Chapter 6: Valuing Bonds Flashcards
What are the differences between the bond’s coupon rate, current yield, and yield to maturity? (LO6-1)
A bond is a long-term debt of a government or corporation. When you own a bond, you receive a fixed interest payment each year until the bond matures. This payment is known as the coupon. The coupon rate is the annual coupon payment expressed as a fraction of the bond’s face value. At maturity the bond’s face value is repaid. In the United States most bonds have a face value of $1,000. The current yield is the annual coupon payment expressed as a percentage of the bond price. The yield to maturity measures the rate of return to an investor who purchases the bond and holds it until maturity, accounting for coupon income as well as the difference between purchase price and face value.
How can one find the market price of a bond given its yield to maturity or find a bond’s yield given its price? Why do prices and yields vary inversely? (LO6-2)
Bonds are valued by discounting the coupon payments and the final repayment by the yield to maturity on comparable bonds. The bond payments discounted at the bond’s yield to maturity equal the bond price. You may also start with the bond price and ask what interest rate the bond offers. The interest rate that equates the present value of bond payments to the bond price is the yield to maturity. Because present values are lower when discount rates are higher, price and yield to maturity vary inversely.
Why do bonds exhibit interest rate risk? (LO6-3)
Bond prices are subject to interest rate risk, rising when market interest rates fall and falling when market rates rise. Long-term bonds exhibit greater interest rate risk than short-term bonds.
What is the yield curve and why do investors pay attention to it? (LO6-4)
The yield curve plots the relationship between bond yields and maturity. Yields on long- term bonds are usually higher than those on short-term bonds. These higher yields compensate holders for the fact that prices of long-term bonds are more sensitive to changes in interest rates. Investors may also be prepared to accept a lower interest rate on short-term bonds when they expect interest rates to rise.
Why do investors pay attention to bond ratings and demand a higher interest rate for bonds with low ratings? (LO6-5)
Investors demand higher promised yields if there is a high probability that the borrower will run into trouble and default. Credit risk implies that the promised yield to maturity on the bond is higher than the expected yield. The additional yield investors require for bearing credit risk is called the default premium. Bond ratings measure the bond’s credit risk.
