Bonds essay

Question 1

What are bonds

Answer 1

Debt securities that are issued by governments, companies and transactional organisations

Question 2

What are a couple of characteristics of bonds?

Answer 2

1. usually have regular periodic fixed coupon payments
2. Repay the face value of the bond at the maturity date

Question 3

What are the 4 main types of bonds?

Answer 3

1. Government
2. Corporate
3. Municpal
4. Mortgage

Question 4

What are some characteristics of Government Bonds?

Answer 4

These bonds take up the largest percentage of the debt market, are the most common, and have no default risk as they are fully backed by the government

Question 5

What are some characteristics of Corporate Bonds?

Answer 5

Debt obligations from companies, are rated and then divided into what is known as an investment grade, these bonds can also come with options features, they also come with default risk

Question 6

Characteristics of mortgage bonds

Answer 6

Debt obligations that are backed by real estate, most popular are called Ginnie Mea’s, Ginnie Mea holder receives the remains of the principal and interest after a fee is removed for insurance and collection of payment, default risk is removed however income stream isn’t certain

Question 7

What are characteristic of Municipal bonds

Answer 7

Debt obligations that are backed by state and city authorities, come with default risk, arent subject to federal tax and usually exempt from state tax too

Question 8

What is term structure ??

Answer 8

The relation between the yield to maturity on a bond, could equally be described as dealing with the determination of spot rates.

Question 9

What do theorists of term structure seek to explain

Answer 9

Why zero-coupon bonds with different maturities have a different yield to maturity

Question 10

What are the 4 main term structure theories ?

Answer 10

1. pure expectations
2. liquidity preferences
3. segmented markets
   4.preferred habita

Question 11

Pure expectations

Answer 11

The theory’s original framework ignores the importance of bond maturity for investors, assumes that investors are risk-neutral, and establishes that the yield-to-maturity (YTM) of various bonds is structured in a way that the projected one-period returns of all bonds are equal.

Question 12

liquidity preferences

Answer 12

The second theory is Liquidity preferences, this theory predicts that investors require a higher expected one-period return to hold bonds with a longer horizon

Question 13

Market Segmentation

Answer 13

this theory suggests that different investors have specific preferences for specific maturity of bonds, this leads to the market being segmented into different sectors based on bond maturities.

Question 14

What do market segmentation theorists examine?

Answer 14

The flow of funds into these market segments to predicts change in yield curve

Question 15

What is the best way to understand pure expectations?

Answer 15

looking at an investor that can follow two alternative strategies, they could either buy a 2-period zero coupon bond or a 1-period zero-coupon bond at time zero and time 1. If pure expectations were to hold than the returns on both will be the exact same

Question 16

With the same example of the investor with 2 alternatives, what will he choose if he is an liquidity preferences investor

Answer 16

Because liquidity preferences investors need a premium to take on more risk-averse bonds, the two-period zero-coupon bond will have a premium to make it more attractive to an investor

Question 17

What role does liquidity preferences play in term structure of interest rates

Answer 17

liquidity preferences plays an important role in shaping the term structure of interest rates, with investors typically requiring higher yields to invest in longer-term bonds due to greater risk and uncertainty.

Question 18

Preferred habitat

Answer 18

this theory is based upon the premise that any investor who matches the life of their assets with the life of their liabilities is in the lowest position of risk. However, an investor who says has short-term preferences may be willing to move out of their comfort zone if a higher yield is offered on a long-term bond than their preferred short-term bond

Question 19

How does the term structure of interest rates affect the valuation of bonds ?

Answer 19

It shows that when interest rates rise, the value of existing bonds with fixed coupon rates decreases because investors can earn higher returns by investing in newly issued bonds with higher coupon rates and vice vursa

Question 20

How does term structure affect the yield curve of a bond

Answer 20

which can have a huge impact on their valuation, for example, a bond with a steep yield curve can indicate expectations of inflation which could further reduce the value of bonds with longer maturities.

Question 21

Who first introduced default risk ?

Answer 21

Fischer, Black and Myron who in 1973 made a major breakthrough when they introduced a new model for valuing corporate and municipal bonds that took into account default risk.

Question 22

What is default risk?

Answer 22

Only comes with corporate or municipal bonds, as these are debt obligations that are backed by a business that depends on its revenue, so the risk of the coupon or the principle not being met is something an investor needs to take into consideration when building their portfolio

Question 23

What is the risk premium?

Answer 23

The difference between the expected return and the return on default-free instrument

Question 24

What is the default premium

Answer 24

It is the difference between the expected return of an asset and the promised return

Question 25

Why are these premiums offered to investors?

Answer 25

They are needed in order to induce the investor as the chance of the bond defaulting is more substantial than default-free instruments

Question 26

Give an example of what returns on a bond would be like with these premiums

Answer 26

If a corporate bond gave a 12% return, it could be comprised of 2% default premium, 1% risk premium and the remainder 9% is the default-free return

Question 27

What would happen if a bond were to default?

Answer 27

Would result in very poor returns or even negative returns for an investor, so for them to invest in these riskier assets they will need a larger return for taking on a larger amount of risk

Question 28

How can investors know if a bond is likely to default?

Answer 28

They look at the bonds credit rating

Question 29

Who gives bonds their credit ratings

Answer 29

bond rating agencies such as Moody’s, standard and poor, and Finch

Question 30

How do they rate the bonds?

Answer 30

they look at the likelihood of loss and the size of the loss if it were to occur and then rate it accordingly

Question 31

What is the range of Moody’s ratings

Answer 31

Goes from Aaa which are the bonds that are said to be the best quality as they have the least amount of risk

All the way down to C which obviously carries the most amount of risk and has very poor prospects of of attaining any investment returns

Question 32

How does default risk affect bond valuation

Answer 32

investors require a higher yield on bonds that have large default risk, so typically bonds with high risk will trade at a discount to their face value, reflecting the higher yield. Furthermore, bonds with low default risk tend to trade at a premium to their face value as investors might be more comfortable paying more for some added safety.

Question 33

What are Tax effects

Answer 33

Bonds that receive a tax advantage on their returns

Question 34

What type of bond has a tax advantage

Answer 34

Municipal bonds, as the coupon payments to the bond owner, are not subject to federal tax and usually not subject to state tax

Question 35

How much lower percentage on yields does municipal bonds offer

Answer 35

Typically 30-40% lower yields than other examples

Question 36

Another example of bonds with tax advantages

Answer 36

Flower-bonds, they sell at a value well below their face value so their yield to maturity would be comparable to other bonds

Question 37

What is their tax advantage ?

Answer 37

They are accepted at face value in payment of estate taxes

Question 38

Whats one more example of tax-exempt bonds

Answer 38

One last example is bonds that have a low coupon that sells for a very different price than their face value, because of this the bonds have 2 components to their return.

Question 39

what are the 2 components of return to a bond with a low coupon

Answer 39

The first is the regular return from the coupon and the second is the return from price appreciation, which is subject to capital gains tax and not income tax, which is normally a lower rate, meaning the investor is taxed less