond maturity, the greater the sensitivity to changes in interest rates

Answer 16

the longer the maturity of the bond, the greater the sensitivity to changes in interest rates and the greater the non-linearity in the relation (the line becomes more curved). This relation arises because as bond maturity increases, the large face value payment received at maturity is realized further in the future and it is more severely impacted by a shift in the discount rate.

Question 17

Coupon and interest rates relationship

Answer 17

the larger the coupon the less sensitive the bond is to interest rate shifts. This relation arises because a larger portion of the total payment amount is received earlier and is thus less effected by shifts in interest rates.

Question 18

Default Risk

Answer 18

Default is the risk that the issuing company or government will default and stop paying coupon payments and potentially not repay the face value of the bond. Typically, bonds are considered low risk. As long as the issuer doesn’t default, the cash flows related to the bond never change and the bond holder is only impacted by a change in bond value if she elects to sell the bond prior to maturity.

Question 19

If company assets are liquidated in bankruptcy, what happens to bondholders

Answer 19

as company assets are liquidated in bankruptcy, bond holders will receive payment prior to shareholders. For these reasons, the expected return to a bond is always lower than the expected return for common stock issued by the same company.

Question 20

the lower and upper bound on the yield to maturity for a bond is the …

Answer 20

the lower and upper bound on the yield to maturity for a bond is the yield to maturity on a matching maturity risk-free debt instrument and the expected return to equity shareholders for the same issuer.