Chapter 7 Bonds & their Valuation

Question 1

Bonds

Answer 1

Long term debt capital.
Borrower obtains funds and in turn agrees to repay principal, make interest payments on specific dates to holders of the bond(lenders)

Question 2

Who issues bonds?

Answer 2

1. Federal govt- Treasury bonds (0 default risk & rates are used as benchmarks)
2. State & Munis-Municipal bonds issued by municipalities & certain non-govt authorities
3. Corporations- Bonds
4. Foreign entities-*county risk premium

Question 3

Types of Corporate Bonds

Answer 3

1. Mortgage (secure bond)- Bond is back by a claim on specific assets. Indenture is a form of agreement that spells out bond holder rights
2. Debentures (Senior unsecured)- unsecured (by any mortgage) long term bond that is senior to the subordinated debt .
3. Subordinated Debenture (Subordinated or Junior unsecured)- long term bond that has claim only after all of the senior (Mortgage, Debenture) claims are settled

Question 4

How are bonds traded?

Answer 4

Over the counter market ( OTC) 
No organized bond market 
By and among large financial institutions 
WSJ reports developments in markets 
Bloomberg reports prices & yields

Question 5

Par value

Answer 5

Face amount of bond paid at maturity

Question 6

Coupon rate

Answer 6

Stated interest rate (generally fixed) paid by the issuer. Multiply by par value to get dollar payment of interest .

Question 7

Covenants

Answer 7

Restrictions on debtor to protect the lender’s interest

Question 8

Call

Answer 8

Borrower’s option to buy the bond back at an agreed to price before the bond reaches maturity
Call provision may be deferred and/or contain a declining call premium

Question 9

Put

Answer 9

Lender’s option to sell the bond back to the borrower at an agreed to price prior to maturity

Question 10

Sinking fund

Answer 10

Requires borrower to retire a portion of bonds at face value (par) on a scheduled basis before maturity. May select bonds by lottery.

Provision to pay off loan over life rather than all at maturity
Reduces risk to investor
Shortens avg maturity
But not good for investors if rate declines after issuance

Question 11

Convertible

Answer 11

Lender’s option to exchange the bond for firm’s common stock

Question 12

Warrant

Answer 12

Long-dated option to buy a stated number of shares of common stock at a specified price . Some are “detachable” and can be sold off

Question 13

Income bond

Answer 13

Pays interest only when the borrower reaches earnings targets

Question 14

Indexed bond

Answer 14

Coupon rate is based upon the rate of inflation

Question 15

Zero coupe bond

Answer 15

A bond that pays no annual interest . Also called a bullet bond.

Question 16

Floating rate bond

Answer 16

Interest rate of the bond is based on a benchmark such as PRIME
1 way for borrowers to avoid inflation risk

Question 17

Premium

Answer 17

Price>par

YTM< current yield

Question 18

Discount

Answer 18

Opposite of premium

Question 19

When does a bond sell at par value?

Answer 19

When its current yield =its YTM

Question 20

rd

Answer 20

Market rate of interest on a bond

Question 21

Current yield

Answer 21

Annual coupon payment / Current bond price

Question 22

Capital gains yield

Answer 22

(Bond price 1- Bond price 0)/ bond price 0

Question 23

YTM (or Expected total return)

Answer 23

Interest rate that equilibrates bond’s value with its expected future cash flows
= current yield(CY) + Capital Gains Yield(CGY)

Question 24

Default risk

Answer 24

Risk of not timely receiving interest and principal.
Measured by probability of default.
Influenced by:
-borrower’s financial strength
-Terms of the bond contract, which are spelled out in the covenants

Question 25

Liquidity risk

Answer 25

Risk of not being able to timely sell the bond except at a large discount

Question 26

Inflation risk

Answer 26

Risk that the rate of inflation will exceed the coupon rate and erode the purchasing power of your coupons

Question 27

Price risk aka interest rate risk or Maturity risk)

Answer 27

Risk of a decline in a bond’s price due to an increase in interest rates

Question 28

Reinvestment risk

Answer 28

Risk that a decline in interest rates will lead to a decline in income from a bond portfolio as bonds expire and proceeds are re-invested at a lower rate, hence reducing income.

Question 29

Short term and high coupon bonds have _____ price risk and_______reinvestment risk

Answer 29

Low price risk and High reinvestment risk

Question 30

Long term and Low coupon bonds have ________price risk and ________reinvestment risk.

Answer 30

High price risk and Low reinvestment risk