Bond Valuation

Question 1

What is a bond?

Answer 1

A bond is a security sold by governments or corporations to raise money from investors today in exchange for promised future payments.

Question 2

What are the key terms associated with bonds? (4)

Answer 2

Face value:

• The amount repaid at the end of the bond’s life.
  Coupon rate:
• The interest rate set by the bond issuer.

Maturity:

• The length of time until the repayment date.

Coupon payment interval:

• The number of interest payments per year.

Question 3

What is a zero-coupon bond?

Answer 3

A bond that does not make coupon payments and is sold at a discount to its face value.

Question 4

What is the primary market for bonds?

Answer 4

The market where bonds are initially issued and sold to investors.

Question 5

What is the secondary market for bonds?

Answer 5

The market where existing bonds are traded among investors.

Question 6

Why are bonds considered less risky than equity? (3)

Answer 6

1. The coupon payable is a legally defined obligation.
2. The nominal value of the bond may be secured against assets (collateralized).
3. Equity holders are subordinate to bondholders in terms of creditor position if a business goes bankrupt.

Question 7

What is a debt covenant?

Why are they put in place?
What happens if one or more are breached

Answer 7

Provisions in a bond contract designed to protect lenders by restricting the actions of the borrower.

• Covenants are inserted into contracts to prevent the company taking actions that will increase the risk of default on the debt
• If one or more covenants are breached, the debt may become repayable immediately.

Question 8

What is the difference between equity and debt finance?

Answer 8

• Equity finance involves raising capital by selling shares,
• while debt finance involves borrowing money through issuing bonds

Question 9

Different time length bonds (3)

Answer 9

Short-term bonds:

• These have a maturity of less than 5 years.

Medium-dated bonds:

• These mature in 5 to 15 years.

Long-term bonds:

• These have a maturity of over 15 years.

These boundaries aren’t rigid. They can be somewhat flexible depending on the context.

Question 10

How do you value a bond?

Answer 10

The value of a bond is the present value of its future coupon payments and face value, discounted at the bond’s yield to maturity (YTM).

Question 11

What is Yield to Maturity (YTM)?

Answer 11

The discount rate that sets the present value of a bond’s future cash flows equal to its current market price.

Question 12

How does bond price sensitivity relate to interest rates?

Answer 12

Bond prices and market interest rates move in opposite directions. When interest rates rise, bond prices fall and vice versa.

Question 13

What is Macaulay Duration?

Answer 13

The weighted average maturity of a bond’s cash flows, measuring the bond’s sensitivity to interest rate changes.

Question 14

What is the yield curve?

Answer 14

A plot showing the relationship between bond yields and maturities, indicating the term structure of interest rates.

Question 15

What are the three main hypotheses explaining the yield curve shape?

Answer 15

1. Expectations Hypothesis:

• Future short-term rates equal the forward rates.

2. Liquidity Preference Hypothesis:

• Investors demand a premium for holding long-term bonds.

3. Inflation Risk Hypothesis:

• Investors demand a premium for long-term bonds due to uncertainty about future inflation

Question 16

What are callable and puttable bonds?

Answer 16

Callable bonds:

• Issuers can call back the bonds at pre-specified prices before maturity, usually offering higher yields.

Puttable bonds:

• Bondholders can resell the bond back to the issuer at pre-specified prices before maturity, usually offering lower yields.

Question 17

What is the term structure of interest rates?

Answer 17

The relationship between maturity and yield, often represented by the yield curve, which can be upward sloping, downward sloping, or flat.

Question 18

Bond prices and market interest rates move in ___________ _____________.

Answer 18

Bond prices and market interest rates move in opposite directions.

When coupon rate = YTM, price = par value.
When coupon rate > YTM, price > par value (premium bond)
When coupon rate < YTM, price < par value (discount bond)