FMP17 - Corporate Bonds

Question 1

Describe features of bond trading and explain the behaviour of bond yield

Answer 1

• As maturity increases, credit spread (and thus yield) increases due to increased likelihood of financial troubles
• As interest rates increase, investors was higher bond yields therefore selling pressure and bond prices decrease
• Low bond liquidity means investors require higher yield

Question 2

Describe bond indenture and explain the role of the corporate trustee in a bond indenture

Answer 2

Bond indenture is legal contract between bondholder and issuer, outlining maturity, coupon, schedule etc.

Corporate trustee looks after interests of bondholders and makes sure issuer is following indenture

Question 3

Define high-yield bonds and describe types of high-yield bond issuers and some of the payment features unique to high-yield bonds

Answer 3

High-yield are bonds with low rating scores (non-investment grade), come about from young companies without a good track record or investment grade bond financial security decreases

Unusual features:
- coupon can increase over time
- can pay more bonds instead of cash coupon

Question 4

Differentiate between credit default risk and credit spread risk

Answer 4

Credit default risk is referring to probability of default on the bond, credit spread risk is the difference between bond yield and risk free rate changing

Credit spread risk is bad because yield is disproportionately low compared to other bonds with same yield but lower risk of default

Question 5

Describe event risk and explain what may cause it to manifest in corporate bonds

Answer 5

Event risk is when something occurs that will affect bonds (such as a natural disaster or CEO death)

Important in corporate bonds is increase in leverage, by mergers etc.

Question 6

Describe the mechanisms by which corporate bonds can be retired before maturity

Answer 6

Must be a covenant in the indenture to allow for this, can be done in a few ways:
- convertible to equity for the bondholder
- make-whole where price is calculated in advance
- sinking funds

Question 7

Describe characteristics of bonds such as issuer, maturity, interest rate, and collateral

Answer 7

Issuers put into five categories:
1. utilities
2. transportation companies
3. industrials
4. financial institutions
5. internationals

Bond is short-term if maturity up to 5 years, medium if 5-12, long otherwise

Bonds categorised in terms of interest structure:
1. fixed rate
2. floating rate
3. zero-coupon

Collateral matters when bond issuer defaults, refers to what will be liquidated to repay bondholders

Question 8

Define recovery rate and default rate and differentiate between issuer default rate and dollar default rate

Answer 8

Default rate is a measure of how likely default on a bond is from an issuer, classified in two ways

Issuer default rate = number of bonds they default on in a year
Dollar default rate = par value of bonds that have been defaulted on

Recovery rate is percentage of face value bond sells for after default

Question 9

Evaluate the expected return from a bond investment and identify the components of the bond’s expected return

Answer 9

Expected loss rate = P(default) * (1 - expected recovery rate)

Expected bond return = risk-free rate + credit spread - expected loss rate