Chapter 11: Bond Fundamentals

Question 1

Bond

Answer 1

a long-term loan with fixed interest payments where an investor agrees to loan money to a company or government in exchange for a predetermined interest rate

Question 2

Principal Value

Answer 2

Amount owed by the issuer to the bondholder at the maturity of the bond.

(face, future, redemption, par value)

Question 3

Coupon rate

Answer 3

Amount of interest paid per year expressed as a percentage of the face value.

Question 4

Term to maturity

Answer 4

o Number of years over which the issuer has contracted to meet the conditions of the obligation set out in the terms of the bond.
o At which time the issuer will redeem the bond by paying the principle value to the holder.

Question 5

Market value

Answer 5

o Present value of all cash flows discounted at the prevailing market rate.

Question 6

What determines market value of a bond?

Answer 6

o Size of the coupon rate in relation to the market rate determines whether the bond trades at:
♣ Par (coupon rate = market rate)
♣ Discount (Coupon rate market rate)

Question 7

Yield to maturity

Answer 7

o Composite rate of return of all payouts, coupons and capital gain.
o Represents the total return on a bond if held until maturity and assuming that all coupons were reinvested at the yield to maturity.

Question 8

5 Bond risk exposures

Answer 8

Interest rate risk
Credit Risk
Yield Curve risk
Liquidity Risk
Call Risk

Question 9

2 Types of Interest rate risk

Answer 9

Price risk

Reinvestment risk

Question 10

2 Types of credit risk

Answer 10

Default risk
Credit spread risk
Downgrade risk

Question 11

Interest rate risk

Answer 11

o The risk to which a portfolio or institution is exposed due to future interest rates being uncertain.
o Bond prices are interest rate sensitive. If rates rise, then the PV of a bond will fall.

Question 12

2 Components of interest rate risk:

Answer 12

• Price Risk

- Reinvestment risk

Question 13

Price risk

Answer 13

• Uncertainty associated with potential changes in the price of a bond caused by changes in the price of a bond caused by changes in interest rate levels and rates of return in the economy.
• Occurs because changes in interest rates affect changes in discount rates, which in turn affect the PV.
• Only relevant when a bond is sold before maturity at a market rate different from the yield to maturity.

Question 14

Reinvestment risk

Answer 14

• Stems from the market rate being different from the yield to maturity.

Question 15

Credit risk

Answer 15

o Risk that the creditworthiness of a bond issuer will deteriorate, increasing the required return on that bond and decreasing its value.

Question 16

3 Components of Credit risk

Answer 16

Default risk
Credit spread risk
Downgrade risk

Question 17

Default risk

Answer 17

possibility that the issuer will fail to meet its obligations regarding the payment of coupons and the eventual principal in a timely manner.

Question 18

Credit spread

Answer 18

• Difference in the yield between different bonds due to their different credit quality.
o Reflects the additional net yield an investor can earn from a bond with more credit risk.

Question 19

Downgrade risk

Answer 19

• Risk that the bond’s price will decline due to a downgrade in its credit rating.

Question 20

Yield Curve risk

Answer 20

o Arises from a non-parallel shift in the yield curve.

o Due to yields of bonds with different maturities changing by different amounts.

Question 21

Liquidity risk

Answer 21

o Given by the difficulty of being able to sell securities quickly at an attractive price.
o Applies only when selling before due date.

Question 22

Call risk

Answer 22

o Faced by a holder of a callable bond if a bond issuer takes advantage of the callable bond feature and redeems the issue prior to maturity.

Question 23

Bond rating

Answer 23

Grade given to indicate a bond’s credit quality.

Measure of a bond’s default.

Question 24

Coupon bonds.

Answer 24

Benefit of receiving an interest payment on a semi-annual basis.

Question 25

Zero-coupon bonds.

Answer 25

Bonds that don’t pay interest.

Bought at a deep discount from their face value.

Question 26

Callable bond

Answer 26

o Type of bond that allows the issuer to retain the privilege of redeeming the bond at some point before it reaches maturity.

Question 27

Putable bond

Answer 27

o Allows the investor to mature the debt at an earlier date.

Question 28

Convertible bond

Answer 28

o Give the holder the option to exchange them for a predetermined number of shares in the issuing company.

Question 29

Extendable bond

Answer 29

o Gives the holder the right to extend its initial maturity at a specific date.

Question 30

Exchangable bond

Answer 30

o Allows the bondholder to exchange it, at a certain price, for common shares in a company other than the one that issued the debt security.

Question 31

Retractable bond

Answer 31

o Provides the investor who owns a longer-term bond with the right to withdraw it at a specific date.

Question 32

Floating rate notes

Answer 32

o Bonds that pay a fluctuating rate of interest.

o The coupon varies by period, depending on the prevailing market rate.