week 15

Question 1

what is bond indenture

Answer 1

contract between issuing company and bondholders includes
basic terms of bonds
total amount of bonds issued
a description of bond security, if bond is secured or unsecured
sinking fund provision
embedded options
details of protective covenants

Question 2

what are bond classifications

Answer 2

security and seniority

Question 3

what is the security bond classification

Answer 3

collateral - secured by financial securities
mortgage - secured by real property, normally land or buildings
debentures - unsecured
notes - unsecured debt with original maturity less than 10 years

Question 4

what is seniority bond classification

Answer 4

senior vs junior, lower rank

Question 5

what does required return depend on

Answer 5

bond characteristics
coupon rate, risk usually equal to yield at issue

Question 6

what are 0 coupon bonds

Answer 6

make no periodic interest payments
coupon rate = 0%
yield to maturity comes from the difference between the purchase price and par value
cannot sell for more than par value
sometimes called 0s or deep discount bonds

Question 7

what are floating rate bonds

Answer 7

coupon rates floats depending on some index value
eg adjustable rate mortgages and inflation-linked treasuries
less price risk with floating rate bonds, coupon floats so less likely to substantially differ from YTM
coupons may have a collar, rate cannot go above ceiling or floor

Question 8

what are semi-annual coupons

Answer 8

bonds that make payments twice a year

Question 9

what are additional bond features

Answer 9

callable
putable
convertible

Question 10

what is a callable bond

Answer 10

grants the issuers the right to retire the bond before scheduled maturity date
allows issuers to change maturity of a bond

Question 11

what is a putable bond

Answer 11

grants bondholders the right to sell the bond back to the issuers at par value on designated date
allows investors to change maturity of a bond

Question 12

what is a convertible bond

Answer 12

gives the bondholders right to exchange the bond for common stock at a pre-specified price
allows investors to take advantage of favourable movements in the stock price

Question 13

why do some bonds have lower tax rates

Answer 13

some bonds have lower/no taxes
yields are usually lower as investors do not demand additional yield to be compensated for tax
comparisons of bonds must use after tax yields

Question 14

what are bond markets

Answer 14

mainly over the counter transactions with dealers and brokers connect electronically
large number of bond issues but low daily volume in single issues
getting up to date prices difficult, particularly on small company or municipal issues

Question 15

what are clean prices

Answer 15

no interest included

Question 16

what are dirty prices

Answer 16

include accrued interest

Question 17

what is the bid price

Answer 17

the price that dealers are willing to pay for the security

Question 18

what is the ask price

Answer 18

what the dealer is willing to sell the bond for

Question 19

what is the bid-ask spread

Answer 19

profit made by dealers on the transaction

Question 20

what are the ask and bid yield

Answer 20

the YTM based on ask and bid prices

Question 21

what are the risks associated with investing in bonds

Answer 21

interest rate
reinvestment
default
call
inflation
exchange rate
liquidity
volatility

Question 22

what is interest rate risk

Answer 22

risk that arises from fluctuating interest rates
how much interest rate risk a bond has depends on how sensitive it is to interest rate changes

Question 23

what does sensitivity to interest rate changes depend on

Answer 23

time to maturity - longer time to maturity increases risk
coupon rate - lower coupon rate increases risk

Question 24

why do high coupon rates carry less risk

Answer 24

larger cash flow earlier in its life, value is less sensitive to changes in discount rates

Question 25

what is credit risk

Answer 25

the risk that the issuer of the bond may default
the calculation of the value of the bond using YTM is based on the assumption that there is no possibility of default
if there is any credit risk, investors will require a higher return

Question 26

what are bond ratings

Answer 26

default risk is measured by quality ratings assigned by three rating companies: moodys, standard and poor and fitch
only concerned with possibility of default risk
highest rating is AAA

Question 27

what are nominal interest rates

Answer 27

interest rates of returns which have not been adjusted for inflation
financial rates are almost always in nominal terms

Question 28

what are real rates of return

Answer 28

interest rates of return that have been adjusted for inflation
percentage change in terms of purchasing power

Question 29

what is the fisher effect

Answer 29

1 + R = (1+r) x (1+h)
1+R - nominal rate
1+r - real rate
1+h - percentage change in price level of goods

Question 30

what is term structure

Answer 30

the relationship between time to maturity and yields, all else equal
effect of default risk, different coupons has been removed

Question 31

what is yield curve

Answer 31

graphical representation of term structure
upward sloping - long rates > short rates
downward sloping - long rates < short rates
flat - long rates = short rates