Bond Investments and Interest Rates

Question 1

What is a bond?

Answer 1

A bond is a debt investment in which an investor loans money to an entity which borrows the fund for a define period of time at a variable or fixed interest rate.

Question 2

Comparing bonds and shares: certainty of returns

Answer 2

Shares: Dividends opened on profits and can be cut
Bonds: Coupons are fixed and legally enforceable

Question 3

Comparing bonds and shares: risk and return

Answer 3

Shares: Risker, higher return
Bonds: Less risky, lower return

Question 4

Comparing bonds and shares: traded markets

Answer 4

Primary: new sales by issuers
Secondary: buying and selling by investors

Question 5

What are the two bond risks?

Answer 5

Default

• not being paid back
• amount of existing debt
• variability of issuer’s cash flows
• measured by credit ratings
• some protection from restrictive covenants

Market interest rates
-when investors’ required return changes, bond prices react

Question 6

Bond Ratings

Answer 6

Measure of investment risk:

• how likely is it that a company will pay interest
• how likely is it that a company will repay principal

Rated by commercial organisations based on:

• company’s financial performance
• economic environment

Investor’s risk policy can limit investment in bonds to “investment grade”. A downgrading of a bond rating can trigger a requirement to sell, causing a fall in the bond price and an increase in its yield.

Question 7

What are restrictive covenants?

Answer 7

Conditions attached to a loan or bond:

• used to protect debt holders
• covenants restricts management’s powers throwing limiting the amount of other debt and target for gearing or current ratios.
• intention is to prevent the risk profile for the company being changed

Breach of covenant is a serious issue- can lead to forced early repayment.