Chapter 3: Bonds - Interest Rates and Credit Risk

Financial Markets and Institutions

What is the key difference between a bond and a loan?

A bond is a securitized loan that is tradable, while a loan is not.

What does 'time to maturity' indicate in a bond?

The length of time until a bond’s principal is repaid.

What is another name for the face value of a bond?

Par value.

How is a bond’s coupon rate expressed?

As the fixed interest payment paid periodically to the bondholder.

Why are zero coupon bonds sold at a discount?

Because they pay no coupons and investors are compensated through price appreciation at maturity.

What collateral is typically used to secure bonds?

Assets such as property, plant, and equipment (PP&E).

How does a debenture differ from a secured bond?

A debenture has no collateral backing, unlike a secured bond.

What happens to bond prices when interest rates rise?

Bond prices fall.

What is price risk in bonds?

The risk of bond value declining due to interest rate changes.

Why do investors face reinvestment risk with coupon bonds?

Because coupon payments may have to be reinvested at lower interest rates.

What is the main concern behind credit risk?

That the issuer may default on promised payments.

What does the recovery rate measure in bond investing?

The percentage of investment recovered if default occurs.

When is a bond considered a premium bond?

When it is priced above par value and YTM is less than the coupon rate.

What does it mean if a bond is priced at par?

It means YTM equals the coupon rate.

When is a bond considered a discount bond?

When it is priced below par value and YTM is greater than the coupon rate.

Why is duration important for bond investors?

It measures bond price sensitivity to interest rate changes.

What formula links duration, yield changes, and returns?

Return ≈ −Duration × ∆yield.

Why are long maturity, low coupon bonds riskier?

They have longer durations and are more sensitive to rate changes.

Why are short maturity, high coupon bonds less risky?

They have shorter durations and are less sensitive to rate changes.

What does convexity add to duration analysis?

It measures how duration changes as interest rates change.

What does a widening credit spread imply about risk?

It implies increasing risk in the market.

How is default probability related to credit spreads?

Higher default probability leads to wider credit spreads.

Why do illiquid bonds have higher yields?

Because investors demand a liquidity premium.

What does an AAA S&P rating indicate?

An extremely strong capacity to meet obligations.

Why is BBB considered the lowest investment grade?

Because it indicates adequate capacity but vulnerability to downturns.

What does a BB rating mean?

It is speculative grade; less vulnerable near-term but faces uncertainties.

What does a CCC rating indicate about issuer risk?

That the issuer is very vulnerable and dependent on favorable conditions.

What does a D credit rating mean?

That the issuer has defaulted, such as missing payments.

What is Moody’s highest rating?

Aaa.

What is the lowest investment-grade Moody’s rating?

Baa3.

What does a Moody’s Ba rating indicate?

That the bond is speculative grade or 'junk.'

What does a Moody’s C rating suggest?

That the bond carries very high credit risk and is near default.

What do credit ratings measure?

The probability of default, assessed by agencies.

Why might credit spreads differ from agency ratings?

Because they reflect real-time market views on default risk, recovery, and liquidity.

What does a negative outlook suggest about a bond’s future rating?

That the rating may be downgraded in the future.

Which ratings qualify as investment grade?

BBB- Baa3 or higher.

What is another name for speculative grade bonds?

Junk bonds.

Why are Treasury bonds considered risk-free?

Because they have no credit risk.