Bond Basics Flashcards
Which bond will exhibit the greatest price volatility?
A. 10-year bond; 7% coupon; 8% yield; duration of 7.25
B. 8-year bond; 0% coupon; 7% yield; duration of 8.00
C. 4-year bond; 4% coupon; 3% yield; duration of 3.74
D. 2-year bond; 2% coupon; 1% yield; duration of 1.97
The best answer is B.
The longer the expiration, the more volatile a bond’s price movements, which narrows the Choices to either A or B. The lower the coupon, the more volatile the bond’s price movements, with the lowest coupon being “0.” An 8-year zero coupon bond will actually be more volatile in price movements than a slightly longer maturity bond (10 years) with a fairly high coupon (7% in this case). The higher coupon means that more of the bond’s value is represented by the interest stream than comes in early and this stabilizes the bond’s price as market interest rates move.
Duration is a concept that is tested as a “basic” idea on Series 7. It represents the amount of time that it will take for an investor to recoup his or her purchase price. The longer the duration, the longer it will take for an investor to get his or her money back and longer term bonds are more volatile. So the higher the duration number, the greater the bond volatility, and duration is often used as a measure of bond price volatility.
Which bond will exhibit the greatest price volatility?
A. 11-year bond; 7% coupon; 8% yield; duration of 7.71
B. 9-year bond; 0% coupon; 7% yield; duration of 9.00
C. 5-year bond; 4% coupon; 3.50% yield; duration of 4.59
D. 3-year bond; 2% coupon; 1.50% yield; duration of 2.93
The best answer is B.
The longer the expiration, the more volatile a bond’s price movements, which narrows the Choices to either A or B. The lower the coupon, the more volatile the bond’s price movements, with the lowest coupon being “0.” A 9-year zero coupon bond will actually be more volatile in price movements than a slightly longer maturity bond (11 years) with a fairly high coupon (7% in this case). The higher coupon means that more of the bond’s value is represented by the interest stream than comes in early and this stabilizes the bond’s price as market interest rates move.
Duration is a concept that is tested as a “basic” idea on Series 7. It represents the amount of time that it will take for an investor to recoup his or her purchase price. The longer the duration, the longer it will take for an investor to get his or her money back and longer term bonds are more volatile. So the higher the duration number, the greater the bond volatility, and duration is often used as a measure of bond price volatility.
Which statements are TRUE?
I Most of the value of a bond is established by the present value of the first payment
II Most of the value of a bond is established by the present value of the last payment
III The longer the maturity of a bond, the greater the bond’s price volatility
IV The shorter the maturity of a bond, the greater the bond’s price volatility
A. I and III
B. I and IV
C. II and III
D. II and IV
The best answer is C.
The actual dollar price of a bond is computed by taking the yearly income stream and principal repayment at maturity and discounting it back to today’s “present value” based on the current market interest rate. Most of the value of the bond comes not from the yearly interest payments, but rather from the final payment when the principal ($1,000 par) is being returned.
From a present value standpoint, if a bond has a long maturity, the present value of the final principal payment is greatly affected by interest rate movements, since many years of compounding are applied to get the present value of the last $1,000 payment. On the other hand, if the bond has a short maturity, the present value of the final $1,000 principal payment is not affected much at all by market interest rate movements, because the basic truth is that the bond will be redeemed shortly at par, so the value of the payment cannot vary much from par.
In 2019, a customer buys 1 GE 8%, $1,000 par debenture, M ‘34, at 85. The interest payment dates are Jan 1st and Jul 1st. The yield to maturity on the bond is:
A. 6.98%
B. 7.58%
C. 8.00%
D. 9.73%
The best answer is D.
The formula for yield to maturity for a discount bond is:
(Bond Cost +Redemption)/2
$80+($150 Dis/ 15 Years to Maturity) $80+$10
—————————————————– = —————
($850 + $1000)/2 $925
$90
——- = 9.73%
$925
A municipal dealer quotes a 4 year, 4% term revenue bond at 98. The yield to maturity is:
A. 4.25%
B. 4.55%
C. 4.75%
D. 5.00%
The best answer is B.
The formula for yield to maturity is:
Annual Income + Annual Capital Gain(Discount)
——————————————————————— = YTM
Average Bond Value
This bond has a coupon rate of 4% = 4% of $1,000 par = $40 of annual income. The bond is purchased at 98% of $1,000 par = $980; and will mature at $1,000 in 4 years, Thus, the $20 capital gain is earned over 4 years for an annual gain of $20 / 4 = $5 per year.
The bond is purchased at $980 and matures at $1,000, for an average value of $980 + $1,000 / 2 = $990.
The YTM is: $40 + $5
————– = 4.545% = 4.55%
$990
A municipal dealer quotes a 9 year, 6% term revenue bond at 92. The yield to maturity is:
A. 6.50%
B. 6.92%
C. 7.12%
D. 7.18%
The best answer is D.
The formula for yield to maturity is:
Annual Income + Annual Capital Gain(Discount)
——————————————————————— = YTM
Average Bond Value
This bond has a coupon rate of 6% = 6% of $1,000 par = $60 of annual income. The bond is purchased at 92% of $1,000 par = $920; and will mature at $1,000 in 9 years, Thus, the $80 capital gain is earned over 9 years for an annual gain of $80 / 9 = $8.88 per year.
The bond is purchased at $920 and matures at $1,000, for an average value of $920 + $1,000 / 2 = $960.
The YTM is: $60 + $8.88
————– = 7.175% = 7.18%
$960
A municipal dealer quotes a 9 year, 6% term revenue bond at 109. The yield to maturity is:
A. 4.58
B. 4.78
C. 5.50
D. 6.00%
The best answer is B.
