Term
| Why are bonds said to comprise the fixed income capital market? |
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Definition
| Most bonds promise either a fixed stream income or a stream of income that is determined by a specific formula (though in reality, this income is usually not fixed) |
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Term
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Definition
| Bonds issued with no coupon payments. Investors receive par value on maturity. |
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Term
| What does a call price do? |
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Definition
| Gives the issuer the right to repurchase the bond at a specified call price before maturity date |
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Term
| Where is the call price usually set? |
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Definition
| At an initial level near par value plus one annual coupon - falls as time passes and nears maturity |
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Term
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Definition
| Bond that can be recalled (repurchased) by the issuer, but only after the call-protection period (cushion) ends |
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Term
| What do convertible bonds allow bondholders to do? |
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Definition
| Give bondholders an option to exchange each bond for a specified number of shares of common stocks of the firm |
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Term
| How do convertible bond prices and yields compare to regular bonds? |
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Definition
| They offer lower coupon rates and stated or promised yields to maturity than nonconvertible bonds |
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Term
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Definition
| Make interest payments that are tied to some measure of current market rates - they do not adjust to changes in the financial condition of the firm |
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Term
| How does the US government mainly borrow funds? |
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Definition
| In large part by selling Treasury Notes and Treasury Bonds. T-notes maturities range up to 10 years, whereas bonds are issued with maturities ranging from 10 to 30 years. |
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Term
| What is the major distinction between T-notes and T-bonds? |
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Definition
| T-bonds may be callable during a given period, usually the last 5 years of the bond’s life |
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Term
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Definition
| Bonds ssued by state and local governments. Similar to Treasury and Corporate bonds except that their interest income is exempt from some of state taxes |
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Term
| What are general obligation bonds backed by? |
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Definition
| The “full faith and credit” of the issuer |
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Term
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Definition
| Bonds issued to finance projects and are backed by the revenues of the project or the municipal agency operating the project. |
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Term
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Definition
Bonds issued by private companies
- Payoff: Bonds usually pay semiannual coupons and the face value at maturity.
- Security: Default risk is a real consideration in the purchase of corporate bonds. |
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Term
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Definition
| Yen denominated bonds sold in Japan by non-Japanese issuers |
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Term
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Definition
| Dollar denominated bonds held outside the US |
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Term
| Where is the international capital market centered? |
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Definition
| London - over 70 countries with offices |
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Term
| What does the price an investor will pay for future bond payments depend on? |
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Definition
- Real risk-free rate of return
- Premium above the Real rate to compensate for expected inflation |
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Term
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Definition
| Price = PV of coupons + PV of par value = Coupon x [1/r – 1/(r *(1+r)t)] + Par value (1/(1+r)t) |
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Term
| When bond price is greater than face value… |
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Definition
| The bond is trading at a premium. Coupon > YTM |
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Term
| When bond price is less than face value… |
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Definition
| The bond is trading at a discount. Coupon < YTM |
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Term
| Yield to Maturity Definition |
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Definition
| The interest rate that makes the PV of a bond’s payments equal to its price. This interest rate is viewed as a measure of the average rate of return that will be earned on a bond if it is bought now and held until maturity. |
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Term
| What serves as the internal rate of return on an investment in a bond? |
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Definition
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Term
| How can the YTM be intepreted within the Bond Price Formula |
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Definition
| The compound rate of return over the life of the bond basing on the assumption that all bond coupons can be reinvested at an interest rate equal to the bond’s YTM |
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Term
| What does current yield of a bond measure? |
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Definition
| Only the cash income provided by the bond as a percentage of the bond price and ignores any prospective capital gains or losses. |
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Term
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Definition
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Term
| What does the call feature allow? |
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Definition
| Allows the issuer of the bond the right (but not the obligation) to retire all outstanding bonds on (or after) a specific date (the call date), for the call price |
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Term
| Are bonds more likely to be called when interest rates are low or when they are high? |
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Definition
| When interest rates are low because firms can reissue bonds at a lower rate |
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Term
| How is the Yield to Call calculated? |
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Definition
| Just like the YTM except that the time until call replaces time until maturity, and the call price replaces the par value |
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Term
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Definition
| A period during which the bond cannot be called, allowing you to enjoy the coupons regardless of interest rate movements |
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Term
| What types of bonds receive an implicit form of call protection? |
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Definition
| Bonds sold at deep discounts |
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Term
| Who is concerned with the expected return of a bond? |
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Definition
| Investors who expect to actively trade in and out of bonds rather than hold until maturity date - Uses estimated market price of bond at expected sale date instead of the par value |
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Term
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Definition
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Term
| 4 Determinants of Bond Safety |
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Definition
1. Coverage ratios - ratios of company earnings to fixed costs. Low or falling coverage ratios, eg times-interest-earned ratio (EBIT/ Interest) signal possible cashflow difficulties
2. Leverage ratios- D/E ratio. A too-high leverage ratio indicates excessive indebtedness, signaling the possibility the firm will be unable to earn enough to satisfy obligations on its bonds
3. Liquidity ratios - current ratio (CA/CL) and quick ratio (CA-inv/CL) measures the firm’s ability to pay incoming bills with cash currently being collected
4. Profitability ratios- measures the rates of return on assets or equity. High return on assets (EBIT/TA) offer better prospects for the firm’s investments |
