Unit 2 Flashcards
T/F: Once issued, bonds are bought and sold in the secondary market.
True.
The 2 primary factors affecting bond’s market price?
Interest rate and credit rating (financial stability of issuer)
If issuers credit rating remains constant, what’s the only other impact on bond’s market price?
Interest Rates
Bond price changes are quoted in: Points or Basis Points?
Bond price changes are quoted in Points - 1 point is 1% of 1000, or $10. There are 100 basis points in 1 point, so 1 point = 1/100 of 1%
100 basis points = 1%
1 basis point = .01%
How much is 80 basis points in terms of $ and %?
A. $8, .8%
We know that 100 basis points = $10 = 1%. So 80 basis points = $8 = .8%
What rating must a municipal bond be higher than to indicate “investment grade” quality?
BBB (S&P) or Baa (Moody’s)
Generally, the (higher/lower) a bond’s rating, the lower the yield?
The higher a bond’s rating, the lower its yield. Safer bonds (less risk) yield lower returns.
If a bond is callable at 102 (par being 100), what’s the value of the call premium, in points and dollars?
100 = par = $1000. So 102 = $1020 or $20 per bond or 2 points
T/F: Nominal Yield = Coupon Yield
True: Nominal/Coupon yield is the fixed percentage of the bond’s par value.
T/F: Current Yield is different than a nominal yield or a coupon yield.
True: Current Yield measures a bond’s coupon payment relative to its market price
Coupon Pmt/ Market Price = Current Yield
Bond prices and yields have an ______ relationship.
Inverse relationship. As interest rates rise, bond prices fall. When a bond trades at a discount, its current yield increases. When a bond trades at a premium, its current yield decreases.
What is the current yield of a 6% bond trading at $800?
CY = Coupon pmt ($) / Market Price
6% bond = $60/$800 = 7.5% current yield
T/F: YTM (Yield to maturity) takes into account the premium paid or discount received by the bondholder to calculate a true yield or return to the investor at maturity.
True: if the investor buys the bond at a discount (below par), the YTM accounts for this increase in return. If the investors pays a premium, this loss is accounted for in the YTM.
T/F: Under normal circumstances, the shorter the bond’s maturity, the greater the yield.
FALSE: The longer a bond’s maturity, the greater the yield. The increased yield attached to longer maturity reflects the potential for credit quality and inflation over time.
The difference in yields between short-term and long-term bonds of the same quality is known as (and reflected in) what?
Yield Curve reflects the difference between short-term and long-term bonds of the same quality.
There are 2 types of corporate bonds. When the issuer has identified specific assets as collateral for interest and principal payments, this is a ______ bond.
Secured bond. In default, bondholder of secured bond can lay claim to collateral.
These types of bonds have no collateral backing them and are classified as either “Debentures” or “Subordinated Debentures”.
Unsecured bonds
Convertible bonds are corporate bonds that can be exchanged for a fixed number of the issuing company’s _____ stock.
Convertible bonds can be exchanged for common stock.
What is the “annualized return if a bond is held to maturity”?
YTM
How do you calculate the numerator in the YTM calculation?
$ Annual Interest +/- (Premium or Discount/# of Years to Maturity), where premium or discount = (Par value - Market Price)
How do you calculate the denominator in the YTM calculation?
Average Price, (Par value + Market Price)/2
Which yield calculation takes into account the potential early redemption date, and the consequent acceleration of discount gained or premium lost?
Yield to Call. Think about it, an investor who buys a callable bond at a premium loses the premium faster if bond is called rather than held to maturity. Same idea for gaining the discount. So, YTC on a premium bond is always less than all other yields to account for the early payment of the premium (loss). YTC on discount is always more than all other yields to account for the early redemption of the discount (return).
If YTC > YTM, bond is likely trading at: par, premium, or discount?
Discount. If YTC is greater than YTM, bond is trading at a discount bc the higher YTC reflects the early redemption of a discount (aka return or yield) on the bond.
If YTM > Coupon, bond is likely trading at: par, premium, or discount?
Discount. Since YTM takes into consideration the premium or discount, when YTM is greater than coupon, this means the bond is trading at a discount, thus providing a greater return or yield.
Bonds are considered a _____ security bc they are preferred (in terms of liquidity) over common and preferred shareholders.
