Investment Theory - Note 10

What is a bond?

A debt security requiring the issuer to make specified payments.

What is a bond's face value (par value)?

The principal amount repaid at maturity.

What is a coupon payment?

A periodic interest payment made to bondholders.

What is a bond's coupon rate?

Annual coupon payments divided by face value.

What is a bond's maturity date?

The date on which its principal becomes due.

What is a bond indenture?

The contract defining the issuer's obligations to bondholders.

Face value $1,000, coupon rate 8%: annual coupon?

$80.

8% coupon on $1,000, paid semiannually: payment amount?

$40 every six months.

What is a callable bond?

A bond the issuer can repurchase at a specified call price.

Why might an issuer call a bond?

To refinance its debt when market interest rates fall.

Why do callable bonds often offer higher yields?

The call option benefits the issuer and disadvantages the investor.

What is a convertible bond?

A bond exchangeable for a specified number of common shares.

Why may convertible bonds offer lower yields?

Investors receive a valuable conversion option.

What is a put bond?

A bond the holder can redeem at specified terms before maturity.

What is a floating-rate bond?

A bond whose coupon adjusts with a reference market rate.

What determines a bond's theoretical price?

The present value of its future coupons and principal.

What is the standard bond pricing formula?

P = Σ[C/(1+r)^t] + F/(1+r)^T.

What does C represent in the bond pricing formula?

Coupon payment per period.

What does F represent in the bond pricing formula?

Face value repaid at maturity.

What discount rate is used in bond pricing?

The appropriate market yield to maturity per period.

What happens to a bond's price when YTM rises?

Its price falls.

What happens to a bond's price when YTM falls?

Its price rises.

What is a discount bond?

A bond trading below its face value.

What is a premium bond?

A bond trading above its face value.

When does a coupon bond sell at par?

When its coupon rate equals its YTM.

When does a coupon bond sell at a discount?

When its coupon rate is below its YTM.

When does a coupon bond sell at a premium?

When its coupon rate exceeds its YTM.

What is a flat (clean) bond price?

The quoted price excluding accrued interest.

What is the invoice (dirty) price?

The quoted bond price plus accrued interest.

Who receives compensation for accrued coupon interest on a sale?

The seller, through the price paid by the buyer.

What is the accrued interest calculation in Note 10?

Coupon per period × Days elapsed / Days in coupon period.

A $40 coupon, 30 of 182 days elapsed: accrued interest?

Approximately $6.59.

How are periods adjusted for semiannual bond pricing?

Use half-year coupon, semiannual yield, and twice the years.

What is convexity in the bond price-yield relationship?

An equal yield decrease raises price more than a yield increase lowers it.

Which generally has greater interest-rate sensitivity?

A longer-maturity bond, other features held constant.

What is yield to maturity (YTM)?

The discount rate equating a bond's price with its promised cash flows.

What is current yield?

Annual coupon payment divided by current bond price.

What is the current yield formula?

Annual coupon / Bond price.

Annual coupon $80, bond price $950: current yield?

Approximately 8.42%.

Does current yield account for capital gains or losses at maturity?

No. It only compares annual coupon income with price.

For a discount bond, how do coupon rate, current yield and YTM compare?

Coupon rate < Current yield < YTM.

For a premium bond, how do coupon rate, current yield and YTM compare?

Coupon rate > Current yield > YTM.

What is bond-equivalent yield (BEY) in this chapter?

The annualized semiannual yield quoted as an APR.

Semiannual yield 4%: bond-equivalent yield?

8%.

Semiannual yield 4%: effective annual yield?

(1.04)^2 − 1 = 8.16%.

What is yield to call (YTC)?

The yield calculated assuming redemption on the call date.

How does YTC differ from YTM in calculation?

Use the call date and call price instead of maturity and face value.

What reinvestment condition supports realizing YTM as a compound return?

Reinvesting coupons at the original YTM.

What happens if coupons are reinvested below YTM?

The realized compound return falls below the original YTM.

What is interest-rate risk for bondholders?

Bond prices may decline when market interest rates rise.

What is reinvestment risk?

Coupon income may earn different returns when reinvested.

How do rising interest rates affect existing bonds?

Their prices fall, but reinvested coupons can earn more.

How do falling interest rates affect existing bonds?

Their prices rise, but reinvested coupons earn less.

What happens to a discount bond's price as maturity approaches if YTM stays constant?

It moves toward face value.

What happens to a premium bond's price as maturity approaches if YTM stays constant?

It declines toward face value.

What is a holding-period return (HPR) on a bond?

Coupon income plus price change, divided by initial price.

Can holding-period return differ from the initial YTM?

Yes, especially when market yields change before sale.

What is a zero-coupon bond?

A bond paying no coupons and only face value at maturity.

How do zero-coupon bondholders earn returns?

By buying below face value and receiving face value at maturity.

What does STRIPS stand for?

Separate Trading of Registered Interest and Principal of Securities.

What are Treasury STRIPS?

Separate zero-coupon claims created from Treasury coupon and principal payments.

What is bond default risk?

The possibility that the issuer fails to make promised payments.

Which major rating agencies are named in Note 10?

Moody's, Standard & Poor's, and Fitch.

What is an investment-grade bond?

A bond rated at least BBB by S&P/Fitch or Baa by Moody's.

What is a speculative-grade bond?

A below-investment-grade bond, often called a junk bond.

Why do junk bonds generally offer higher promised YTM?

They carry greater default risk.

Does a high promised YTM guarantee a high realized return?

No. Defaults can prevent investors receiving promised payments.

What is a default premium?

The yield spread over comparable Treasury bonds for default-risk compensation.

What is a protective covenant?

A bond contract restriction designed to protect bondholders.

What is a sinking fund?

A provision requiring periodic retirement of some outstanding bonds.

What is subordination of further debt?

A restriction protecting existing bondholders' priority.

What is the purpose of dividend restrictions in an indenture?

To limit distributions that could weaken bondholder protection.

What happened to credit spreads during the 2008–2009 crisis?

They increased dramatically in the historical data shown.

What is a yield curve?

A graph of bond yields against their time to maturity.

What is the term structure of interest rates?

The relationship between yields and maturities for comparable bonds.

What does an upward-sloping yield curve indicate?

Longer-maturity bonds have higher yields.

What does an inverted yield curve indicate?

Shorter-maturity bonds have higher yields than longer maturities.

What does the expectations theory say?

Bond yields reflect expectations about future short-term interest rates.

Under pure expectations theory, why might long-term yields rise?

Investors expect future short-term rates to rise.

What is a forward rate?

An implied interest rate for a future period.

What is the two-year spot-rate relationship?

(1+s2)^2 = (1+s1)×(1+f1,2).

How do you calculate the one-year forward rate starting next year?

f1,2 = (1+s2)^2/(1+s1) − 1.

One-year yield 8%, two-year yield 8.995%: implied next-year rate?

Approximately 10%.

What does the expectations hypothesis imply about holding-period returns?

Expected returns across maturities should be approximately equal.

What is liquidity preference theory?

Investors demand compensation for holding riskier long-term bonds.

Why can longer-term bonds have higher yields without expected rate increases?

A positive liquidity premium.

What is a liquidity premium?

Extra expected return required for bearing longer-term bond risk.

What is the liquidity-premium relationship in Note 10?

Forward rate = Expected future short rate + Liquidity premium.

How does a liquidity premium affect interpretation of forward rates?

Forward rates may exceed expected future short rates.

Can both expectations and liquidity premiums shape the yield curve?

Yes. Both contribute to observed yield-curve shapes.