Debt valuation

Question 1

What two things does a flat yield make use of?

Answer 1

Income-seeking non-tax payers

Irredeemable bonds

Question 2

Three other terms used for flat yield:

Answer 2

Interest yield
Running yield
Simple yield

Question 3

What does Gross Redemption Yield consider?

Answer 3

Annual redemption due to income and gain through to redemption

Question 4

What is a basic formula for Gross Redemption Yield?

Answer 4

Flat yield + Profit/Loss at redemption

Question 5

What is the formula for flat yield?

Answer 5

Gross annual coupon / market price X 100

Question 6

Why are bonds with a lower coupon more attractive to higher rate taxpayers?

Answer 6

The coupon received from most bonds is generally taxable, but any gain made on redemption (or subsequent sale) is not taxable. This makes bonds with a low coupon attractive to higher rate taxpayers, as the price may be lower than par, resulting in a part of the return coming in the form of a tax-free capital gain.

Question 7

How do we price the bond at present value?

Answer 7

A bond is a series of cash flows. Discounting these cash flows at a required rate allows us to price the bond at a present value of those cash flows.

Question 8

How is a company’s debt valued?

Answer 8

Calculate the pay-off that debt holders can expect to receive, taking into account the risk of default.

Question 9

What is a clean price and what is a dirty price?

Answer 9

Clean price is the price of a coupon bond not including any accrued interest. Dirty price is the price of a bond that includes accrued interest between coupon payments.

Question 10

What is accrued interest?

Answer 10

Accrued interest = Payment X (Number of days since last payment)/(Number of days in payment period)

Question 11

What is the spread?

Answer 11

Difference between the yield on one investment and the yield on another measured in basis points (0.01)

Question 12

What is the conversion ratio?

Answer 12

The conversion ratio is the number of shares that each £100 of nominal values of the bonds can convert into.

Conversion ratio = (Nominal value)/(Conversion price of shares)

Question 13

State the relationship between interest rates and bond prices.

Answer 13

As interest rates rise, bonds fall and vice versa.

Question 14

What is the redemption date on a bond?

Answer 14

Date upon which bond’s face value is repaid to bondholders.

Question 15

Explain the modified duration of a bond.

Answer 15

Measure of volatility - approximate percentage change in a bond’s price for a 1% change in interest rates. Bonds with a higher modified duration will be more volatile. Long-date low coupon bonds are the most volatile.

Question 16

What is the relationship between inflation and the yield curve?

Answer 16

Yield curves show the nominal yield. Real yield curves show inflation-adjusted yields and can be observed by looking at the yield curve for index-linked instrument. The difference between the nominal yield curve and the real yield curve reveals an expectation of inflation.

Question 17

Explain negative yields.

Answer 17

Where investors are paying to lend money. Occurring in some government bond markets, where the uncertainty of the economic climate in general creates an increased desire to put money somewhere safe – even if you have to pay for it.