Chapter 12 - Investing in Bonds

Question 1

Define Bonds

Answer 1

long-term debt securities issued by government agencies or corporations that are collateralized by assets.

Question 2

Define Debentures

Answer 2

long-term debt securities issued by corporations that are secured only by the corporation’s promise to pay (riskier than bonds).

Question 3

Par value

Answer 3

for a bond, its face value, or the amount returned to the investor at the maturity date when the bond is due.

Market price is expressed as a percentage of the bond’s par value.
A bond quoted as selling for 95.21 is selling for 95.21% of its par value.
Coupon payments are normally paid semi-annually.

Question 4

Term to maturity

Answer 4

the date at which a bond will expire and the par value of the bond, along with any remaining coupon payments, is to be paid back to the bondholder.
Bonds maturities vary between 1 and 30 years

Question 5

Bond Characteristics - Call feature

Answer 5

allows the issuer to repurchase the bond from the investor before maturity.
- Offer a slightly higher return than similar bonds without a call feature.

Question 6

Bond Characteristics - Sinking Fund

Answer 6

a pool of money that is set aside by a corporation or government to repurchase a set amount of bonds in a set period of time.

Usually places a limit on how much of an issue can be repurchased at the sinking fund price.

Question 7

Bond Characteristics - Convertible bond

Answer 7

a bond that can be converted into a stated number of shares of the issuer’s stock at a specified price

Question 8

Bond Characteristics - Extendible bond

Answer 8

a short-term bond that allows the investor to extend the maturity date of the bond.

Question 9

Bond Characteristics - Put feature

Answer 9

allows the investor to redeem the bond at its face value before it matures.

Question 10

Bond Characteristics - Current yield

Answer 10

the yield derived by dividing the bond’s annual coupon payments by its current market price.

Question 11

Bond Characteristics - Yield to maturity (YTM):

Answer 11

the annualized return on a bond if it is held until maturity.

If a bond sells at par value, its yield to maturity equals the coupon rate.

Question 12

Bond Characteristics - Yield to call (YTC)

Answer 12

yield on a bond if the issue remains outstanding until its call date
- the price that will be paid if the issuer of a callable bond opts to pay it off early.

Question 13

Bond Characteristics - Discount Bond

Answer 13

a bond that is trading at a price below its par value.
- Yield to maturity would exceed the coupon rate.

Question 14

Premium bond

Answer 14

a bond that is trading at a price above its par value.
- Yield to maturity would be less than the coupon rate.

Question 15

Bonds Trading in the Secondary Market

Answer 15

Investors can sell their bonds to other investors before the bonds reach maturity.

Bond prices change in response to interest rate movements and other factors.

Investors buy or sell bonds from a brokerage firm’s bond inventory.

Question 16

Term structure of interest rates

Answer 16

illustrates the relationship between bond yield to maturity and time to maturity.

• Resulting curve is known as a yield curve.
• Shape of the yield curve reflects the market’s sentiment about the direction for interest rates over time.
• Yield curve shapes include normal, steep, inverted, and flat.

Question 17

Term structure of interest rates - liquidity preference theory

Answer 17

investors require a premium for investing in longer-term bonds.

Question 18

Term structure of interest rates - pure expectations theory

Answer 18

the shape of the yield curve is a reflection of the market’s expectation for future interest rate movements.

Question 19

Term structure of interest rates - Market segmentation theory

Answer 19

the shape of the yield curve is determined by the supply and demand of bonds for various market players in different segments of the yield curve.

Question 20

Types of Bonds - GOC and Crown Corporation Bonds

Answer 20

Government of Canada bonds: debt securities issued by the Canadian government.
- No default risk.
- can be sold in a secondary market.

Federal Crown corporation bonds: debt securities issued by corporations established by the federal government.
- No default risk.

Question 21

Types of Bonds - PMCHY

Answer 21

Provincial bonds: debt securities issued by the various provincial governments.
- Default risk varies by province, but is very low.

Municipal bonds: long-term debt securities issued by local governments.
- Low default risk, not common.

Corporate bonds: long-term debt securities issued by large firms.
- Subject to default risk.
- Terms and conditions will vary with the needs of the corporation.

High-yield bonds: Bonds issued by less stable corporations that are subject to a higher degree of default risk.

Question 22

Other Fixed-Income Products

Answer 22

T-bills
Banker’s acceptance (BAs)
Commercial paper
Canada Savings Bonds (CSBs)
Mortgage-backed securities (MBSs)
Strip bonds
Real return bonds

Question 23

Other Fixed-Income Products - Real Return Bonds

Answer 23

Real return bonds: long-term debt securities issued by the Government of Canada that protect an investor from inflation risk.
- All other bonds are exposed to inflation risk.
- The par value of the bond is adjusted for changes in the inflation rate.
- Coupon payments will increase with each increase in the face value.

Question 24

Return from Investing in Bonds

Answer 24

-Return depends on the price at the time you sell the bond.
-The calculation of a bond’s price assumes that all interest received through the years will be reinvested at the current interest rate.

Question 25

Return from Investing in Bonds - Impact of interest rate movements

Answer 25

• If the bond coupon rate (3%) is less than the current coupon rate (4%) on similar bonds, you must sell the bond at a discount.
• If the bond coupon rate (3%) is more than the current coupon rate (2%) on similar bonds, you can sell the bond for a premium.
• Interest rate movements and bond prices are inversely related.

Question 26

Tax Implications of Investing in Bonds

Answer 26

-Interest income is taxed as ordinary income.
-Tax on interest income must be paid in the year it is earned.
-Selling bonds at a price different than what you originally paid for them results in a capital gain (or loss).

Question 27

Risk from Investing in Bonds

Answer 27

• Default risk: the risk that the borrower of funds will not repay the creditors.
• Risk premium: the extra yield required by investors to compensate for default risk; an additional return beyond the risk-free rate you could earn from an investment.
• Use of Risk Ratings to Measure the Default Risk
• Relationship of Risk Rating to Risk Premium
  on a bond.

Impact of Economic Conditions.

Call (prepayment) risk: the risk that a callable bond will be called.

Inflation risk: the risk that the purchasing power of a bond investment will diminish due to a relative increase in inflation.

Reinvestment risk: the risk that the income earned from a bond cannot be reinvested at the same or a higher rate of interest

Liquidity risk: the risk that a bond will be difficult to sell quickly without cutting the price

Interest rate risk: the risk that a bond’s price will decline in response to an increase in interest rates.

Question 28

Bond Investment Strategies

Answer 28

Most strategies involve investing in a diversified portfolio of bonds rather than in one bond.
- Reduces your exposure to possible default.
- May not reduce your interest rate and reinvestment risks.

Interest Rate Strategy: selecting bonds based on interest rate expectations.

Passive Strategy: investing in a diversified portfolio of bonds that are held for a long period of time.

Maturity Matching Strategy: selecting bonds that will generate payments to match future expenses.