6) Other bond categories Flashcards
What are zero-coupon bond
Bullet Bonds – Bonds that don’t pay coupons
How is a zero coupon bond priced? (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.
What is the BKM (Bondary Knot method)?
When do traders prefer zero coupon bonds and why? (2)
- 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.
What is a callable bond?
A callable bond is a bond that includes an embedded call option.
It’s an option but not an ________________
obligation
When does the call feature allow the issuer to redeem the bond? (3)
- After a specified date (Lockout period)
- At the specified call price.
- Bond can be called at different scheduled dates after the call date
What is the call price? (2)
- Pre-determined
- Normally above par, or “make-whole call,”
What types of callable bonds are there? (3)
- European
- American, or
- Bermudan style.
When is it conductive to make a bond call? (3)
- 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.
Why do companies issue callable bonds? (3)
- 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
Who benefits more (issuer or investor) when bond is called and how? (2)
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.
Under what circumstances does the issuer benefit, when the bond is called?
When interest rates drop, and they are able to replace a high coupon bond with a low coupon bond
Who losses when a bond is called and under what circumstances? (2)
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)
When does the investor win and how?
Enjoy high reinvestment returns or sell bond at a premium.
- 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)
higher
coupon
face
Do investors like callable bonds, why? (1 pro and 3 cons)
- 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
Would you buy a callable or non-callable bond; under what circumstances would you make money by
buying a callable? (4)
- 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.)
What is a puttable bond?
The bondholder has the option to sell (put) the bond back to the company before maturity at the put price (predetermined).
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.
bondholder
yield
Under what circumstance would you exercise that right to “put” your bond? (2)
- When the bond price drops below the put price or equals the put price.
- After the lockout period.
Why would a company issue a putable bond? (2)
- 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
What are the incentives for the issuer to buy a putable bond? (3)
- 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.
What are floating rate bonds?
Interest payments tied to some measure of current market rates.
What are convertible bonds?
Can exchange bond for shares in the company.
When do you buy a callable bond?
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
What are the sources of return from a bond? (3)
1) Coupon payments/the income stream
2) Reinvestment income (coupons received earlier are reinvested)
3) Capital gain or loss.
