Bonds and Interest Rates

par value/face value

total amount the bond issuer will commit to pay back at the end of the bond maturity period

coupon payments

The payments of interest that the bond issuer makes to the bondholder. These are often specified in terms of coupon rates. The coupon rate is the bond coupon payment divided by the bond’s par value.

bond price

the price the bondholder (the lender) pays the bond issuer (the borrower) to hold the bond (to have a claim on the cash flows documented on the bond); the price of a bond is the net present value of all future cash flows expected

default risk

the risk that the company issuing the bond may go bankrupt and default on its loans

default premium

The difference between the promised yields on a corporate bond and the yield on an otherwise identical government bond. In theory, the difference compensates the bondholder for the corporation’s default risk.

credit ratings

bonds are rated by credit agencies (Moody’s, Standard & Poor’s) which examine a company’s financial situation, outstanding debt, and other factors to determine the risk of default. Companies guard their credit ratings closely, because the higher the rating, the easier they can raise money and lower the interest rate

investment grade bonds

these bonds have high credit ratings and pay a relatively low rate of interest

junk bonds

also known as high yield bonds, these bonds have poor credit ratings, and pay a relatively high rate of interest

U.S. Treasury bills, notes, and bonds

bills mature in one year or less, notes in two to 10 years, and bonds in 30 years (The 30-year U.S. Treasury bond is also called the Long Bond)

Yield to Maturity

the measure of the average rate of return that will be earned on a bond if it is bought now and held until maturity

callable bonds

A company can buy back a bond so that it is not committed to paying large coupon payments in the future. An issuer can only call a bond if the bond was originally issued one; the risk that a bond will be called is reflected in the bond’s price

yield to call

the yield calculated up to the period when the bond is called back

zero coupon rates

Offers no coupon or interest payments to the bondholder; the only payment the zero-coupon bondholder receives is the payment of the bond face value upon maturity; the returns on their coupon bonds must be obtained by paying a lower initial price than their face value for them. These bonds are priced at a considerable discount to par value

forward rates

These are agreed-upon interest rates for a bond to be issued in the future. For example, the one-year forward rate for a five-year US Treasury note represents the interest forward rate on a five-year T-note that will be issued one year from now (and that will mature six years from now). This “forward” rate changed daily just like the rates of already issued bonds. It is essentially based on the market’s expectation of what the interest rate a year from now will be, and can be calculated using the rates of current bonds

Fed tools to regulate money supply

1. Open market operations (Fed writes a check to buy securities and thereby increases the money supply to do such things as buy back government bonds in the market)

2. Raise or lower interest rates (banks usually quickly follow by raising or lowering their prime rate)

3. Manipulate the reserve requirement for various banks to control the money flows and thereby the interest rate (banks that are members of the Federal Reserve are required to maintain a minimum balance in a reserve account with the Fed; lowering has the same expansionary effect as banks can make more loans with the deposits it has)

floating rate

lenders issuing long term bonds such as mortgages whose yield depend on an interest rate which adjusts to account for changes in inflation; floating rate protects lenders from inflation

What is the relationship between a bond’s price and it yield?

They are inversely related. that is if a bond’s price rises, it’s yields falls, and vice versa. Simplu put, current yield = interest paid annually/market price x 100%

How are bonds priced?

Bonds are priced on the net present value of all future cash flows expected from the bond

How would you value a perpetual bond that pays $1000 a year in coupons?

Divide the coupon by the current interest rate. For example, a corporate bond with an interest rate of 10% that pays $1,000 a year in coupons forever would be worth $10,000.

Why should a company issue debt versus equity?

1. A company needs steady cash flow before it can consider issuing debt; if it can, it should prefer to issue debt versus issuing equity

2. If the expected return on equity is higher than debt, the company will issue debt (if a company believes that projects completed will increase its market value, issuing debt will not require selling a percentage of the company

3. interest payments are tax-deductible and can benefit from tax shields

4. sends a quieter message to the market regarding a company’s cash situation

what major factors affect the yield on a corporate bond?

1. Interest rates on comparable U.S. Treasury bonds

2. The company’s credit risk; the size of the spread depends on the company’s credit risk: the riskier the company, the higher the interest rate the company must pay to convince investors to lend it money, and therefore the wider the spread over U.S. Treasuries

If you believe interest rates will fall, which should you buy: a 10 year coupon bond or a 10-year zero-coupon bond?

The 10-year zero coupon bond as it is more sensitive to changes in interest rates than an equivalent coupon bond, so its price will increase more if interest rates fall.

Which is riskier: a 30-year coupon bond or a 30-year zero coupon bond?

A 30-year zero-coupon bond: a coupon bond pays interest semi-annually; then pays the principal when the bond matures. A zero coupon bond pays no interest but pays one lump sum upon maturity. The coupon bond is less risky because you receive some of your money back over time, whereas with a zero-coupon bond you must wait 30 years to receive any money back (zero coupon bonds are also more sensitive to changes in interest rates)

if the price of the 10-year Treasury note rises, does the note’s yield rise, fall, or stay the same.

The yield falls

If you believe interest rates will fall, should you buy bonds or sell bonds?

Some bond prices rise when interest rates fall, so you should buy bonds.

How many basis points equal 50%?

Bond yields are measured in basis points, which are 1/100 of 1 percent (1 bp = 0.01%). 1 percent = 100 basis points.

Why can inflation hurt creditors

If you are a creditor lending money at a fixed rate, inflation cuts into the percentage that you are actually making. If you lend out money at 7 percent a year, and inflation is 5 percent, you are only really clearing 2 percent

How would the following scenario affect the interest rates: the President is impeached and convicted.

While it can’t be said for certain, chances are that these kind of events will lead to fears that the economy will go into recession, so the Fed would want to balance those fears that the economy will go into recession, so the Fed would want to balance those fears by lowering interest rates to expand the economy.

What does the government do when there is a fear of hyperinflation?

The government has fiscal and monetary policies it can use in order to control hyperinflation. The monetary policies (the Fed’s use of interest rates, reserve requirements, etc)