Week 2 - Bond Markets

Question 1

What are bonds?

Answer 1

Fixed-income securities representing a borrowing arrangement.

Issuer (e.g., a company or university) borrows money from investors.

Pays interest (“coupons”) periodically + returns principal (par value) at maturity.

If no coupons are paid → sold at a discount (known as a zero-coupon bond).

Question 2

What is face value in bonds?

Answer 2

Face Value (par value or principal value) is the payment made to the bondholder at the maturity of the bond.

Question 3

what is maturity in bonds?

Answer 3

Maturity is how long the bond lives. It is the date that the Face Value is paid to investors and the issuer ends his obligation.

Question 4

What are coupons in bonds?

Answer 4

Coupons are the interest (or Coupon) payments paid to the bondholders, commonly annually or semi-annually. Coupon is the periodic interest payment.

Question 5

What is the coupon rate?

Answer 5

Coupon rate is the annual interest rate which is defined as the interest payment (coupon) divided by face value.

Question 6

What is yield to maturity?

Answer 6

YTM (Yield to Maturity):
The bond’s total return if held to maturity, with all coupons paid and reinvested at the same rate.

It’s the discount rate (IRR) that makes the present value of all future cash flows equal to the bond’s market price.

Question 7

What else is yield to maturity also known as?

Answer 7

Yeild to maturity is also known as “book yield” or “redemption yield”.

Question 8

Why is yield to maturity important?

Answer 8

Why is YTM important?

It helps determine whether a bond investment is profitable; help compare between bonds too.

Bond investors usually observe the bond prices, coupon rates, and maturity, and a required return they are looking for.

They can compare between YTM and their required rates of return.

If YTM > their required rate of return, this bond appears to be an attractive buy.

Question 9

what is a A zero-coupon bond?

Answer 9

A zero-coupon bond pays no coupon (C) and only returns the principal (P) at maturity.

Typically the market price is lower than the principal/face value (P).

Question 10

What are the ten types of bonds?

Answer 10

the ten types of bonds are:

1) Straight or vanilla bonds
2) Zero-coupon bonds
3) Variable/Floating rate bonds/Notes
4) Callable (or redeemable) bonds
5) Puttable bonds
6) Perpetual/Consol bonds
7) Index-linked bonds
8) Income bonds
9) Treasury Bills (or T-Bills)
10) Gilts

Question 11

What are Straight or vanilla bonds?

Answer 11

Straight or vanilla bonds Pay a fixed coupon at regular intervals for a fixed period to maturity with the return of principal on the maturity date

Question 12

What are Zero-coupon bonds?

Answer 12

Zero-coupon bonds Pay no coupon and thus are sold at a (“deep”) discount to their principal value, and all the reward derives from the principal value on the maturity date. It is also called a Pure Discount Bond.

Question 13

What are Variable/Floating rate bonds/Notes?

Answer 13

Variable/Floating rate bonds/Notes
coupon payments change over time; they have variable interest/coupon rate.

Question 14

What are Callable (or redeemable) bonds?

Answer 14

Callable (or redeemable) bonds
is where the issuer has the option to redeem before the bond reaches its maturity at the issuer’s discretion. The callable price is defined at the issue date.

Question 15

What are Puttable bonds?

Answer 15

Puttable bonds give the bondholder the right to force the issuer to buy back the bond at a set price on specific dates before maturity.

Question 16

What are Perpetual/Consol bonds?

Answer 16

Perpetual/Consol bonds are Bonds with no maturity date and the coupons are paid indefinitely.

Question 17

What are Index-linked bonds?

Answer 17

Index-linked bonds pay Coupon payments that are linked to a specific price index (e.g., consumer price index (CPI)).

Question 18

What are Income bonds?

Answer 18

Income bonds only guarantee the repayment of face value. Coupon payments are made only if the issuing company earns enough income.

Question 19

What are Treasury Bills (or T-Bills)?

Answer 19

Treasury Bills (or T-Bills) are Short-term debt instruments with maturity in one year or less from their issue date. T-Bills are issued by the US Government.

Question 20

What are Gilts?

Answer 20

Gilts are Government bonds in the U.K., India, and several other countries. Gilts have a wider range of maturities and can be short (less than 5 years), medium (5 to 15 years), or long-term (15+ years) securities.

Question 21

What is duration?

Answer 21

Duration is the weighted average time until all the bond’s cash payments are received.It measures the exposure of the bond’s price to fluctuations in interest rates.

