Bond Valuation & Interest Rates Flashcards
Why do some bonds sell at a discount?
A bond will sell at a discount if the coupon rate is lower than the required return on a bond, since it provides insufficient coupon payments compared to that required by investors on other similar bonds.
** When the YTM > coupon rate
Why do some bonds sell at a premium over par value?
A bond will sell at a premium if the coupon rate is higher than the required return on a bond, since it provides periodic income in the form of coupon payments in excess of that required by investors on other similar bonds.
**A bond trades at a premium when its coupon rate is higher than prevailing interest rates. (In other words, when the coupon rate > the YTM)
When do bonds sell at par value?
For a bond to sell “at par” means that it is selling at full face value. When a bond sells at full face value, the coupon rate (or the bond yield) is equal to the yield to maturity (YTM) ~ since bond interest does not compound.
What is the relationship between the price of a bond and it’s yield to maturity (YTM)?
~The bond price is the present value of the cash flows from a bond.
~ The YTM is the interest rate used in valuing the cash flows from a bond.
What is the relationship between the current yield & YTM for premium bonds?
Current yield > YTM
What is the relationship between the current yield & YTM for discount bonds?
YTM > Current yield
What is the relationship between the current yield & YTM for bonds selling at par value?
Current yield = YTM
What is a bond’s current yield?
A bond’s annual coupon divided by its price
What is the maturity on a 10 percent coupon bond that sells for par value?
The maturity is indeterminate. A bond selling at par can have any length of maturity.
What is a bond’s yield to maturity (YTM)?
The interest rate required in the market on a bond.
The YTM takes into account the bond’s current market price, par value, coupon interest rate and time to maturity.
Is the yield to maturity (YTM) on a bond the same thing as the required return?
YTM is the required rate of return on a bond expressed as a nominal annual interest rate. For noncallable bonds (locked interest rates), the YTM & required rate of return are used interchangeably.
Is the yield to maturity (YTM) the same thing as the coupon rate?
Nooooooope. Unlike yield to maturity & required return, the coupon rate is not a return used as the interest rate in bond cash flow valuation. It is a fixed percentage of par over the life of the bond used to set the coupon payment amount.
If a bond is purchased and held to maturity, then YTM is the ________ or _______ on the investment.
Return or yield
Bond ratings do what?
Assess default risk
What is the definition of a Bond?
A promise to make periodic interest payments for a set number of years, followed by payment of the face value.
What are the “parts” of a bond?
- Face value or par value~ amount repaid at maturity ($1,000)
- Maturity~ time until face value is repaid.
- Coupon~ periodic interest payment
- Coupon rate~ annual coupon / face value
- Yield to maturity~ market rate of return on the bond
- “Current yield”~ annual coupon / price
Longer-term bonds have more interest rate risk than ____________.
Shorter-term bonds
Lower coupon rate bonds have more interest rate risk than ________________.
Higher coupon rate bonds
Bond prices & bond yields move in what direction of each other?
Opposite
What are the 6 bond features?
- Bond Indenture
- Face Value
- Security
- Seniority
- Call Provision
- Bond Covenants
How much interest rate risk a bond has depends on how sensitive its price is to interest rate changes.
This sensitivity depends on what 2 things?
- The time to maturity <> the *longer the time to maturity, the greater the interest rate risk
- The coupon rate <> the *lower the coupon rate, the greater the interest rate risk
What’s the difference between real & nominal rates?
Nominal rates - called “nominal” because they have NOT been adjusted for inflation.
Real rates - rates that have been adjusted for inflation.
What is a simple definition of the Fisher Effect?
The relationship between nominal returns, real returns, and inflation.
1 + R = (1 + r) x (1 + h)
R –> nominal rate of return on dollars invested
r –> real rate of return on goods & services we can
buy with $)
h –> inflation rate
