Bonds Flashcards
What is a bond?
A security that is issued in connection with a borrowing arrangement
What does par/face value mean?
The payment to the bondholder on the bond’s maturity date
What is the coupon rate?
A bond’s interest payment relative to its par value
What is a bond indenture?
The contract between the issuer and the bondholder
what is accrued interest?
what is the formula for accrued interest?
Annual coupon payment/2 *
Days since last coupon payment/ days separating coupon payments
What is the sale/invoice price of a bond?
flat price + accrued interest
What are corporate bonds?
long term contracts where bondholders lend money to a company
usual maturity = 7-30 years
many investors buy and hold to maturity
What does a callable bond allow?
Allows the issuer to repurchase the bond at a specified call price before the maturity date
(eg if interest rates fall & the bond has a high coupon rate may want to return bond and replace with a lower coupon paying issue)
what do callable bonds typically come with?
Call protection (initial time period in which the bond can’t be called)
Who does call protection benefit?
Benefits firms
Burden to bondholders
Suppose a company issues two bonds with identical coupon rates and maturity dates. One bond is callable, however, the other is not. Which bond will sell at a lower price?
The callable bond will sell at a lower price as they give the right but no obligation to the issuer to redeem them prior to predetermined maturity date.
Issuers hold a call option which is a privilege for the issuer. The buyers would not be willing to pay as much knowing that.
no free lunches in finance.
What are convertible bonds?
carry a similar interest rate to normal bonds but also give bondholders option to exchange each bond for a specific no. of shares of common stock of a firm
What is the conversion ratio?
the no. of shares for which each bond Amy be exchanged
How do you calculate the conversion ratio?
Par value of bond / conversion price
What is the market conversion value?
Value of the convertible bond if it were converted into ordinary shares at the current share price
What do convertible bonds offer?
Lower coupon rates
Lower yields to maturity
What are puttable bonds?
Gives the holder the option to exchange for par value at some date
or to extend the bond for a given no. of years
When will a bondholder be likely to extend a potable bond?
If the bond’s coupon rate > current market yields
What is a floating rate bond ?
Has interest rate that is reset periodically according to specified market rate
bond pays approx current market rates
What is the major risk with floaters?
rate doesn’t adjust to changes in the firm’s financial conditions
doesn’t take the idiosyncratic risk of firms onto account, if a firm’s performance declines, then their credit risk rises which should be reflected in the interest rate, however when the interest rate is tued to the market rate rate this will not be the case
What is preferred stock?
considered equity but commonly pays fixed dividends
What is the difference between bonds and preferred stock?
failure to pay the promised dividend does not result in corporate bankruptcy
Disadvantage of preferred stock
Not tax deductible expenses
reduces attractiveness
What are foreign bonds?
Issued by a borrower from a country other than the one in which the bond is sold.
Examples of foreign bonds
Samurai bonds (yen denominated bonds sold in Japan by non-Japanese issuers).
Bulldog bonds (£-denominated foreign bonds sold in UK)
What are Eurobonds?
Denominated in one currency, usually that of the issuer, but sold in other national markets
Examples of eurobonds
Euroyen bonds
Eurosterling bonds
What are inverse floaters?
like floating-rate bonds, except coupon rate falls (/increases)
when the general level of interest rates rises (/falls)
What are asset backed bonds?
use income from a specified group of assets to service the debt
What are catastrophe (CAT) bonds?
a form of insurance securitization. Investors in these bonds receive compensation in the form of higher coupon rates for taking on the risk. But in the event of a catastrophe, the bondholder will lose all or part of their investments
What are indexed bonds?
make payments that are tied to general price index or commodity price
What is the formula to calculate nominal returns?
(interest + price increase) / initial price
What is the formula for real returns?
(1 + nominal returns)/
1 + inflation
What is the bond price?
The price an investor is willing to pay for a bond depends on the present value of the cash flows expected to be received by holding the bond
What is the cash flow from bonds?
Coupon payments + par value
What is the formula for bond value?
Present value of coupons + present value of par value
Discount rate used is comprised of :
Risk-free rate
Expected inflation premium Risk-premium
What if the interest rate is not the same as the coupon rate?
The bond price will not be equal to the par value
What does a higher interest rate lead to?
REDUCES present value of future coupon payments and final payment
What does a lower interest rate lead to?
INCREASES present value of future coupon payments and final payment
What does longer maturity of a bond mean?
greater sensitivity of price to interest rate fluctuations
Also the longer the period for which your money is tied up, the greater the loss, and the greater the drop in bond prices.
What is the equation for bond value?
sum of: coupon/(1 + r)^t + Par value/ (1 + r)^t
What is the yield to maturity ?
the interest rate that makes the present
value of a bond’s payments equal to its price
A measure of the average rate of return that will be earned on a bond if it is bought now and held until maturity
What is the current yield?
the bond’s annual
coupon payment divided by its price
What are premium bonds?
Sell above par value
Coupon rate > Current yield > YTM
What are discount bonds?
Sell below par value
Coupon rate < Current yield < YTM
Yield to call
Low interest rates
The price of the callable bond is flat since the risk of repurchase or call is high
High interest rates
The price of the callable bond converges to that of a normal bond since the risk of call is negligible
When will YTM equal the rate of return realised over the life of the bond?
if all coupons are reinvested to earn the bond’s YTM
What is realised compound return?
he compound rate of return assuming that coupon payments are reinvested until maturity
What is horizon analysis?
Forecasting the realized compound yield over various holding periods or investment horizons
What happens when interest rates increase?
Bond price falls reducing the value of portfolio
Reinvested coupon income will compound more rapidly
When does a bond sell at par?
Coupon rate = market interest rate
When does a bond sell below par?
Coupon rate < market interest rate
When does a bond sell above par ?
Coupon rate > market interest rate
When does the rate of return on the bond equal the yield?
When YTM is unchanged over the period
What does a higher bond yield do?
reduces bond price → reduces holding period return
What does a lower bond yield do?
increases bond price → increases holding period return
What is a zero coupon bond?
Only one payment on maturity date of the bond (no coupon payments). Sell at discount from par value
What is an example of a zero coupon bond?
US Treasury bills - short term
Where does investors’ return come from?
in the form of price appreciation
What should happen to the price of longer term zero coupon bonds as time passes?
On their maturity date, zeros sell at par
Before maturity, they sell at discount because of time value of money
What is the formula for the price of a zero coupon bond?
P = par value/ (1 + r)^n
What are Original Discount Bonds?
Built-in price appreciation is treated as an implicit interest payment for tax purposes (even if the asset does not make a payment)
Additional gains/losses arising from market interest rate fluctuations are treated as capital gains/losses if OID bond is sold.
