chapter 6 book: Bond valuation Flashcards
short term bonds, with a maturity of less than one year
called bills or paper
bonds, with a maturity of more than ten years
bonds
bonds, with a maturity between one and ten years
notes
the main bond issuers in Canada
federal, provincial, and municipal governments
government agencies
corporations
non-resident issuers
the main bond purchasers in Canada
institutional investors
in particular, insurance companies, pension funds, and bond mutual funds
The key feature of a bond
the issuer agrees to pay the bondholder (investor) a regular series of cash payments and to repay the full principal amount by the maturity date
bullet payment or balloon payment
a principal payment made in one lump sum at maturity
why are bonds often referred to as fixed income securities?
because the interest payments and the principal repayment are specified, or fixed, at the time the bond is issued
the bond purchaser knows the amount and timing of the future cash payments to be received, barring default by the issuer
what does the price of a bond depend on
will depend on the level of interest rates at that time
bond indenture
a legal document that specifies the payment requirements and all other salient matters relating to a particular bond issue, held and administered by a trust company
includes all relevant details for a particular bond issue
collateral
assets that can serve as security for the bond in case of default
fiduciary
The trust company makes sure that the covenant provisions within the indenture are observed by the issuer
a third party who acts to ensure that the best interests of bondholders are upheld
covenant provisions
clauses within the indenture that lay out the legal rights of the bondholder and the obligations of the issuer
The par value, also known as face value or maturity value
represents the amount that is paid at maturity for traditional bonds
The par value of most bonds is $1,000
The term to maturity of a bond
the time remaining until the maturity date
interest payments, or coupons for a bond
determined by multiplying the coupon rate (which is stated on an annual basis) by the par value of the bond
amounts paid on a bond at regular intervals
mortgage bonds
debt instruments that are secured by real assets
debentures
either unsecured or secured by other assets not already as collateral for other deb instruments
mortgage bonds
debt instruments that are secured by real assets
government bonds are mortgage bonds or debentures?
debentures
Collateral trust bonds
secured by a pledge of other financial assets, such as common shares, bonds, or treasury bills
Equipment trust certificates
secured by equipment, such as the rolling stock of a railway
Protective covenants
clauses in the trust indenture that restrict the actions of the issuer
negative covenants
prohibit certain actions
positive covenants
specify actions that the firm agrees to undertake
Callable bonds
give the issuer the option to “call,” or repurchase, outstanding bonds at predetermined call prices
for this to happen, market interest rates must have declined
why do callable bonds have prices over par value when bought back?
(im not sure for this one)
because they represent more risk for the holder
it is like an incentive to attract holders
retractable (or putable) bonds
allow the bondholder to sell the bonds back to the issuer at predetermined prices at specified times earlier than the maturity date
the maturity of the bond is retracted, or shortened
for this to happen, market interest rates must have increased
callable bonds are allowed to be call back when market interest rates increase or decrease?
decrease
retractable bonds are allowed to be sold back to the issuer when market interest rates increase or decrease?
increase
extendible bonds
allow the bondholder to extend the maturity date of the bond
Sinking fund provisions
require the issuer to set money aside each year so that funds are available at maturity to pay off the debt
provisions are made in which two ways?
- the firm repurchases a certain amount of debt each year so that the amount of debt goes down
- the firm pays money into the sinking fund to buy other bonds, usually government bonds, so that money is available at maturity to pay off the debt
Sinking fund provisions are advantageous to whom?
generally advantageous to issuers and not the holders
issuers avoid paying back full amount at maturity
Purchase fund provisions
similar to sinking fund provisions
require the repurchase of a certain amount of debt only if it can be repurchased at or below a given price
Purchase fund provisions are advantageous to whom? why’
to the debt holder
they provide some liquidity and downward price support for the market price of the debt instruments
Convertible bonds
can be converted into common shares at predetermined conversion prices
Convertible bonds may be offered to make debt issues more attractive to investors
the price of a bond
the present value of the future payments on the bond
basically, the present value of the interest payments and the par value repaid at maturity
discount bonds
bonds trading below par value
premium bonds
bonds trading above par
when market interest rates are lower than the bond coupon rate, the bond trades at premium or discount?
