Chapter 11: Bond Fundamentals Flashcards
Bond
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
Principal Value
Amount owed by the issuer to the bondholder at the maturity of the bond.
(face, future, redemption, par value)
Coupon rate
Amount of interest paid per year expressed as a percentage of the face value.
Term to maturity
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.
Market value
o Present value of all cash flows discounted at the prevailing market rate.
What determines market value of a bond?
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)
Yield to maturity
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.
5 Bond risk exposures
Interest rate risk Credit Risk Yield Curve risk Liquidity Risk Call Risk
2 Types of Interest rate risk
Price risk
Reinvestment risk
2 Types of credit risk
Default risk
Credit spread risk
Downgrade risk
Interest rate risk
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.
2 Components of interest rate risk:
- Price Risk
- Reinvestment risk
Price risk
- 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.
Reinvestment risk
• Stems from the market rate being different from the yield to maturity.
Credit risk
o Risk that the creditworthiness of a bond issuer will deteriorate, increasing the required return on that bond and decreasing its value.
3 Components of Credit risk
Default risk
Credit spread risk
Downgrade risk
Default risk
possibility that the issuer will fail to meet its obligations regarding the payment of coupons and the eventual principal in a timely manner.
Credit spread
• 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.
Downgrade risk
• Risk that the bond’s price will decline due to a downgrade in its credit rating.
Yield Curve risk
o Arises from a non-parallel shift in the yield curve.
o Due to yields of bonds with different maturities changing by different amounts.
Liquidity risk
o Given by the difficulty of being able to sell securities quickly at an attractive price.
o Applies only when selling before due date.
Call risk
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.
Bond rating
Grade given to indicate a bond’s credit quality.
Measure of a bond’s default.
Coupon bonds.
Benefit of receiving an interest payment on a semi-annual basis.
