Investment Vehicle Characteristics: Debt Securities (II.7.2)

Question 1

What is the nominal Yield?

Answer 1

Nominal yield = coupon or interest rate on the face of the bond

Question 2

Formula for Current Yield on bonds:

Answer 2

Current Yield = annual interest / market price

Example:
An investor purchases a 9% bond @90, the current yield is:
(9% x $1000) / (90 x $10) =
90 / $900 = 10%

Question 3

Explain bond reactions based on duration and interest rate changes

Answer 3

Short-term bonds react the quickest to interest rate changes.
Long-term bonds react the greatest (biggest movement) to interest rate changes.

Question 4

Do long-term or short-term bonds carry more risk? Which is considered to be safer when ranking the safety of investments?

Answer 4

Long-term bonds carry more risk than short-term bonds.
Short-term bonds are considered to be safer when ranking the safety of investments.

Question 5

Define duration of a bond

Answer 5

Duration is a measure of the sensitivity of a bond’s market price to changes in interest rates.

Example: A bond with a duration of 5 will have a price movement of 5% for every 1% movement in the interest rate.

Question 6

Explain how duration compares to maturity for zero-coupon bonds and coupon bonds

Answer 6

A zero-coupon bond always has a duration equal to its maturity.

Coupon bonds always have a lower duration because the coupon bonds pay interest whereas the zero-coupon has no interest payment.

Question 7

How is the bond price volatility measured for large yield changes >1%?

Answer 7

For large yield changes greater than 1%, the bond price volatility is measure by convexity.

Question 8

Formula for After-Tax Yield

Answer 8

After-Tax Yield = annual interest x (100% - investor’s tax rate)

Example: An investor buys a taxable bond with a coupon of 4% at par. The bond is exempt from state tax and the investor has a 28% marginal tax-rate.
4% x (100% - 28%) = 0.04 x 0.72 = 0.0288 or 2.88% after-tax yield