Bond Basics (Debt) Flashcards
What type of security is a bond?
A debt security.
What does debt security mean?
Loan obligation of the issuer. The issuer is borrowing capital (principal) that must be repaid with interest to the lender (investor)
Who issues bonds?
U.S. Government, agencies of the U.S. Government, municipal governments, and corporations.
What are the types of registration forms for bonds?
Bearer (physical certificate), registered as to principal only (physical), and fully registered or book entry.
What are the three maturity structures of bonds?
Term, serial, and series.
What is a term bond?
Issued on the same date and matures on the same date.
What is a serial bond?
Issued at the same time but with staggered maturity dates. Serial w/balloon payments refers to a large payment of principal at one of the maturity dates.
What is a series bond?
Staggered issue dates with the entire offering maturing on the same date.
What are the synonyms of par?
Face, principle, and denomination.
What is par?
Amount the issuer will repay to the investor at maturity. Interest is based on par.
What is coupon?
Annualized rate of interest. Based on par. Periodic interest (usually every 6 months). Principal only at maturity (Zero coupon bonds).
What is maturity?
Length of time from issuance until the issuer’s scheduled repayment of the principal.
What is the market price?
What potential investors are willing to pay for the bond in the market.
What is a discount bond?
Priced below par. The “discount” is the amount below par.
What is a premium bond?
Priced above par. The “premium” is the amount above par.
The main factor affecting the bond’s market price is the comparison of what?
Fixed coupon and fluctuating market interest rates.
If market rates are lower than the bond’s coupon rate the price does what?
Increases
If market rates are higher than the bond’s coupon rate the price does what?
Declines
What is nominal yield and how is it calculated?
Indicates the rate of interest paid by the issuer.
NY = Annual Income/Par
What is current yield and how is it calculated?
Rate of return for that coupon based on the current price of the bond in the marketplace.
CY = Annual Income/Current market value
What is yield to maturity and how is it calculated?
Annualized rate of return if the bond is held to maturity.
YTM = Annual Income +/- Annualized capital gain/or loss/Purchase price + redemption price/2
What is yield to call and how is it calculated?
Annualized rate of return if the bond is held to until the next call date.
YTC = Annual income +/- Annualized capital gain or loss/Purchase price + call price/2
What are some optional bond features?
Call provisions and put provisions.
What is a call provision and how it benefits the issuer?
Allows the issuer to force redemption of the bond at a set price on specific call dates.
If market rates are falling it allows the elimination of higher coupon bonds and replacement with lower coupon bonds.
If interest rates are not failing it allows the elimination of future interest payments.
What is a call provision and how it benefits the investor?
Call protection. Minimum period after issuance in which the bond cannot be called.
Call premium. Compensation for risk of being called early. Call premiums for call dates decrease as the bond approaches maturity.
Each call premium sets a ceiling on the market price as that call date approaches.
When are bonds more likely to be called?
Higher coupons, lower call premiums, and longer maturities.
What are put provisions?
Allows the bondholder to force the issuer to accept redemption at a set price and at a set date.
How are term bonds quoted?
Price quotes
How are serial bonds quoted?
Basis (Yield) quotes
Corporate and municipal bonds are quoted in what?
1/8ths.
All corporate and municipal term bonds must be in a whole number or whole number plus a fraction and the fraction must have a denominator or 2, 4 or 8.
U.S. Government bonds are quoted in what?
1/32nds.
All US Government bonds must be either a whole number or a whole number with a placeholder (., -, :) followed by a number representing the numerator to be divided by a denominator of 32.
1 basis point is equal to?
10 cents or 0.01% of par.
100 basis points is equal to?
$10 or 1% of par.
What issues are typically yield quotes?
Municipal bonds and corporate equipment trust certificates.
What kind of risk are associated with bonds?
Default (credit) risk, interest rate (market) risk, reinvestment risk, call risk, purchasing power risk, marketability risk, exchange risk, legislative risk, and political risk.
Explain default (credit) risk.
Issuer will not be able to fulfill its obligation to repay principal and future interest.
Explain interest rate (market) risk.
Market interest rates rise causing bond prices to fall.
Explain reinvestment risk.
Market interest rates decline forcing interest and/or principal to be reinvested at a lower rate.
Explain call risk.
Bondholder is forced to redeem prior to maturity (usually due to falling market interest rates).
Explain purchasing power risk.
Decrease in buying power due to inflation.
Long term fixed income is most susceptible.
Explain marketability risk.
Security will be difficult to sell (marketability risk) or without offering at a discount (liquidity risk).
Explain exchange risk.
Foreign investment that pays in a foreign currency.
When converting into U.S. dollars may result in a decrease in value (if the U.S. dollar is “strong”).
Explain legislative risk.
An adverse impact on an investment(s) due to a change in regulations.
Explain political risk.
An adverse effect on an investment(s) due to change in government.
What are the three yield curve types?
Normal (ascending), flat, inverted (descending).
A widening yield curve spread is an indicator of what?
Negative economic indicator
A narrow yield curve spread is an indicator of what?
Positive economic indicator
On a typical scale from high to low how is it listed?
Corporate, U.S. Government, Municipals.
What is bond volatility?
Measure of change in either prices or yields.
In terms of price volatility what makes a bond more volatile? (Maturities)
Longer maturities.
Most of the value of the bond lies with the final repayment of principal. Shorter maturity bonds have more stable prices due to the nearer return of principal. Longer maturity bonds fluctuate in value more due to a much later return of principal.
In terms of price volatility what makes a bond more volatile? (Coupons)
LOWER COUPONS and/or LOWER PRICED are MORE volatile
This rule applies when the bonds have the same or similar maturities. Lower coupon bonds have longer durations (and therefore increased risk and volatility).
Are short term bonds more volatile than long term?
Yes.
Short term bonds are MORE volatile. As new bonds are issued, those with shorter maturities tend to have greater changes in coupons and those with longer maturities tend to have lesser changes I coupons offered.
Credit risk chart. (Moody’s, S&P, and Fitch’s)
