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Business Finance > Module 6: Bonds and Their Value > Flashcards

Module 6: Bonds and Their Value Flashcards

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1
Q

Bonds are just _________.
Stocks (equity’s) are just _________.

A
  • annuities
  • perpetuities
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2
Q

a way for a company to publicly issue debt.

A

bond

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3
Q

At the bottom of it all, a bond is just a _________.

A

contract

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4
Q

What are the 2 things that the contract (a bond) will tell?

A
  1. Will tell the people who purchased the bonds what their payments will be in the future (what they’ll receive)
  2. Any conditions the company has that the purchaser of the bond has to conform to.
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5
Q

T or F: bonds (these contracts) can be quite long and involve a lot of details.

A

True

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6
Q

T or F: A bond can be structured however a company wants it to be. However, bonds do tend to follow fairly standardized conditions.

A

True; (Russian Vodka in payment instead of money for example)

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7
Q

If a company wants to borrow money, then they can _________ bonds.

A

issue

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8
Q

How much the bondholders lend a company money is really just how much the ________ can _____ those bonds for initially.

A

company; sell

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9
Q

Most of the time, companies will try to structure the bonds so that it sells close to _____, but usually there will be some variation in the ______ rate from when the bond gets finalized to when they are actually able to sell it.

A

par; interest

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10
Q

T or F: Bonds usually sell exactly for par value.

A

False; probably won’t sell EXACTLY for par value, but typically very close

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11
Q

T or F: A bond is similar to a mortgage payment where you pay even payments over time and pay down the balance of the bond.

A

False; a bond is usually structured so that it makes coupon payments, so it will pay the interest over time and then pay back the par value/face value at the end.

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12
Q

Most bonds pay _____________.

A

semiannually (ex: if it says we’re paid $50 per year, the payment would be $25 every 6 months –> (50/2))

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13
Q

Bonds typically have an (annuity/peretuity) structure where we’ve got (even/odd) cash flows every 6 months (sometimes every year, or could be monthly or quarterly because we can structure payments however we want).

A
  • annuity
  • even
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14
Q

the stated interest payment made on a bond; usually expressed as a rate (ex: interest rate)

A

coupon

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15
Q

A coupon (it’s rate, like interest rate) will always be expressed as an ________ percentage.

A

annual (ex: even if companies are paying bondholders semi-annually, it would be a 5% rate, it pays out $50 a year, but if it were semi-annual, it would just pay half of that $50 dollars every 6 months ($25).)

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16
Q

the principal amount of a bond that is repaid at the end of the term (two definitions).

A

face value / par value

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17
Q

the annual coupon divided by the face value of a bond.

A

coupon rate (ex: we get a 5% coupon rate from doing 50 (the coupon)/1,000 (par value))

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18
Q

Maturity is the specified date on which the _______ amount of a bond is paid.

A

principal

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19
Q

the rate required by the market on a bond.

A

Yield to Maturity (YTM)

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20
Q

Yield to Maturity is the rate that you discount the cash flows at to get the _________ price.

A

market

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21
Q

T or F: Once a bond is issued, all the terms of the bond are set. It can’t be changed without re-negotiating with the bondholders. So, if interest rates change (which can either be interest rates demanded by the market are changing, which has nothing to do with the bond itself (ex: fed is lowering interest rates right now to stimulate the economy back up since they feel they have inflation under control) OR the risk premiums (like treasuries)

A

True

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22
Q

bonds issued by the government

A

treasuries

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23
Q

Treasuries are typically (risk-filled/risk-free). Why?

A

Risk-free; because government can print money to pay back the debt they owe (however, this causes inflation)

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24
Q

Typically, ________ bonds are going to have to pay a higher rate than treasury bonds because bondholders are taking that extra risk that we may not get all the payments.

A

corporate

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25
Q

The premium size can change depending on how ____ _____ people are. When people are really worried about risk and they want that safety, they may demand really (small/big) spreads. Other times, they may not be worried about risk, so they only need to be compensated a little bit to take on that extra risk.

A

risk tolerant; big

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26
Q

If a company is doing really well/is growing a lot, it’s very easy for them to service the debt right now, which means you would probably be okay with holding a (higher/lower) rate of interest.

A

lower (bc you are prob not worried about that company defaulting on its payments to you)

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27
Q

If a company is struggling and cash is tight, then bondholders will probably want a (low/high) rate of interest to hold that debt.
This shows that a company’s ____ _______ can also affect how much interest people demand for that particular company.

