Chapter 12 Part 3 Flashcards
For investors who purchase discount bonds, their highest yield will be their
yield to maturity, followed by their current yield. Their lowest yield will be their nominal yield
premium bonds. Their highest yield will be
their nominal yield, followed by their current yield, and their yield to maturity
For investors who purchase bonds at par,
their nominal yields, current yields and yields to maturity will be identical
Bonds have two major advantages for investors compared to stocks:
First, bonds are usually considered a safer investment than stocks. (There is less chance that the investor will lose all or a significant portion of his capital.) Second, they provide investors with a more predictable source of income
A bond owner who has to sell a bond before it matures may lose
part of his principal. The issuer may also gel into financial trouble and default on its obligations.
Interest-Rate Risk
the risk that interest rates might increase causing the market prices of their bonds to decrease
Bonds with longer maturities tend to be more vulnerable to
interest-rate risk than bonds that mature in a shorter period, as do zero-coupon bonds
Duration is a measurement of a given bond’s
sensitivity to interest-rate swings. Factors affecting a bond’s duration include its coupon rate and maturity. It is expressed in years and the greater a bond’s duration, the more sensitive it is to changes in interest rates.
Inflation {Purchasing-Power) Risk
Inflation (or the fear of inflation) is one reason why interest rates increase. Inflation diminishes the real value of a dollar by decreasing its purchasing power (which is why inflation risk is also called purchasing-power risk). Inflation is a major concern for bondholders. It hurts them in two ways–interest rates rise, causing the market price of their holdings to fall while the purchasing power of their interest payments also decreases
Credit Risk
Another major risk for bond investors is that the issuer may default-it may not be able to meet its obligations to pay interest and principal to the bondholders. This is called credit risk. Not surprisingly, issuers that arc considered poor credit risks must pay a higher rate of interest to induce investors to purchase their bonds
Securities issued by the U.S. government have the
lowest possible credit risk. Their risk of defaulting is virtually zero. This is because they are backed by Uncle Sam’s ability to tax and print money, which is almost unlimited
Most investors rely on an organization that specializes in analyzing the credit risk of bond issues
Moody’s and Standard and Poor’s (S&P) are the two most prominent of these companies. Each evaluates the possibility that an issuer might default and assigns the issue a credit rating. This rating can be raised or lowered later depending on subsequent events. A lowered credit rating can cause a bond’s price to drop significantly
investment-grade
bonds that are rated Aaa to Baa or AAA to BBB
speculatiue
Bonds that are rated Ba or BB or below
D means that the
issuer has defaulted
high-yield (junk bonds)
Bonds that are rated Ba or BB or below
A corporation must pay the
interest on its bonds before it pays dividends to its preferred or common stockholders. In the event that the company goes bankrupt, bondholders and other creditors must be satisfied before the stockholders may claim any of the company’s remaining assets
Capitalization
“A company’s capitalization is the total of all the various securities that the company has issued in order to finance its operations. It includes common stock, preferred stock, and long-term
bonds (bonds that will take a year or more to mature)”
Corporate bonds are divided into two major categories
secured and unsecured. The difference between them is that secured bonds are backed by a specific piece of corporate property, while unsecured bonds are not
Secured bonds are
backed by particular assets that the corporation owns. In the event of the corporation defaulting, the trustee will take possession of the asset and sell it on the bondholders’ behalf. Thus, secured bondholders have a high degree of protection