Question 22

What are Credit Rating Agencies ?

Answer 22

Credit Rating Agencies are companies that provide ratings to the debtor’s ability to pay back the debt’s interests and/or principal value as promised in the debt contract

Question 23

What is Default Risk Premium ?

Answer 23

Default Risk Premium is the additional yield on a bond that investors require for bearing credit risk

Question 24

What is Default or Credit Risk ?

Answer 24

Default or Credit Risk is the risk that a bond issuer may default on its bonds

Question 25

What is term structure?

Answer 25

The term structure of interest rates refers to the relationship between spot rates with different maturities.

Question 26

What is the yield curve?

Answer 26

The yield curve is a graph that displays the relationship between yield (spot rates) and maturity

Question 27

What is expectations theory?

Answer 27

Expectations Theory states that the interest rate on a long-term bond equals the average of expected future short-term rates over its life. Investors see bonds of different maturities as "perfect substitutes" and choose based on expected return.

Question 28

what are the three stylised facts about interests?

Answer 28

1 ) Interest rates on bonds of different maturities move together over time. 2) When short-term rates are low, yield curves tend to slope upward; when short-term rates are high, they are more likely to invert (slope downward). 3) Yield curves almost always slope upward, reflecting higher long-term rates.

Question 29

What is expectations theory?

Answer 29

The interest rate on a long-term bond is equal to the average of the short-term interest rates that are expected to be occurred over the life of the long-term bond. Buyers of bonds do not prefer bonds of one maturity over another; they will not hold any quantity of a bond if its expected return is less than that of another bond with a different maturity. Bonds like these are said to be perfect substitutes.

Question 30

what is market segmentation theory?

Answer 30

The interest rate on a long-term bond is equal to the average of the short-term interest rates that are expected to be occurred over the life of the long-term bond. Buyers of bonds do not prefer bonds of one maturity over another; they will not hold any quantity of a bond if its expected return is less than that of another bond with a different maturity. Bonds like these are said to be perfect substitutes.

Question 31

do short or long term bonds bear more interest rate risk?

Answer 31

Short-term bond bear less interest-rate risk.

Question 32

what are Eurobonds?

Answer 32

Eurobonds – issued and/or traded in the UK in a currency other than sterling.

Question 33

what are the four main types of yield curves?

Answer 33

the four main types of yield curves: 1. Flat Yield Curve 2. Rising Yield Curve 3. Inverted Yield Curve 4. Hump-Shaped Yield Curve

Question 34

what are the three facts about interest rates you need to know to explain yeild curves?

Answer 34

Facts about interest rates: 1. Interest rates on bonds of different maturities move together over time 2. When short-term interest rates are low, yield curves are more likely to have an upward slope; when short-term rates are high, yield curves are more likely to slope downward and be inverted 3. Yield curves almost always slope upward

Question 35

what are the Theories of the Term Structure to explain yeild curves?

Answer 35

1. Expectations Theory a. The interest rate on a long-term bond is equal to the average of the shortterm interest rates that are expected to be occurred over the life of the longterm bond b. Buyers of bonds do not prefer bonds of one maturity over another; they will not hold any quantity of a bond if its expected return is less than that of another bond with a different maturity c. Bonds like these are said to be perfect substitutes d. It explains why the term structure of interest rates changes at different times e. It explains why interest rates on bonds with different maturities move together over time (fact 1) f. It explains why yield curves tend to slope up when short-term rates are low and slope down when short-term rates are high (fact 2) g. Cannot explain why yield curves usually slope upward (fact 3) 2. Market Segmentation Theory a. Bonds of different maturities are not substitutes at all b. Investors have preferences for bonds of one maturity over another c. The interest rate for each bond with a different maturity is determined by the demand and supply of that bond d. If investors have short desired holding periods and generally prefer bonds with shorter maturities that have less interest-rate risk, then this explains why yield curves usually slope upward (fact 3) 3. Liquidity Premium Theory a. The interest rate on a long-term bond will equal an average of short-term interest rates expected to occur over the life of the long-term bond plus a liquidity premium that responds to supply and demand conditions for that bond b. Short-term bond bear less interest-rate risk c. Bonds of different maturities are substitutes but not perfect substitutes d. Yield curves tend to slope upward when short-term rates are low and to be inverted when short-term rates are high; explained by the liquidity premium term in the first case and by a low expected average in the second case.