A

high; own position

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28
Q

What is the only way bondholders can adjust the rate of return (interest rate), that they’re going to get?

A

The price bondholders are going to pay (All the future cash flows are already stated– these aren’t going to change (unless you renegotiate through bankruptcy or something).

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29
Q

If bondholders pay MORE for the same cash flows, they’ve got a (higher/lower) rate of return.

A

lower

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30
Q

If bondholders pay LESS for the same cash flows, they’re going to have a (lower/higher) rate of return.

A

higher

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31
Q

The price of a bond is equal to the _____ ______ of the bond’s cash flows.

A

present value

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32
Q

(Coupon rate/yield to maturity) affects our payment, while (coupon rate/yield to maturity) is what we’ll discount our cash flows at.
That is, you should use (coupon rate/yield to maturity) for I/Y.

A
  • Coupon rate
  • Yield to maturity
  • Yield to maturity
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33
Q

When the Yield to Maturity is equal to (same as) the Coupon Rate, the bond will trade for _______.
This means that _____ will be equal to ______.

A
  • par (it’ll trade for it’s face value)
  • FV = PV
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34
Q

When Yield to Maturity is MORE than Coupon Rate, the bond will be trading at a __________ to par.
In this instance, we as the bondholder, have (gained/lost) money.

A
  • discount to par (price of bond will have gone down)
  • LOST money because price has gone down (ex: the bond we paid $1,000 for is now worth $939.25)
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35
Q

If we are discount cash flows at a HIGHER rate (higher YTM) than the coupon rate, we will have a (higher/lower) PV.

A

lower PV (which means the price of bond will have gone down)

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36
Q

When interest rates go up, the returns for bonds go (up/down).

A

down

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37
Q

T or F: As long as you are holding a bond until maturity, the price of a bond won’t affect your returns. But, if you might have to sell it early, since rates have gone up, it hurts your return.

A

True

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38
Q

When Yield to Maturity is LESS than Coupon Rate, the bond will be trading at a __________ to par.
In this instance, we as the bondholder, have (gained/lost) money.

A
  • premium (trading for more than par value)
  • GAINED money because price has gone up
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39
Q

When interest rates fall, the returns for bonds go (up/down).

A

up

40
Q

If we are discount cash flows at a LOWER rate (lower YTM) than the coupon rate, we will have a (higher/lower) PV.

A

higher PV (rates going down cause price of bond to go up)

41
Q

T or F: With a bond, we are accumulating interest each year.

A

FALSE; just paying out the interest each year (or however frequent our payments are); the balance of the bond isn’t changing over time (until the very end, when we pay it back).

42
Q

What is the benefit for a company to sell a bond?

A

It’s a way for companies (usually larger ones) to borrow money for financing.

43
Q

T or F: Even if a company has the money to do what they want, they may still prefer to use debt financing (issuing bonds) if they think they can get it cheaply. With debt financing, we also get tax breaks, so companies may still choose to use debt financing over other sources even if we have other sources available.

A

True

44
Q

T or F: semi-annual payments will make a difference in terms of the price we get (that is, the frequency of payment affects the price we get) if we’re trading at the coupon rate.

A

False; WILL make a difference in terms or price we get if we’re NOT trading at the coupon rate. (when YTM does NOT = Coupon Rate)

45
Q

When solving for Yield To Maturity, we are solving for ______ in the financial calculator.

A

I/Y

46
Q

If payments are made semi-annually for a bond, and you are calculating the Yield to Maturity, what must you do after getting your answer from the financial calculator?

A

Must multiply this by 2. (we always want to state YTM as an ANNUAL rate unless specified otherwise)

47
Q

a bond’s annual coupon divided by its price.

A

Current Yield

48
Q

To calculate coupon rate, you do: annual payment / (price/par).

To calculate current yield, you do: annual payment / (price/par)

A
  • par
  • price
49
Q

For a bond that is trading at (a premium/par/ a discount), the current yield and coupon rate will be the same.

A

par

50
Q

If the bond is trading at a premium (price is bigger than par value), the current yield will be (lower/higher) than the coupon rate.

A

lower

51
Q

If the bond is trading at a discount (price is lower than par value), the current yield will be (lower/higher) than the coupon rate.

A

higher

52
Q

The current yield can be used to compare bond’s abilities to generate ________ _____ _______ invested.

A

income per dollar

53
Q

Oftentimes, people who are (holding/selling) bonds are looking at current yield because they want to generate a ______ income.

