High Yield Financial Concepts Flashcards
How could the risks associated with a bond be decomposed?
- Risk Free Rate
- Risk Premium
What does the risk premium for a bond represent?
The risk premium reflects the compensation provided for risks such as default loss and illiquidity risks
What does par mean?
Par mean 100% of face value
What happens at maturity for a bond?
The principal is paid to the holder of the bond
What is call protection?
Call protection, as the name implies, prevents issuers from “calling,” or repaying, debt prior to its scheduled maturity date.
Why do investors appreciate call protection?
For investors, it ensures a debt investment offers duration and a minimum amount of profit. Since investors assume the risk that results might deteriorate, in which case the price of the debt will decline, they want some incentive if the business improves.
What is a make-whole premium?
The present value of all interest payments due through the first call date and includes the prepayment premium. The discount rate is usually equal to the rate of low risk investments readily available for capital redeployment, generally assumed to be equal to the rate of treasury debt with a comparable maturity plus 50 basis points or 0.5%
What is a debt’s yield?
A debt’s yield is its rate of return.
What is a debt’s yield based on?
- Price of debt
- Interest Rate
- Performance of Company
- Other Economic Features
If an investor pays 100% (or par) for a note that pays 10% coupon, what is the yield?
10%
What is the credit spread and how does it relate to the risk premium?
The risk premium is also called the credit spread and can be simply understood as the difference between the yield and the risk-free rate
How many basis points equals 1%?
100bps equals 1%
What does the risk premium compensate the bond holder for?
This value reflects the excess compensation being provided for the probability of default loss and illiquidity risk, among other factors.
How are default loss rates calculated?
Default loss is based on default rates and losses and can be estimated using past experience.
If the high yield bond market had a 4% chance of default and an estimated loss of 55% in default scenarios, what percentage of the risk premium correlates to default loss?
it would imply the asset class required 220 bps of compensation (4% multiplied by 55%) just to compensate for anticipated default-related losses.
If the default-related loss rate is calculated to be 200bps, but the credit spread is 300bps, what does this indicate?
This might imply that spreads overly compensate for risks or perhaps the market is factoring in a greater than historical default loss to occur. Another factor that contributes to credit spreads is illiquidity.
Why does call protection allow a bond to trade at a premium to par?
Call protection imposes prepayment penalties on the issuer so this represents an additional payment that is built into the bonds price
What does yield-to-call represent?
Yield-to-call (YTC): the YTC is the rate of return an investor would realize if the bond is called by the issuer at the first call date, which in the above example is year three. If the bond, in our example, is bought at 100% and repaid at 105% in year three, it will have an 11.5% YTC.
What is yield-to-maturity represent?
Yield-to-maturity (YTM): the YTM is the return at maturity – in year six using our above example.
If a bond was bought at 95% (or $950 per $1,000 face value bond), received 10% interest per year ($100) and was repaid at 100% (or $1,000 per bond) at maturity, it would have an 11.2% YTM. The reason this amount is higher than the interest rate is because the bond is purchased at a discount to the value it is ultimately repaid at
What does Yield-to-Worst represent?
This is the worst possible yield based on the bond’s call schedule, it is known as the YTW.
