Lecture 5

Question 1

Face Value

Indenture

Answer 1

Nominal Value / Par Value = 1000
(Written in 100 notional amount)

Indenture: Actual contract (agreement)

Question 2

US Treasuries

Answer 2

Reference for “risk-free Asset”

Maturity < 1Y = Bills
Maturity < 10Y = Notes
Maturity < 10 or 30Y = Bonds

Question 3

Bond types

Answer 3

• Callable Bonds: Can be repurchased before maturity date
• Convertible bonds: can be exchanged for shares
• Putable bonds: Gives the holder in the option to retire or extend the bond
• Floating rate bonds: adjustable coupon rate (LIBOR)
• preferred stocks: Shares with characteristics of both equity and fixed income (dividends paid before common)

Question 4

Bond innovations

Answer 4

Inverse floaters: coupon falls when reference rate rises

Asset-backed bonds: MBS

Catastrophe bonds

TIPS

Question 5

Relationship Bondprice and yield

Answer 5

Yields are equivalent to required rates of return
• Prices and yields have an inverse
relationship
• The bond price curve is convex
• The longer the maturity, the
more sensitive the bond’s price
to changes in market interest
rates

Question 6

Yield to maturity

Answer 6

Interest rate that makes the present value of the bond’s payments equal to its price is the yield to maturity
• Solve the bond formula for r
• r is the internal rate of return (IRR)

Question 7

Current Yield

Answer 7

Bond’s annual coupon payment divided by the bond price
• For premium bonds (that sell above face value)
Coupon rate > Current yield > YTM

Question 8

Yield to call

Answer 8

Yield to call is the yield of callable bonds, adjusted for the built-in call option

The price of the callable bond is flat over a range of low interest rates because the risk of repurchase (call) is high
• When interest rates are high, the risk of call is negligible and the values of the straight and the callable bonds converge

Question 9

YTM vs HPR

Answer 9

YTM:
It is the average return if the bond is held to maturity
• Depends on coupon rate, maturity, and par value
• All of these are readily observable

HPR:
It is the rate of return over a particular investment period
• Depends on the bond’s price at the end of the holding period, an unknown future value
• Can only be forecasted by horizon analysis

Question 10

Strips

Answer 10

STRIPS: Separate Trading of Registered Interest and Principal of Securities program by the Treasury

Longer term bonds,where the coupons and the principal are traded separately

At maturity zeros sell at par, thus their discount decreases with age

Question 11

Name 5 determinants of Bond safety

Answer 11

Coverage ratios
•Leverage ratios, debt-to-equity ratio
• Liquidity ratios 
•Profitability ratios
• Cash flow-to-debt ratio

Question 12

What are the Bond Indentures

Answer 12

Sinking funds: is a way to call bonds early to smooth the payout of the issuer firm
Subordination of future debt: restricts additional borrowing and creates seniority between “bond classes”
• Dividend restrictions: a covenant that forces the firm to retain assets rather than paying them out to shareholders
• Collateral: a particular asset bondholders receive if the firm defaults

Question 13

The difference in YTM and default risk

Answer 13

There is a difference between the yield based on expected cash flows and yield based on promised cash flows

Question 14

CDS

Answer 14

Insurance on a loan (hedging)

Institutional bondholders,e.g. banks, use CDS to enhance creditworthiness of their loan portfolios (Regulatory loophole: Lower Buffer rate: Arbitrage)

Can be used to speculate that bond
prices will fall (Naked CDS Ban)

Question 15

Collateralized debt obligation (CDO)

Answer 15

Reallocate credit risk in the fixed income markets

Loans are pooled together and split into tranches with different levels of default risk (and those prices)

Question 16

Yield curves

Answer 16

Flat yield curve

Rising yield curve

Inverted yield curve

Hump shaped yield curve

Question 17

Bond pricing through yield curve

Answer 17

• Yields on different maturity bonds are not all equal
• We need to consider each bond cash flow as a stand-alone zero-coupon bond
• Bond stripping and bond reconstitution offer opportunities for arbitrage
• The value of the bond should be the sum of the values of its parts

Question 18

Two types of yield curves

Answer 18

Pure Yield Curve
• Uses stripped or zero coupon Treasuries
• May differ significantly from the on-the-run yield curve
• This is typically provided by central banks

On-the-run (most recent) Yield
• Uses recently-issued coupon bonds selling at/or near par value

Question 19

Yield curve with certain interest rates

Answer 19

Holding a 2 year zero bond or 2 1 year bonds should be the same

Spot rate: The rate that prevails today for a given maturity
Short rate: The rate for a given maturity at different points in time

The spot rate is the geometric average of its components short rates

If the next years short rate is greater than this year’s short rate, the yield curve slopes up: rates are expected to rise (or large liquidity premium wanted)

Question 20

Theories of term structure

Answer 20

1. The Expectations hypothesis theory
   • Observed long-term rate is a function of today’s short-term rate and expected future short-term rates
2. Liquidity preference theory
   • The yield curve has an upward bias built into the long-term rates because of the liquidity premium

The yield curve reflects expectations of future interest rates
The yield curve is a good predictor of the business cycle (Inverted yield curve may indicate that interest rates are expected to fall and signal a recession)