A

holding; fixed

54
Q

Imagine you’re a retiree, and you purchase a bond so that you get like a check every 6 months and you can live off this income. What calculation would you most likely be looking at in relation to this scenario:
a. Coupon rate
b. Yield to Maturity
c. Par Value
d. Current Yield

A

d. Current Yield

55
Q

Bonds with a (higher/lower) current yield will generate more income per dollar invested.

A

higher

56
Q

T or F: Current yield is a rate of return.

A

False; it is NOT a rate of return (not taking into account time value of money or anything)

57
Q
  • When choosing between two bonds when investing, if all we care about is our overall return (we want a higher rate of return), then we should look at ______ _____ _______ of both bonds.
  • If it’s ________ for both bonds, then it doesn’t matter which bond you choose.
  • When choosing between two bonds, what is the one instance where this would be different? What would we look at for this?
A
  • Yield to Maturity
  • equal
  • If we care about WHEN we’re receiving our cash flows and have a preference of that income being spread out. We could look at Current Yield. (would choose the one that has the higher current yield)
58
Q

T or F: If markets are efficient, then bonds that have the same amount of risk should have the same return.

A

True

59
Q

Bond that only pays the par value (so PMT = 0)

A

Zero Coupon Bonds

60
Q
  • How do you calculate the price of a zero coupon bond?
  • The only difference with these is that instead of multiple cash flows, we’ll have a single cash flow. Because of this, a zero coupon bond should always sell at (a discount/a premium/par).
A
  • Same as always, calculate the PV of future cash flows.
  • Discount
61
Q

T or F: A zero coupon bond should always sell at a premium.

A

False; should always sell at a discount (for the YTM to be higher than 0%, it has to sell at a discount)

62
Q

Why would zero coupon bonds be attractive to investors?

A

We can do things like liability matching (So, if you have a specific liability that you’re wanting to cover and not have to worry about interest rate risk, then these are attractive)

63
Q

the risk of a change in the value of a bond because of a change in the interest rate.

A

interest rate risk

64
Q
  • Bond prices and market rates move in (the same/opposite) directions.
    So:
  • When rates going up, bond price will go (up/down) (sell at a (discount/premium) (which means if you’re holding bonds, they are now worth (less/more)).
  • When rates going down, bond price will go (up/down) (sell at a (discount/premium) (which means if you’re holding bonds, they are now worth (less/more) if you want to sell those bonds).
A
  • opposite
  • down; discount; less (lost money)
  • up; premium; more (gained money)
65
Q

As a bondholder, you like it when the FED is (increasing/lowering) interest rates.

A

lowering

66
Q

All else being equal, the longer the time to maturity, the (greater/less) the interest rate risk.

A

greater

67
Q

All else being equal, the higher the coupon rate, the (higher/lower) the interest rate risk.

A

lower

68
Q

T or F: A bond’s value will be less sensitive to interest rate risk if the coupon rate goes up, which means we’re spreading out the value of the bond more across time.

A

True

69
Q

When a bond’s coupon rate is GREATER than the YTM, the bond’s price will be (greater/less) than its par value.

A

greater

70
Q

When a bond’s coupon rate is LESS than the YTM, the bond’s price will be (greater/less) than its par value.

A

less

71
Q

the relationship between interest rates and the time-to-maturity of a debt security. (how interest rates will vary with time-to-maturity)

A

term structure

72
Q

Bonds that mature soon tend to have (higher/lower) interest rates than bonds that mature further out in the future.

A

lower

73
Q

T or F: sometimes, bonds with different times-to-maturity will have the same YTM

A

True (like when the graph is flat)

74
Q

The Yield on Bonds is made up of what 5 things?
Put a * next to the 3 that are considered the “risk component”?

A
  1. Real Interest Rate
  2. Inflation Premium
  3. Interest Rate Risk Premium *
  4. Default Risk Premium *
  5. Liquidity Premium *

(All of these will go into determining what interest rate is required in the market, and all of these can change across time as circumstances change)

75
Q

Match each of the following definitions to what term they describe (all of these is what makes up the Yield on Bonds):
1. compensation for waiting
2. compensation for price increases
3. like how we talked about corporate bonds will typically pay more than treasuries
4. how quickly we could convert it to cash

A
  1. Real Interest Rate
  2. Inflation Premium (when inflation is higher, prices go up, so you need a higher return to compensate for that)
  3. Default Risk Premium
  4. Liquidity Premium

(no definition listed for Interest Rate Risk Premium)

76
Q

Most of the time, short term bonds tend to be (less/more) liquid than long-term bonds. (Particularly true of treasuries)

A

more

77
Q

the written agreement between the corporation and the lender detailing the terms of the debt issue.