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Term
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Definition
| A contract between the issuer and the bondholder |
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Term
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Definition
| A set of restrictions on the firm issuing the bond to protect the rights of bondholders |
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Term
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Definition
| An account set-up by a municipality (or corporation) to redeem or purchase its bonds prior to maturity. By having a sinking fund, a municipality can reduce its debt load over time, avoiding the need to finance a large lump sum when the bond reaches maturity. Typically, a municipality is required to put a certain amount in the sinking fund every year |
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Term
| How does a firm establish a sinking fund |
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Definition
1) repurchasing a fraction of outstanding bonds in open market each year
2) purchasing a fraction of outstanding bonds at a special call price associated with the sinking fund provision |
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Term
| Subordination of Future Debt |
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Definition
| Subordination clauses restrict the amount of additional borrowing, ie additional debt might be subordinated in priority to existing debt and in the event of bankruptcy, subordinated or junior debtholders will not be paid unless the senior debt has been fully paid |
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Term
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Definition
| Limits the amount of dividends a bond issuer may distributre. These limitations protect bondholders because they force firms to retain assets rather than paying them out to stockholders |
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Term
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Definition
| A particular asset of the firm that the bondholders receive if the firm defaults on the bond. If the collateral is property, the bond is called a mortgage bond |
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Term
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Definition
| The difference between the promised yield on a corporate bond and the yield on an otherwise-identical government bond that is riskless in terms of default - To compensate for the possibility of default of corporate bond issuances |
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Term
| The pattern of default premiums offered on risky bonds is sometimes called.. |
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Definition
| Risk structure of interest rates |
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Term
| What happens to yield spreads during a recession? |
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Definition
| Yield spreads tend to be wider |
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Term
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Definition
| 1. Bond Prices are Related Inversely to the Yield to Maturity (convex relationship between prices and YTM) 2. Effect of Time on Bond prices 3. The Longer the Maturity, the More Sensitive a Bond’s Prices are to Changes in the Yield to Maturity 4. The Sensitivity of the Price of a Bond to Changes in the Yield to Maturity Increases at a Decreasing Rate with the Length to Maturity 5. There is a Linear Relationship between a Bond’s Coupon Rate and its Price |
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Term
| How does the price of a coupon bond change between coupon payments? |
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Definition
| Rises between coupon payments, but tumbles on the coupon date, reflecting the amount of the coupon payment. |
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Term
| If you feel interest rates will decline in the future, what type of bond should you buy? |
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Definition
| You will want to maximize your interest rate sensitivity. Thus, you should be in long maturity bonds with low coupons |
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Term
| If you think interest rates will rise in the future, what type of bonds should you invest in? |
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Definition
| You should minimize your interest rate sensitivity. Thus, you should hold bonds with short maturities and high coupon rates |
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Term
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Definition
| A measure of bond price volatility, which captures both price and reinvestment risk and which is used to indicate how a bond will react in different interest rate environments - the average amount of time that it takes to receive the interest and the principal |
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Term
| Advantages of considering a bond's duration |
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Definition
- Improvement over yield-to-market because factors in reinvestment risk - Bond duration is a better indicator than bond maturity of impact of interest rates on bond price (price volatility)
- Compares the sensitivity to changes in interest rates |
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Term
| What does bond duration calculate? |
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Definition
| The weighted average of the cash flows (interest and principal payments) of the bond, discounted to the present time |
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Term
| What are the 3 properties of bond duration? |
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Definition
1. Bonds with higher coupon rates have shorter durations
2. Bonds with longer maturities have longer durations
3. Bonds with higher YTM lead to shorter durations |
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Term
| How do the type of bonds you hold differ with interest rate expectations? |
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Definition
- If interest rates are going up, hold bonds with short durations
- If interest rates are going down, hold bonds with long durations |
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Term
| How does a coupon bond's duration compare to its maturity? |
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Definition
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Term
| What type of relationship is there between coupon and duration? |
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Definition
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Term
| What type of relationship is there between duration and maturity? |
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Definition
| Direct - duration increases with maturity but at a decreasing rate |
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Term
| What type of relationship is there between YTM and duration? |
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Definition
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Term
| What will something that shortens the life of a bond do to duration? |
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Definition
| Cause a reduction in bond’s duration (call or sinking fund) |
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Term
| What is the duration of a zero coupon bond equal to? |
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Definition
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Term
| Conserative bond investment strategy |
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Definition
- Main focus is high current income
- High credit quality bonds are used
- Usually longer holding periods |
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Term
| Aggressive bond investment strategy |
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Definition
- Main focus is capital gains
- Usually shorter holding periods with frequent bond trading
- Use forecasted interest rate strategy to time bond trading |
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Term
| Buy-and-hold bond investment strategy |
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Definition
| Replace bonds as they mature or quality declines |
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Term
| Bond ladder investment strategy |
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Definition
- Set up "ladder" by investing equal amounts into varying maturity dates (i.e. 3-, 5-, 7- and 10-year)
- As bonds mature, purchase new bonds with 10-year maturity to keep ladder growing
- Provides higher yields of longer-term bonds and dollarcost averaging benefits |
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Term
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Definition
| Occur when investor sells one bond and simultaneously buys another bond in its place |
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Term
| Yield pick up-swap investment strategy |
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Definition
- Sell a lower yielding bond and replace it with a comparable credit quality bond with higher yield
- Often done between different bond sectors (i.e. industrial bonds vs. utility bonds) |
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