6) Other bond categories

Question 1

What are zero-coupon bond

Answer 1

Bullet Bonds – Bonds that don’t pay coupons

Question 2

How is a zero coupon bond priced? (2)

Answer 2

• It is priced on the basis of the receipt of the nominal value upon maturity.
• Therefore, its initial price is much lower than the nominal value (discount)

Convention to price such bonds on semi-annual compounding basis.

Question 3

What is the BKM (Bondary Knot method)?

Answer 3

Question 4

When do traders prefer zero coupon bonds and why? (2)

Answer 4

• Traders prefer zero-coupon bonds when interest rates are expected to fall.
• They are ideal for long-term, targeted financial needs at a foreseeable time.

Question 5

What is a callable bond?

Answer 5

A callable bond is a bond that includes an embedded call option.

Question 6

It’s an option but not an ________________

Answer 6

obligation

Question 7

When does the call feature allow the issuer to redeem the bond? (3)

Answer 7

• After a specified date (Lockout period)
• At the specified call price.
• Bond can be called at different scheduled dates after the call date

Question 8

What is the call price? (2)

Answer 8

• Pre-determined
• Normally above par, or “make-whole call,”

Question 9

What types of callable bonds are there? (3)

Answer 9

• European
• American, or
• Bermudan style.

Question 10

When is it conductive to make a bond call? (3)

Answer 10

• At or any time after the call date (after lockout period), for most callable bonds.
• When interest rates drop to a level where the issuer has the opportunity to replace a high-coupon bond with a low coupon bond.
• When the bond price is equal to or above the call price.

Question 11

Why do companies issue callable bonds? (3)

Answer 11

• To refinance at lower interest rates and reduce your interest bill.
• The company won’t be locked up in high interest rate regime for a long time
• Allows companies to respond to change in interest rates

Question 12

Who benefits more (issuer or investor) when bond is called and how? (2)

Answer 12

The issuer benefits, how?
o Issuer is in the position to benefit at the beginning because the issuer has the right but not the obligation.

Question 13

Under what circumstances does the issuer benefit, when the bond is called?

Answer 13

When interest rates drop, and they are able to replace a high coupon bond with a low coupon bond

Question 14

Who losses when a bond is called and under what circumstances? (2)

Answer 14

Investor/lender loses if the bond eventually gets called, how?
o They lose because they get stuck with their money when interest rates are low.
o Get expose to reinvestment risk. (Reinvesting at low yields)

Question 15

When does the investor win and how?

Answer 15

Enjoy high reinvestment returns or sell bond at a premium.

Question 16

• Callable bonds offer _______ yields (more risk) because they offer more yields the ___________ rates are higher, or they trade at a discount.
• The call price is higher than the ____ value. (They offer higher yields relative to option-free bonds)

Answer 16

higher
coupon
face

Question 17

Do investors like callable bonds, why? (1 pro and 3 cons)

Answer 17

• Yes, on one side they offer high yield (coupon or discount).
• No, they expose them to reinvestment risk. (Investor reinvesting their money at low interest rates)
• No, Price appreciation is capped
• No, don’t always have positive convexity

Question 18

Would you buy a callable or non-callable bond; under what circumstances would you make money by
buying a callable? (4)

Answer 18

• Yes, you can buy a callable bond.If you know it is not going to get called. Get high yields
• It will not get called if interest rate stays constant or do not drop below call price. (Enjoy high yield till maturity)
• As an issuer to issue callable bonds if you know interest rates will drop.
• Reserve bank controls interest rates and for that reason cannot issue callable bonds (They are independent.)

Question 19

What is a puttable bond?

Answer 19

The bondholder has the option to sell (put) the bond back to the company before maturity at the put price (predetermined).

Question 20

This is a benefit to the ____________. Hence, in general they will sell at a relatively lower ______ (sell at a premium, lower coupon) relative to similar non-putable bonds.

Answer 20

bondholder
yield

Question 21

Under what circumstance would you exercise that right to “put” your bond? (2)

Answer 21

• When the bond price drops below the put price or equals the put price.
• After the lockout period.

Question 22

Why would a company issue a putable bond? (2)

Answer 22

• To incentivise investors, some companies are not “attractive”.
• To make a meal out their bet on interest rates decline.
  o i.e., to make a saving/raise more money based on betting on market conditions
  o Betting on an interest rate decline. Take advantage of their forecast on interest rates

Question 23

What are the incentives for the issuer to buy a putable bond? (3)

Answer 23

• A puttable bond allows investors to sell back the bond to the issuers and reinvest their money at higher interest rates.
• To compensate the issuer for the risk of borrowing at high interest rates puttable bonds will offer lower coupons relatively to straight bonds and may be sold at a premium or higher price.
• A lower coupon means the issuer will pay a low interest. Selling at a premium or higher price means the issuer will be able to raise more finance.

Question 24

What are floating rate bonds?

Answer 24

Interest payments tied to some measure of current market rates.

Question 25

What are convertible bonds?

Answer 25

Can exchange bond for shares in the company.

Question 26

When do you buy a callable bond?

Answer 26

Anticipating interest rates to increase over the life of the bond, remain constant or decrease but not to the extent of pushing up the bond price above call price

Question 27

What are the sources of return from a bond? (3)

Answer 27

1) Coupon payments/the income stream
2) Reinvestment income (coupons received earlier are reinvested)
3) Capital gain or loss.