A

indenture

78
Q

In bankruptcy, the company has a certain amount of assets and a bunch of people who expect to get paid back. At the end of the line are the (bond/equity) holders. There will be some bonds that are more _____, so they get paid back ahead of other bonds.

A

equity; senior

78
Q

An indenture will specify what 6 things?

A
  1. Terms of the Bond
  2. Security (ex: if the bond is going towards a project that has assets that will stay valuable like land and real estate, this can stand for security for the loan)
  3. Seniority (where you are in line; where you are with bankruptcy.)
  4. Repayment (some bonds will specify repayment over time in indenture, where companies agree to buy back a certain number of bonds each year, so that when they get to the end of the debt cycle it’s not like they owe the full amount they borrowed (like maybe they paid off half ahead of time or something)
  5. Call Provision (if it’s a call option, the company has the option to basically retire the debt early. So, if it matures in 30 years we may have a call provision that allows us to retire it in 20 years)
  6. Protective Covenants (things the company agrees to do or not do)
79
Q

when companies are paying in over time to retire some of that debt rather than just waiting until the end of the debt cycle to pay it all off to bondholders.

A

sinking fund

80
Q

Call Provisions (benefit/harm) the company and (benefit/harm) the investors.

A
  • benefit (bc they have the option to pay the debt off early or pay it at the end (they aren’t forced to do anything; just get to do whichever one benefits them)
  • harm (so investors will demand higher return)
81
Q

If all else is equal between two bonds but one is a call provision, investors (should/shouldn’t) choose it.

A

shouldn’t

82
Q

What are 2 types of call provisions?

A
  1. Call Premium (usually, if companies are going to retire bonds early, they’ll have to pay a premium. Percent of this premium will go down as you get closer to the debt date)
  2. Yield-to-Call
83
Q

what makes a bond more secure for the debtholders, so companies won’t have to pay quite as much interest rate?

A

Protective Covenants (ex: one protective covenant might be that the company agrees to publish their certain financial ratios every so often so the bondholders can monitor how safe the debt is)

84
Q

T or F: Typically, corporate or municipal (government) debt will get rated by similar rating agencies.

A

False; DIFFERENT

85
Q

What are the 2 big bond rating agencies?

A
  1. Standard and Poors (S&P)
  2. Moody’s
86
Q

an easy to understand metric that tells us how safe the debt is, how likely it is to pay back.

A

bond ratings (the rating system)

87
Q

What is the highest rating for a bond; means the debt that company has a strong capacity to pay and very unlikely to default.

A

AAA

88
Q

The big dividing line between bond ratings to determine which bonds they can hold: going from _____ (still considered investment grade) to ____

A

BBB to BB; B

89
Q

Investment grade debt is an important distinction for (small/large) ________ institutions (like insurance companies and pensions) because they may be required to either only hold investment grade debt because it has a much lower probability of default or only hold a certain amount of below investment grade debt.

A

large financial institutions

90
Q

The higher you go in bond ratings (like AAA at the top), the (higher/lower) interest rate companies have to pay.
The lower you go in bond ratings (D being the lowest, which is already in default), the (lower/higher) interest rate companies have to pay.

A

lower; higher

91
Q

T or F: A bond that is in default is a bad investment.

A

False; not necessarily, just depends on the return you can get from it.

92
Q

T or F: Going into default means a company is going to go into bankruptcy.

A

False; doesn’t

93
Q

When we get to bankruptcy, typically we want the company to be able to _________, because a company that’s continuing to operate, if there’s any path for them to get profitable, then it’s more likely that we will get paid back vs. if we just gut the company for parts

A

restructure

94
Q

T or F: An all equity firm cannot go bankrupt.

A

True; it is more financially secure than one that has debt.

95
Q

Answer the following questions as to whether they pertain to debt or equity:
1. Which one is NOT an ownership interest (don’t have rights as an owner)?
2. Creditors don’t have voting rights.
3. Common stockholders vote for the board of directions and other issues
4. Interest is considered a cost of doing business and is tax deductible ← big advantage for companies
5. Dividends are not considered a cost and are not tax deductible
6. Holders have legal recourse if interest or principal payments are missed, or if the company violates any of the covenants on _____.
7. Dividends are not a liability of the firm and stockholders have no legal recourse if dividends are not paid
8. can lead to financial distress and bankruptcy

A
  1. Debt
  2. Debt
  3. Equity
  4. Debt
  5. Equity
  6. Debt
  7. Equity
  8. Debt

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