Lecture 17 Bonds

Question 1

What is a bond?

Answer 1

Loan agreement where one party lends money and receives interest payments

Question 2

What is an indenture?

Answer 2

Contract between issuer and bondholder that specifies par value, coupon rate and maturity

Question 3

What is the formula of a bond price?

Answer 3

Bond Price = SIGMA ( Interest payments / (1 + r)^t) + Par Value / (1 + r)^T

Question 4

What is the face or par value of a bond?

Answer 4

Principal repaid at maturity

Question 5

How are bonds traded? 4 characteristics

Answer 5

Privately with limited accessibility on platforms.
There is less regulatory burden because it is private.
No formal credit rating is required.
Less liquid because it is not so accessible.

Question 6

What is the TIPS?

Answer 6

Treasury Inflated Protection Security. This bond provides protection against inflation by moving with the inflation rate. Therefore, it guarantees a real rate of return.

Question 7

Who are buyers of TIPS?

Answer 7

Investors who believe the prices in the economy will rise and investors who are averse to the risk of inflation.

Question 8

What is Cat Bond?

Answer 8

Catastrophe bond. This bond promises financial security to countries with high catastrophe risks. In case, the country is hit by a catastrophe the principal is used to cover the damages. Otherwise, the principal is returned with a high yield. Also, high coupon payments.

Question 9

What is the yield?

Answer 9

Expected return from a bond, used as discount rate. (r in the formula)

Question 10

If the risk of a bond goes up, what happens with the yield?

Answer 10

Yield goes up as well because investors require a higher return because of the risk, therefore bond price goes down and vice versa.

Question 11

If the risk of a bond goes down, what happens with the bond price?

Answer 11

Bond price goes up because the yield goes down. If the risk decreases, investors require less return for taking the risk.

Question 12

Describe the relationship between coupon rate and YTM in terms of premium, par and discount.

Answer 12

When coupon rate > ytm, the bond is trading at a premium.
When coupon rate = ytm, the bond is trading at par.
When coupon rate < ytm, the bond is trading at a discount.

Question 13

What happens with the prices of bonds over time?

Answer 13

They converge towards par value because there is less and less uncertainty about the risk.

Question 14

Which 3 characteristics of a bond lead to more sensitivity to interest rate swings?

Answer 14

Longer maturity, smaller coupons and smaller YTM.

Question 15

How does a longer maturity lead to more sensitivity to interest rate swings?

Answer 15

Since the bond price is determined by discounting cash flows, a longer maturity has more cashflows to discount and therefore, the interest rate has more effect.

Question 16

How do smaller coupon rates lead to more sensitivity to interest rate swings?

Answer 16

With smaller coupon rates, there is more emphasis on the large payment of the par value at maturity and since this is further in the future, it is more sensitive to discount rates.

Question 17

How does smaller YTM lead to more sensitivity to interest rate swings?

Answer 17

With a small YTM, the bond price is close to the par value of the bond. Therefore, it has a higher duration and therefore greater sensitivity to interest changes.

Question 18

What is duration?

Answer 18

Duration measures the bond’s sensitivity to changes in interest rates. It reflects the time it takes for a bond’s cashflows to be paid back and that can be translated to how sensitive the bond’s price is to a change in interest rates.

Question 19

What is convexity?

Answer 19

Convexity measures how the duration of a bond changes as interest rates change.

Question 20

What is default risk premium?

Answer 20

The premium investors get for taking on default risk in a bond.

Question 21

Who assesses default risk?

Answer 21

Rating agencies using ratios like leverage, liquidity and profitability.

Question 22

What is a callable bond and when will it be exercised?

Answer 22

The issuer has the option to pay the principal back before maturity at a predetermined price. This is attractive for an issuer when the interest rates have fallen. The issuer pays a call premium for this and there is often a call protection period.

Question 23

What is convertible bond and when will it be exercised?

Answer 23

Gives bondholder the option to convert his bond into shares of the company. Interesting if the bond price has dropped or if the stock price has increased.

Question 24

What is a puttable bond and when will it be exercised?

Answer 24

Gives bondholder the right to force the issuer to pay back the principal earlier. Interesting if interest rates are rising.