The formula for yield to maturity for a premium bond is:
Annual Interest - Annual Cap. Loss
————————————————– = Yield to Mat. on Prem
(Bond Cost + Redemp Price)/2 Bond
$60 - ($90 Premium/9 years to maturity) $60-$10 $50
——————————————————— = ————- = ——- =
($1090 + $1000)/2 $1045 $1045
4.78%
A municipal dealer quotes a 2 year, 8% term revenue bond at 106. The yield to maturity is:
A. 1.88%
B. 4.85%
C. 7.54%
D. 8.00%
The best answer is B.
The formula for yield to maturity for a premium bond is:
Annual Interest - Annual Cap. Loss
————————————————– = Yield to Mat. on Prem
(Bond Cost + Redemp Price)/2 Bond
$80 - ($60 Premium/2 years to maturity) $80-$30 $50
——————————————————— = ————- = ——-
($1060 + $1000)/2 $1030 $1030
4.85%
Yield curve analysis is useful for an investor in debt securities for all of the following reasons EXCEPT:
A. the yield curve is used to compare the marketability risk of one issue to that of another
B. investors can compare rates of return relative to changing maturities
C. the yield of a specific security can be compared to the market expectation for similar securities
D. the curve shows market expectations for interest rates
The best answer is A.
The yield curve is not used to compare the marketability risk of different issuers. This is the risk that the security will be difficult to sell. The yield curve shows market expectations for interest rates - depending on the shape of the curve. An ascending curve indicates that interest rates are likely to rise in the future; a descending curve indicates that interest rates are likely to fall in the future. Because the yield curve shows all the market interest rates for all maturities, investors can compare rates against differing maturities. The yield curve is an average for securities of a given risk class. An investor can compare the yield on a specific security to the curve for the risk class to evaluate the attractiveness of that investment. If there is a great demand for a specific maturity, the price will be pushed up and the yield lowered. One can pick this out in a yield curve since the curve would drop for that specific maturity.
The yield curve shows the yields of:
A. different maturities of the same type of security
B. different types of securities with the same maturity
C. different risk classes of securities with the same maturity
D. different maturities of securities with different risk classes
The best answer is A.
The yield curve compares the yields of all maturities for the same type of security (e.g., the yields for all maturities of U.S. Government securities; the yields for all maturities of AAA rated corporate securities, etc.)
Yield curve analysis is useful for an investor in debt securities because:
I the curve shows market expectations for interest rates
II investors can compare rates of return relative to changing maturities
III the yield of a specific security can be compared to the market expectation for similar securities
IV the curve can show relative demand for differing maturities by comparing the change in yield to the change in maturity
A. I, II only
B. II, III only
C. I, III, IV
D. I, II, III, IV
The best answer is D.
All of the statements are true regarding yield curve analysis. The curve shows market expectations for interest rates. Because it shows all the rates for all maturities, investors can compare rates against differing maturities. The yield curve is an average for securities of a given risk class. An investor can compare the yield on a specific security to the curve for the risk class to evaluate the attractiveness of that investment. If there is a great demand for a specific maturity, the price will be pushed up and the yield lowered. One can pick this out in a yield curve since the curve would drop for that specific maturity.
During a period when the yield curve is normal:
A. short term bond prices are more volatile than long term bond prices
B. long term bond prices are more volatile than short term bond prices
C. short term and long term bond prices are equally volatile
D. no relationship exists between short term and long term bond price changes
The best answer is B.
Whether the yield curve is ascending (normal), flat or descending, long term bond prices always move faster than short term bond prices, as interest rates change. This is due to the compounding effect on the bond’s price that occurs, which increases with longer maturities.
When the yield curve is ascending, which of the following statements are true?
I Short term rates are lower than long term rates
II Short term rates are higher than long term rates
III To maximize income, an investor should invest in short term maturities
IV To maximize income, an investor should invest in long term maturities
A. I and III
B. I and IV
C. II and III
D. II and IV
The best answer is B.
During periods when the yield curve is ascending (a normal curve), long term rates are higher than short term rates. In this case, one would buy higher yielding long term securities to maximize income.
Which of the following would cause the yield curve to be ascending?
A. An increase in demand for long term bonds from investors
B. An increase in the laddering of bond portfolios by investors
C. The Federal Reserve pursuing a tight monetary policy
D. Short term yields declining at the same time as long term yields are increasing
The best answer is D.
An ascending yield curve is a normal curve - short term yields are normally lower than long term yields. Choice D describes an ascending curve. If there is an increase in demand for long term bonds, then long term bond prices rise and their yields fall. This can cause their yields to fall below short term rates - an inverted yield curve - making Choice A wrong. If the Federal Reserve is pursuing a tight money policy, this will raise short term rates (the Fed exerts its influence at the short end of the yield curve). Again, this can cause the curve to invert - making Choice C wrong. Finally, a “laddered” bond portfolio is one that has maturities staggered at roughly even intervals - say 5, 10, 15, 20, 25 and 30 years out. Thus, every 5 years, bonds are maturing and if rates have been rising, the proceeds are reinvested at higher current rates. This gives some protection to the value of the portfolio in a period of rising interest rates. Because purchases are being made at even intervals across the yield curve, laddering should not distort the shape of the yield curve - making Choice B wrong.
Under the “market expectations” theory of yield curves, when investors expect interest rates to rise in the future, the yield curve should be:
A. ascending
B. descending
C. inverted
D. flat
The best answer is A.
Under the “market expectations” theory of yield curves, when investors expect interest rates to rise in the future, the yield curve will have an upward slope. Conversely, when investors expect interest rates to fall in the future, the yield curve will have a downward slope. If investors are uncertain as to the future direction of market interest rates, then the yield curve will be flat.
