chp 6 Flashcards
define bond indenture
states the terms of a bond as well as the amounts and dates of all payments to be made
define maturity date of the bond
final repayment date of the bond
define term of bond
the time remaining until the repayment date
define coupons (of a bond)
the promised interest payments of a bond
define the face value or principal of the bond
the notional amount we use to compute the coupon payments - usually face value is repaid at maturity
how is the amount of coupon payment determined by
the coupon rate of the bond
how is the coupon rate set
set by the issuer and stated on the bond indenture
what’s the coupon rate of a bond
the percentage of face value paid out as coupons each year
what’s the formula to coupon payment
CPN = (coupon rate x face value)/number of coupon payments per year
what’s a zero-coupon bond
a bond that doesn’t make coupon payment
investor only receives the face value of the bond on the maturity date
what makes up a majority of zero-coupon bond
treasury bills
are zero coupon bonds traded at a discount
yes they are always traded at a price lower than the face value bs investor is compensated for the time value of the money
they are called pure discount bonds
what’s the yield to maturity
of a bond is the discount rate that sets the present value of the promised bond payments equal to the current market price of the bond
what’s the IRR of an investment in a zero coupon bond
the rate of return that investors will earn on their money if they buy the bond at its current price and hold it to maturity
what’s the formula of yield to maturity of n-year zero coupon bond
YTM = (FV/P)^(1/n) -1
why would investors have a negative yield
in times of negative yields, investors have their money in bonds bc of the safety and convenience that it’s worth the negative yield
can bonds be traded at premium or on par
yes
premium = price greater than their face value
par = price equal to their face value
what’s the relationship between the bond prices and yields
if a bond trades at a discount, it’s YTM will exceed its coupon rate
if a coupon bond’s yield to maturity exceeds its coupon rate, the present value of its cash flows at the yield to maturity will be less than its face value and the bond will trade at a discount
what happens to an investor’s return from a bond with a coupon that trades at a premium to its face value
investor’s return from the coupons is diminished by receiving a face value less than the price paid for the bond
when does a bond trade at a premium
when it’s YTM is less than its coupon rate
when does a bond trade at a price equal to its face value
when its coupon rate is equal to its yield to maturity
when does a bond trade at a price less than its face value
when its coupon rate is less than its YTM
why does the market price of a bond change over time?
- bond gets closer to its maturity date - PV of bond’s remaining cash flows changes as the time to maturity decreases
- changes in market interest rates affect the bond’s YTM and its price
how much does the price of a bond drop per coupon period
usually drops by the amount of the coupon
for a bond trading at a premium, the price drop when a coupon is paid will be larger than the price increase between coupons, so the bond’s premium will tend to decline as time passes.
If the bond is trading at a discount, the price increase between coupons will exceed the drop when a coupon is paid, so the bond’s price will rise and its discount will decline as time passes.
Ultimately, the prices of all bonds approach the bonds’ face value when the bonds mature and their last coupon is paid.
what’s the relationship between interest rates and bond yields
as interest rates and bond yields rise, bond prices will fall and vice versa.
how does the sensitivity of a bond’s price change to interest rates
depends on the timing of its cash flows
shorter-maturity, zero-coupon are less sensitive to changes in interest rates than are longer-term, zero-coupon bonds
bonds with higher coupons rates are les sensitive to interest rate changes than identical bonds with lower coupon rates
define a bond’s duration
the sensitivity of bond’s price to changes in interest rates
the value-weighted average maturity of a bond’s cash flows.
higher the duration the more sensitivity the bond is to interest rates
define the dirty price of a bond
the actual cash price or value of a bond computed by determining the present value of the bond’s remaining cash flows
define the clean price of a bond
bond’s cash price less an adjustment for accrued interest, the amount of the next coupon payment that has already accrued
clan price = dirty price - accrued interest
what’s the formula to accrued interest
coupon amount x (days since last coupon payment/days in current coupon period)
immediately before a coupon payment is made, the accrued interest will equal the full amount of the coupon, whereas immediately after the coupon payment is made, the accrued interest will be zero.
what happens to bond prices in actuality
bond prices are subject to the effects of both the passage of time and changes in interest rates. Bond prices converge to the bond’s face value due to the time effect, but simultaneously move up and down due to unpredictable changes in bond yields.
what happens to cash flows as the coupon increases
earlier cash flows become relatively more important than later cash flows in the calculation of the present value.
define the coupon paying yield curve
a plot of the yield of coupon bonds of different maturities
define benchmark bonds
specific bond issues that are used by the bank of canada and practitioners
what are corporate bonds
bonds issued by corporations
define credit risk
the risk of default by the issuer of any bond that is not default free; an indication that the bond’s cash flows are not known with certainty
How does the credit risk of default affect bond prices and yields?
Because the cash flows promised by the bond are the most that bondholders can hope to receive, the cash flows that a purchaser of a bond with credit risk expects to receive may be less than that amount. As a result, investors pay less for bonds with credit risk than they would for an otherwise identical default-free bond.
Because the yield to maturity for a bond is calculated using the promised cash flows, the yield of bonds with credit risk will be higher than that of otherwise identical default-free bonds.
what’s the formula of a expected return fo a 1 year zero-coupon bond
expected return: (expected cash flow/price) - 1
is the YTM of a defaultable bond equal to the expected return of investing in the bond
it is not equal Because we calculate the yield to maturity using the promised cash flows rather than the expected cash flows, the yield will always be higher than the expected return of investing in the bond
how to determine the price of a bond
discount this expected cash flow using a cost of capital equal to the expected return of other securities with equivalent risk
what’s the relationship between YTM and expected bond return
Note that the bond’s price decreases, and its yield to maturity increases, with a greater likelihood of default. Conversely, the bond’s expected return, which is equal to the firm’s debt cost of capital, is less than the yield to maturity if there is a risk of default. Moreover, a higher yield to maturity does not necessarily imply that a bond’s expected return is higher
define investment grade bonds
bonds in the top 4 categories of creditworthiness with a low risk of default
what are bonds in the bottom five categories of creditworthiness
speculative bonds, junk bonds, high-yield bonds bc their likelihood to default is high
what does the rating of creditworthiness for bonds dependent on
The rating depends on the risk of bankruptcy as well as the bondholders’ ability to lay claim to the firm’s assets in the event of such a bankruptcy. Thus, debt issues with a low-priority claim in bankruptcy will have a lower rating than issues from the same company that have a high priority in bankruptcy or that are backed by a specific asset such as a building or a plant.
what’s the different between the yields of various bonds and gov’t of canada yields
default spread or credit spread
define credit spread
the difference between the yield of a risky bond and riskless bond that are otherwise identical in their features
Credit spreads fluctuate as perceptions regarding the probability of default change.
where is credit spreads higher in
Note that the credit spread is higher for bonds with lower ratings and therefore a greater likelihood of default.
define sovereign bonds
bonds issued by national governments
why does the prices and yields of sovereign debt behave much like corporate debt
Because most sovereign debt is risky
The bonds issued by countries with high probabilities of default have high yields and low prices.
sovereign debt vs corporate debt
Unlike a corporation, a country facing difficulty meeting its financial obligations typically has the option to print additional currency to pay its debts. Of course, doing so is likely to lead to high inflation and a sharp devaluation of the currency. Consequently, debt holders carefully consider inflation expectations when determining the yield they are willing to accept because they understand that they may be repaid in money that is worth less than it was when the bonds were issued.
why do defaults occur from countries
either because the necessary inflation/devaluation would be too extreme, or sometimes because of a change in political regime
