Week 2 - Bond Markets Flashcards
What are bonds?
Bonds are a fixed-income security that is issued with a borrowing arrangement,
Usually obligating the issuer to make periodic payments of interest to the bondholder (investor) over the life of the bond
Issuer (e.g., UoS) must pay the investor something for the privilege of using their money.
Interest payments or “coupons” plus the principal value (par value) of the bond.
Or, if no coupons are paid, need to purchase at a lower price than the principal value of the bond (par value), i.e., a zero-coupon bond.
What is face value in bonds?
Face Value (par value or principal value) is the payment made to the bondholder at the maturity of the bond.
what is maturity in bonds?
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.
What are coupons in bonds?
Coupons are the interest (or Coupon) payments paid to the bondholders, commonly annually or semi-annually. Coupon is the periodic interest payment.
What is the coupon rate?
Coupon rate is the annual interest rate which is defined as the interest payment (coupon) divided by face value.
What is yield to maturity?
YTM is the total return anticipated of a bond, assuming that it will be held to maturity with all coupon payment made as scheduled and reinvested at the same rate.
Can be viewed as the internal rate of return (IRR) of an investment in a bond if the investor holds the bond until maturity.
It is the discount rate that equate the sum of all discounted future cash flows (coupons + principal) of a bond with its market price (fair value); IRR!
Thus, the present value of a bond’s coupon payments and principal is accounted for.
What else is yeild ot maturity also known as?
Yeild to maturity is also known as “book yield” or “redemption yield”.
Why is yield to maturity important?
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.
what is a A zero-coupon bond?
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).
What are the ten types of bonds?
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
What are Straight or vanilla bonds?
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
What are Zero-coupon bonds?
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.
What are Variable/Floating rate bonds/Notes?
Variable/Floating rate bonds/Notes
coupon payments change over time; they have variable interest/coupon rate.
What are Callable (or redeemable) bonds?
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.
What are Puttable bonds?
Puttable bondsare bonds hwre the bondholder has the option to force the issuer to repurchase the security at a specific price and dates before maturity. The repurchase price is defined at the issue date
What are Perpetual/Consol bonds?
Perpetual/Consol bonds are Bonds with no maturity date and the coupons are paid indefinitely.
What are Index-linked bonds?
Index-linked bonds pay Coupon payments that are linked to a specific price index (e.g., consumer price index (CPI)).
What are Income bonds?
Income bondsare when only face value is promised to be paid to the bondholders; the coupon payments are paid only if the income generated by the firm is sufficient.
What are Treasury Bills (or T-Bills)?
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.
What are Gilts?
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.
What is duration?
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.
What are Credit Rating Agencies ?
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
What is Default Risk Premium ?
Default Risk Premium is the additional yield on a bond that investors require for bearing credit risk
What is Default or Credit Risk ?
Default or Credit Risk is the risk that a bond issuer may default on its bonds
What is term structure?
The term structure of interest rates refers to the relationship between spot rates with different maturities.
What is the yield curve?
The yield curve is a graph that displays the relationship between yield (spot rates) and maturity
What is expectations theory?
Expectations Theory is the 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.
what are the three stylised facts about interests?
Interest rates on bonds of different maturities move together over time.
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.
Yield curves almost always slope upward.
What is expectations theory?
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.
what is market segmentation theory?
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.
do short or long term bonds bear more interest rate risk?
Short-term bond bear less interest-rate risk.
what are Eurobonds?
Eurobonds – issued and/or traded in the UK in a currency other than sterling.
what are the four main types of yield curves?
the four main types of yield curves:
1. Flat Yield Curve
2. Rising Yield Curve
3. Inverted Yield Curve
4. Hump-Shaped Yield Curve
what are the three facts about interest rates you need to know to explain yeild curves?
Facts about interest rates:
1. Interest rates on bonds of different maturities move together over time
- 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
- Yield curves almost always slope upward
what are the Theories of the Term Structure to explain yeild curves?
- 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) - 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) - 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.
