Chapter 6: Valuing Bonds

Question 1

What is a bond?

Answer 1

A security that obligates the issuer to make specified payments to the bondholder.

Question 2

What is face value?

Answer 2

Payment at the maturity of the bond. Also called principal or par value.

Question 3

What is a coupon?

Answer 3

The interest payments paid to the bondholder.

Question 4

What is the coupon rate?

Answer 4

The annual interest payment as a percentage of face value.

Question 5

What (generally) happens when the market interest rate exceeds the coupon rate?

Answer 5

Bonds sell for less than face value.

And vice-versa, if market interest rate is below the coupon rate, bonds sell for more than face value.

Question 6

What happens to a bond when interest rates rise?

Answer 6

PV of payments to be received by the bondholder falls, and bond prices fall.

Question 7

What is interest rate risk?

Answer 7

The risk in bond prices due to fluctuations in interest rates.

Question 8

What is current yield?

Answer 8

The annual coupon payment divided by the bond price.

Question 9

What is yield to maturity?

Answer 9

Discount rate at which the PV of the bond’s payments equals the price.

Question 10

What is the rate of return?

Answer 10

Total income per period per dollar invested OR (coupon income + price change) ➗ investment

Question 11

What is the yield curve?

Answer 11

Plot of relationship between bond yields to maturity and time to maturity.

Question 12

What is the default risk?

Answer 12

The risk that a bond issuer may default on payments. Also called credit risk.

Question 13

What is the default premium?

Answer 13

The additional yield on a bond that investors require for bearing credit risk.

Question 14

What is the investment grade?

Answer 14

Bonds rated Baa or above by Moody’s or BBB or above by Standard & Poor’s or Fitch.

Question 15

What is a junk bond?

Answer 15

Bond with a rating below Baa or BBB.

Question 16

What is a secured debt?

Answer 16

Debt that, in the event of a default, has first claim on specified assets.

Question 17

What are protective covenants?

Answer 17

Conditions imposed on borrowers to protect lenders from unreasonable risks.

Question 18

What is a zero-coupon bond?

Answer 18

No coupon payments along the way; only pays at maturity.

Zero-coupon treasuries often called ‘strips’ because they have been stripped away from the bonds and sold separately.

Question 19

What is a floating-rate bond?

Answer 19

Have coupon payments that are not fixed but fluctuate with short-term interest rates.

Question 20

What are convertible bonds?

Answer 20

Can be exchange for a specified number of shared is the issuing corporation’s common stock.

Question 21

What are the differences between the bond’s coupon rate, current yield, and yield to maturity?

Answer 21

When you own a bond, you receive a fixed interest payment each year until maturity, and this payment is known as a 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. The current yield is the annual coupon payment expressed as a % 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 + difference between purchase price & face value.

Question 22

How can one find the market price of a bond given its yield to maturity or find a bonds yield given its price?

Answer 22

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 PV of bond payments to the bond price is the yield to maturity.

Question 23

Why do bond prices and yields vary inversely?

Answer 23

Because PVs are lower when discount rates are higher, price and yield to maturity vary inversely.

Question 24

Why do bonds exhibit interest rate risk?

Answer 24

Bond prices are subject to interest rate risk, rising when market interest rates fall and falling when market rates rise. Long-term bonds exhibit grater interest rate risk than short-term bonds.

Question 25

What is the yield curve and why do investors pay attention to it?

Answer 25

The yield curve plots the relationship between bond yields to maturity. Yields on long-term bonds are usually higher than those on short-term bonds. These higher yields compensate holders for the fact that price of L-T bonds are more sensitive to changes in interest rates. Investors may also be prepared to accept a lower interest rate on S-T bonds when they expect interest rates to rise.

Question 26

Why do investors pay attention to bond ratings and demand a higher interest rate for bonds with low ratings?

Answer 26

Investors demand higher promised yields if there is a high probability that the borrowers 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.

Question 27

What is the formula for a bond price?

Answer 27

Bond Price = PV(coupons) + PV(face value)
or
Bond Price = (coupon x annuity factor) + (face value x discount factor)