Bonds are considered a “senior” security.
Bond interest (coupon) accrues (daily, monthly, annually) and is paid (monthly, semiannually, or annually)?
Interest accrues daily and is paid semiannually.
When is the final interest payment on a bond paid?
Final interest payment is paid at maturity with repayment of principal.
What does the following bond name mean?
5M ABC J&J15 8s of 21
5M = 5 bonds ABC = Issuer J&J15 = semiannual interest pmt dates (Jan 15 and July 15) 8s = annual coupon rate 21 = maturity year
If a bond is trading at 85, what is the market price?
$850 - bonds are priced in terms of percentage of par. 85% of $1000 = $850
Corporate bonds trade in what increments of par?
1/8% which equals $1.25
Why would an issuer use their call option?
Issuers use their call option to call the bonds before maturity if interest rates in the general market are lower than when the bonds were issued.
If CY > Coupon, bond is trading at (par, premium, discount)?
When CY > Coupon, bond is trading at a discount because current yield measures the bond’s coupon pmt relative to market price. Recall, CY = $ coupon pmt/market price.
On the Yield Curve, what is on the Y axis and what is on the X axis?
Y axis = Yield, X axis = Years to Maturity
A NORMAL (rather than Inverted) Yield Curve predicts that interest rates will (rise or fall) in the future?
A normal yield curve predicts interest rates will rise in the future - indicates economic expansion.
What are the two primary types of Corporate Bonds?
Secured (backed by collateral) & Unsecured (no collateral - “debentures”)
Is a Debenture a secured or unsecured corporate bond?
Unsecured Corporate Bonds are also called Debentures.
What are the 3 main types of Secured Corporate Bonds?
1) Mortgage Bonds: the mortgages that back them are the collateral
2) Collateral Trust Bonds - where securities of other companies are used as collateral
3) Equipment Trust Certificates - finances the purchase of capital equipment which = the collateral
What are the 2 main types of Unsecured Corporate Bonds?
1) Debentures - backed by general credit of the issuer.
2) Subordinated Debentures - paid last of all debt obligations
List the liquidation hierarchy starting with unpaid wages (total of 7).
- Unpaid wages
- Taxes
- Secured debt (bonds and mortgages)
- Unsecured debt and general creditors (debentures)
- Subordinated debt
- Preferred Stock
- Common
What are “Guaranteed Bonds” backed by?
Company other than the issuer - i.e. parent company
When a company is reorganizing and coming out of bankruptcy, what types of bonds will they issue?
Income (aka Adjustment) Bonds
In which type of bonds, does interest not accrue if issuer doesn’t have enough money to pay it?
Income Bonds - therefore, not suitable for investors seeking income.
What type of bonds do not pay interest?
Zeroes (Zero Coupon Bonds) - the fact that they do not pay interest means that their prices reflect the general interest rate environment.
Why types of bonds allow investors to speculate on the general interest rate environment?
Zeroes allow investors to speculate on interest rate movements.
Zero coupon bonds are issued at what, but mature at par? What can the difference between issue price and par considered?
Zero coupon bonds are issued at a deep discount, but mature at par. Difference can be considered the return.
What is unique about the taxation of zeroes?
Zeroes are taxed on their “accreted value” (the difference between what they purchased it at and par value) even if it has not yet matured. In addition, the cost basis of the investment increases each year by the amount of taxable income. If held to maturity, there will be no capital gain.
What is the accreted value of a zero-coupon bond if bought at $400, on which the investor will be taxed?
$600
If investor’s accreted value in zero coupon bond is $600 with a 10 year maturity, on what amount will they be charged tax?
$60 annually. To find taxable income on zero: Accreted Value / Years to Maturity = $600/10 = $60
Each year, the cost basis on a zero coupon bond increases by what amount, for tax purposes?
Each year, the cost basis on a zero increases by the amount of taxable income, as calculated by accreted value divided by years to maturity. IE) If original cost basis was $400, meaning accreted value was $600 and 10 years to maturity, taxable income = $60. So, each year, cost basis increases by $60.
Why is a zero coupon bond considered a security without reinvestment risk?
bc no interest payments to reinvest.
Which 2 parties are involved in the Trust Indenture?
Bond issuer & Trustee (on behalf of bondholders)
