Fixed Income

Question 1

What is the relationship between a bond’s price and its yield?

Answer 1

They are inversely related. That is, if a bond’s price rises, its yield falls and vice versa. Simply put, current yield = interest paid annually/market price * 100 percent.

Question 2

How are bonds priced?

Answer 2

Bonds are priced based on the net present value of all future cash flows expected from the bond.

Question 3

How would you value a perpetual bond that pays you $1,000 a year in coupon?

Answer 3

Divide the coupon by the current interest rate. For example, a corporate bond with an interest rate of 10 percent that pays $1,000 a year in coupons forever would be worth $10,000.

Question 4

When should a company issue debt instead of issuing equity?

Answer 4

First, a company needs a steady cash flow before it can consider issuing debt (otherwise, it can quickly fall behind interest payments and eventually see its assets seized). Once a company can issue debt, it should almost always prefer issuing debt to issuing equity.

Generally, if the expected return on equity is higher than the expected return on debt, a company will issue debt. For example, say a company believes that projects completed with the $1 million raised through either an equity or debt offering will increase its market value from $4 million to $10 million. It also knows that the same amount could be raised by issuing a $1 million bond that requires $300,000 in interest payments over its life. If the company issues equity, it will have to sell 20 percent of the company, or $1 million/$5 million ($5 million is the new value of the company after the capital infusion). This would then grow to 20 percent of $10 million, or $2 million. Thus, issuing the equity will cost the company $1 million ($2 million - $1 million). The debt, on the other hand, will only cost $300,000. The company will therefore choose to issue debt in this case, as the debt is cheaper than the equity.

Also, interest payments on bonds are tax deductible. A company may also wish to issue debt if it has taxable income and can benefit from tax shields. Finally, issuing debt sends a quieter message to the market regarding a company’s cash situation.

Question 5

What major factors affect the yield on a corporate bond?

Answer 5

The short answer: interest rates on comparable U.S. Treasury bonds and the company’s credit risk. A more elaborate answer would include a discussion of the fact that corporate bond yields trade at a premium, or spread, over the interest rate on comparable U.S. Treasury bonds. (For example, a five-year corporate bond that trades at a premium of 0.5 percent, or 50 basis points, over the five-year Treasury note is priced at 50 over.) The size of this spread depends on the company’s credit risk: the riskier the company, the higher the interest rate the company must pay to convince investors to lend it money and, therefore, the wider the spread over U.S. Treasuries.

Question 6

If you believe interest rates will fall, which should you buy: a 10-year coupon bond or a 10-year zero coupon bond?

Answer 6

The 10-year zero coupon bond. A zero coupon bond is more sensitive to changes in interest rates than an equivalent coupon bond, so its price will increase more if interest rates fall.

Question 7

Which is riskier: a 30-year coupon bond or a 30-year zero coupon bond?

Answer 7

A 30-year zero coupon bond. Here’s why: A coupon bond pays interest semiannually, then pays the principal when the bond matures (after 30 years, in this case). A zero coupon bond pays no interest, but pays one lump sum upon maturity (after 30 years, in this case). The coupon bond is less risky because you receive some of your money back over time, whereas with a zero coupon bond you must wait 30 years to receive any money back. (Another answer: The zero coupon bond is more risky because its price is more sensitive to changes in interest rates.)

Question 8

What is the Long Bond trading at?

Answer 8

The Long Bond is the U.S. Treasury’s 30-year bond. This question is particularly relevant for sales and trading positions, but also for corporate finance positions, as interviewers want to see that you’re interested in the financial markets and follow them daily.

Question 9

If the price of the 10-year Treasury note rises, does the note’s yield rise, fall or stay the same?

Answer 9

Since bond yields move in the opposite direction of bond prices, if the price of a 10-year note rises, its yield will fall.

Question 10

If you believe interest rates will fall, should you buy bonds or sell bonds?

Answer 10

Since bond prices rise when interest rates fall, you should buy bonds. This question is almost guaranteed to be asked, in one form or another, of someone interviewing for a debt- or market-related position.

Question 11

How many basis points equal .5 percent?

Answer 11

Bond yields are measured in basis points, which are 1/100 of 1 percent. 1 percent = 100 basis points. Therefore, .5 percent = 50 basis points.

Question 12

Why can inflation hurt creditors?

Answer 12

Think of it this way: If you are a creditor lending out money at a fixed rate, inflation cuts into the percentage that you are actually making. If you lend out money at 7 percent a year, and inflation is 5 percent, you are only really clearing 2 percent.

Question 13

How would the following scenario affect the interest rates: the President is impeached and convicted.

