Lesson 7 bonds

 liquidity preference theory

assumes that investors prefer buying short-term securities because these securities have less interest rate risk. 

level of the yield curve,

determined by the real rate of interest and expected rate of inflation. 

Fisher Effect

The nominal interest rate is determined by the real interest rate and the expected rate of inflation.

1 + nominal interest rate = (1 + real interest rate) × (1 + expected inflation rate)

Real Interest Rate

The real interest rate is simply the nominal rate less the rate of inflation.

expectation theory in finance

also known as the expectations hypothesis, is a theory about the relationship between short-term and long-term interest rates. It proposes that the yield on a long-term bond is essentially the average of the yields on a series of short-term bonds that investors expect to hold in the future. In simpler terms, long-term rates are determined by the market's expectations of future short-term rates

type of corporate bonds risk

interest rate risk and default risk

Interest Rate Risk

If market interest rates go up, the value of your bond goes down.

Default Risk

when the borrower is unable to pay the coupon and or the principal.

default premium or credit spread

the difference between the promised yield on a corporate bond and the yield on a Canada bond with the same coupon and maturity. It is the additional yield investors require for bearing credit risk.

investment-grade bond

Bond rated Baa or above by Moody’s, or BBB or above by Standard and Poor’s or DBRS.

speculative-grade, high-yield, or junk bonds.

Bonds rated BB and below

"What is the coupon rate of a bond?"

"The annual coupon payment expressed as a fraction of the bond’s face value."

"What is the current yield of a bond?"

"The annual coupon payment expressed as a fraction of the current bond’s price."

"What does yield to maturity (YTM) measure?"

"The average rate of return to an investor who purchases the bond and holds it until maturity."

"How are bonds valued?"

"By discounting the coupon payments and the final repayment by the yield to maturity on comparable bonds."

"What interest rate makes the present value of bond payments equal to the bond price?"

"The yield to maturity."

"Why do bond prices and yield to maturity move in opposite directions?"

"Because present values are lower when discount rates are higher."

"What causes the general level of interest rates to vary over time?"

"Changes in the real rate of interest and expected inflation."

"What is a yield curve?"

"A snapshot of yields on bonds of different maturities at a point in time."

"What is interest rate risk in bonds?"

"The risk of bond price fluctuations due to changes in interest rates."

"Which bonds have greater interest rate risk?"

"Long-term bonds and low-coupon bonds."

"Why do investors look at bond ratings?"

"To determine the risk of default on a bond."

"What is the default premium?"

"The additional return that investors demand for bearing credit risk."