Bond Basics

Question 1

What are the characteristics of a “Zero coupon bond”?

Answer 1

• Stated par value with no stated interest rate
• Purchased at a DISCOUNT, and mature at PAR
• They are the most volatile price-wise

Question 2

What combination makes a bond’s price very volatile?

Answer 2

Long maturity and low interest rate

Question 3

Term bond characteristics and 1 example:

Answer 3

Issued and Mature on the same date

Example: US gov’t bonds

Question 4

Serial bond characteristics and 1 example:

Answer 4

Issued on the same date, but mature on different date

Examples: Municipal bonds and corporate ETC’s

Question 5

Series bond characteristic and 1 example:

Answer 5

All issued on different dates, but mature on the same date

Example: Long term construction

Question 6

How are term bonds quoted?

Answer 6

At percentage of par (dollar bonds)

Question 7

How are corporate bonds quoted?

Answer 7

Percent of par in 1/8ths

Question 8

How are US Govt. bonds quoted?

Answer 8

Percent of par in 1/32nds

Question 9

How are municipal bonds quoted?

Answer 9

On a yield basis

Question 10

Where does most of a bond’s value lie?

Answer 10

In the final principal repayment

Question 11

List of bond prices from highest to lowest for DISCOUNT bonds:

Answer 11

1. YTC
2. YTM
3. CY
4. Coupon/Nominal

Question 12

List of bond prices from highest to lowest for a PREMIUM bond:

Answer 12

1. Coupon
2. CY
3. YTM
4. YTC

Question 13

Define interest rate risk:

Answer 13

Risk that rising interest rates will call bond prices to fall (also called market risk)

Question 14

Define Purchasing power risk:

Answer 14

Risk that inflation will lower the value of a bond (especially long term ones)

Question 15

Marketability risk:

Answer 15

Risk that something will be hard to sell

Note: Not a risk for treasuries, but a big risk for munis

Question 16

Liquidity risk:

Answer 16

Risk that security can only be sold by incurring large costs

Question 17

Reinvestment risk:

Answer 17

Risk that when interest is received and reinvested, it has to be reinvested at a lower yielding security because interest rates have fallen

Question 18

Exchange rate risK

Answer 18

Risk that value of foreign currency in which the investment is denominated will weaken

Question 19

What does the yield curve show?

Answer 19

Market rates of interest for bonds of different maturities and similar credit rankings

Question 20

When is a yield curve normal?

Answer 20

• when monetary policy is LOOSENED
• economic expansion
• when maturities lengthen, yields increase

Question 21

When is the yield curve flat?

Answer 21

• monetary policy is tightened

- occurs when economy is peaking

Question 22

When is the yield curve inverted?

Answer 22

• short term rates rise ABOVE long term rates (inverted)

- severely tightened economic policy

Question 23

What are the 3 theories for yield curve shape?

Answer 23

1. liquidity preference
2. Market segmentation
3. Expectations (positive - rates rise, negative - rates fall)

Question 24

What is the yield spread, and what does it mean?

Answer 24

Yield spread is the difference between Government and AAA rated corporate yields:

Widening spread means coming recession (Widen = Worry)
Narrowing spread means coming expansion (Narrow = No worry)

Question 25

What is the formula for YTM for a premium bond?

Answer 25

(Bond cost + Redemption price) / 2

Question 26

What is the formula YTM for a discount bond?

Answer 26

(Bond cost + Redemption price) / 2

Question 27

How are inflation rates and interest rates correlated?

Answer 27

Positively correlated. If inflation goes up, interest rates go up, and vice versa

Question 28

The credit rating of a guaranteed corporate bond is based on the credit quality of the…

Answer 28

Corporate GUARANTOR (not the issuer)