premium
when market interest rates are higher than the bond coupon rate, the bond trades at premium or discount?
discount
if interest rates decrease, what happens to bond prices?
bond prices increase
if interest rates increase, what happens to bond prices?
they decrease
how do the effects of a given change in market interest rates (yields) on the price of bonds (both increase and decrease) compare? how does a yield curve show this?
for a given change in interest rates, bond prices will increase more when rates decrease than they will decrease when rates increase
the curve is steeper for lower interest rates, which means that a given change in interest rates will have a much greater impact on bond prices when rates are lower than it will if they are higher
the longer the time to maturity, the more or less sensitive the bond price is to changes in market rates? what does this mean in regards to risk?
the more sensitive the bond price is to changes in market rates
risks are increased for the bond holder
when the coupon rate is the same as the market interest rate, what is the price of the bond?
the same as par
which type of bond pay a higher amount at maturity, those with high coupon rates or low coupon rates?
low coupon rates
interest rate risk
The sensitivity of bond prices to changes in interest rates
which bonds have higher interest rate risks?
longer-term bonds with lower coupon rates with lower market yields
duration of bonds
An important measure of interest rate risk
measures the approximate percentage change in the price of a bond for a given change in the appropriate market interest rate
two crucial points of duration
- The prices of bonds with higher durations are more sensitive to interest rate changes than are those with lower durations
- All else being equal, durations will be higher when (1) market yields are lower, (2) bonds have longer maturities, and (3) bonds have lower coupons
cash price of a bond
price of a bond plus the accrued interest
The discount rate used to evaluate bonds
basically, the market interest rate
the yield to maturity (YTM)
The current yield (CY)
the ratio of the annual coupon interest divided by the current market price
CY = Annual Interest / B
not a true measure of the return to a bondholder because it disregards the bond’s purchase price relative to all the future cash flows
only uses just the next year’s interest payment
what are the similarities or differences between YTM, bond rate, and current yield if the bond is trading at par?
they will all be the same
what are the similarities or differences between YTM, bond rate, and current yield if the bond is trading at discount?
Coupon rate < CY < YTM
because lower bond prices mean that the YTM (market interest rates) is higher than Coupon rate
what are the similarities or differences between YTM, bond rate, and current yield if the bond is trading at premium?
Coupon rate > CY > YTM
because higher bond prices mean that the YTM (market interest rates) is lower than Coupon rate
Treasury bills (T-bills)
short-term government debt obligations that mature in one year or less
do not make regular interest payments but are sold at a discount from their par (or face) value
The interest earned is the difference between the purchase price and the face value
treasury bill formula
P = F / (1 + (KBEY · n/365))
A zero coupon bond
structured similarly to a long-term T-bill
does not make regular interest payments but is issued at a discount and repays the par value at the maturity date
The return earned represents the difference between the purchase price and the redemption price
we value these bonds by assuming semi-annual discounting periods
formula for zero coupon bond
same as PV shit
which is more sensitive to market interest rate changes between regular bonds and zero coupon bonds? why?
zero coupon bonds
because they make no coupon payments at all
Floating rate bonds (floaters)
have adjustable coupons that are usually tied to some variable short-term rate
the coupon rates increase as interest rates increase and vice versa
provide protection against rising interest rates and tend to trade near their par value
Real Return Bonds
provide investors with protection against inflation
provide real yield in which a nominal yield is adjusted for inflation
we peg the face value to the rate of inflation (as measured by the CPI) and having the coupon rate apply to the inflation-adjusted face value
Canada Savings Bonds (CSBs)
they cannot be traded and have no secondary market
their prices do not change over time
the only two forms that Canada Savings Bonds (CSBs) are available
(1) regular interest bonds, which pay out the annual interest amounts
(2) compound interest bonds, which reinvest the interest,