Answer 13

While it can’t be said for certain, chances are that these kind of events will lead to fears that the economy will go into recession, so the Fed would want to balance those fears by lowering interest rates to expand the economy.

Question 14

What does the government do when there is a fear of hyperinflation?

Answer 14

“The government has fiscal and monetary policies it can use in order to control hyperinflation. The monetary policies (the Fed’s use of interest rates, reserve requirements, etc.) are discussed in detail in this chapter. The fiscal policies include the use of taxation and government spending to regulate the aggregate level of economic activity. Increasing taxes and decreasing government spending slows down growth in the economy and fights inflation.

Question 15

Where do you think the U.S. economy will go over the next year? What about the next five years?

Answer 15

Talking about the U.S. economy encompasses a lot of topics: the stock market, consumer spending, and unemployment, to name a few. Underlying all these topics is the way interest rates, inflation, and bonds interact. Make sure you can speak articulately about relevant concepts discussed in this chapter when forming a view on the U.S. economic future.

Question 16

How would you value a perpetual zero coupon bond?

Answer 16

The value will be zero. A zero coupon doesn’t pay any coupons, and if that continues on perpetually, when do you get paid? Never-so it ain’t worth nothing!

Question 17

Let’s say a report released today shows that inflation last month was very low. However, bond prices closed lower. Why might this happen?

Answer 17

Bond prices are based on expectations of future inflation. In this case, you can assume that traders expect future inflation to be higher (regardless of the report on last month’s inflation figures), and therefore they bid bond prices down today. A report that showed that inflation last month was benign would benefit bond prices only to the extent that traders believed it was an indication of low future

Question 18

If the stock market falls, what would you expect to happen to bond prices and interest rates?

Answer 18

You would expect that bond prices would increase and interest rates would fall.

Question 19

If unemployment is low, what happens to inflation, interest rates. and bond prices?

Answer 19

Inflation goes up, interest rates also increase, and bond prices decrease.

Question 20

What is a bond’s “Yield to Maturity”?

Answer 20

A bond’s yield to maturity is the yield that would be realized through coupon and principal payments if the bond were to be held to the maturity date. If the yield is greater than the current yield (the coupon/price), it is said to be selling at a discount. If the yield is less than the current yield, it is said to be selling at a premium.

Question 21

What do you think the Fed will do with interest rates over the next year, month, etc.?

Answer 21

This question is particularly relevant for anyone studying the markets and interested in a markets-based position. What’s important is understanding the existing fed-funds rate, the prior cuts/increases in this rate by the Fed, and the general economic outlook. There is no right answer to this question, but interviewers will be looking for you to have a well-versed view of where the economy is headed and the prior Fed moves. Be prepared to back up your assertions, regardless of how you answer.

Question 22

What is a credit default swap?

Answer 22

CDS is financial instrument that acts as insurance against a corporate default. Thus, investors can purchase a company’s bond (thereby getting exposure to credit and interest rate risk) and hedge their exposure to the credit risk by purchasing CDS on that particular company. CDS is a relatively new security and has come under scrutiny recently, as often times more CDS contracts exist than outstanding company bonds. Essentially, a CDS contract protects an investor against fluctuations in cash flows in the event of a corporate bankruptcy. On the other hand, investors can issue CDS contracts for companies, thus betting against bankruptcies and thus collecting cash payments from others. The CDS market is a multi-trillion dollar market, where both hedging and proprietary strategies are employed by thousands of firms.

Question 23

What is duration?

Answer 23

Very simply put, duration is the measure of sensitivity of a bond’s price to changes in interest rates. Duration is measured in years. Typically, the longer the bond issuance, the more sensitivity to interest rates (as there are more cash flows in later periods) and the higher the duration. Therefore, the lower the duration that a bond has, the less volatility and sensitivity to interest rates it will have.

Question 24

What is convexity?

Answer 24

As duration is the measure of sensitivity of a bond’s price to changes in interest rates, convexity is the measure of sensitivity of a bond’s duration to changes in interest rates. In essence, duration could be considered the first derivative of a bond’s interest rate sensitivity and convexity the second.

Question 25

What is the yield curve? What does it look like?

Answer 25

The yield curve is very literally a plotted curve of the U.S. government treasury bonds. The X axis represents the given maturities (1/2/3/5/10/30 year, for example) and the Y axis represents the associated interest rates. A curve is generally considered to be normal (where interest rates are greater for longer-term securities), flat, or inverted (where interest rates are greater for shorter-term securities). Those with market-related interviews should know this information cold, as well as the recent trading levels of all of these securities.