Chapter 12 Part 2 Flashcards Preview

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Flashcards in Chapter 12 Part 2 Deck (20):

When a bond reaches its date of maturity, it will be

redeemed, meaning that a bondholder will receive her bond's par value plus her last interest payment. The issuer's obligation to the bondholder has ended and the debt is considered retired. However, some bonds are redeemed before they mature


Call Provisions

Bonds often contain a provision that gives the issuer the right to redeem them before they arc due (mature). The investor receives the par value of the bond and the interest payments stop. This is known as a call provision since it allows the issuer lo call in outstanding bonds



Call provisions usually benefit the issuer, which has the option of calling in the bonds when interest rates drop. The issuer can then refinance the debt at a lower rate of interest-much like a homeowner might refinance a mortgage if interest rates drop after he purchases it


Since issuers tend to redeem bonds early when interest rates are falling, the bondholders are unlikely to be able to

reinvest their money for the same rate of return that they were previously receiving


call protection

Most callable bonds contain a restriction on how soon the bonds can be called, typically 5 to 10 years from the date the bonds are issued


call premium

Often, the issuer also has to pay the bondholders more than the par value of the bond in order to compensate them for redeeming the bonds early.


Sinking Call Fund

Many issuers establish a special fund called a sinking fund into which they deposit money each year in order to redeem their bonds. The fund is then used to redeem bonds either when they mature or earlier. Most sinking funds are used to redeem a portion of the bonds beginning a few years prior to maturity


The advantage of a sinking fund for investors is that it

helps to ensure that the bonds will be paid off in an orderly fashion. the disadvantage is the same as a call provision--the issuer may redeem the bonds at a time when interest rates are low, making it difficult for the bondholders to reinvest their money and receive a comparable interest rate


There are three different methods of calculating bond yield

nominal yield, current yield, and yield to maturity


Yield is

the return that someone receives from an investment


A bond's nominal yield

is the same as the bond's coupon rate. if a bondholder purchases a 10% Lemon County bond, then her nominal yield is 10%


Current yield measures

the annual interest that the investor receiues from the bond compared to its current market price. It is calculated by dividing the bond's annual interest payment (par value multiplied by the nominal yield) by the bond's current market price


Suppose that an investor had just purchased that 10% Lemon County bone! for $800. What would her current yield be?

1. The bond's annual interest payment equals its nominal yield multiplied by its par value. 10% multiplied by $1,000 = $100. 2.Current Yield= $100 annual interest/$800 market price = .125 = 12.5%


Yield to maturity takes into account

everything that an investor receives from the bond from the time she purchases it until the bond matures. This return includes the bond's regular interest payments, plus the difference between what the investor paid for the bond and what she receives when the bond matures (the bond's par value). An investor who purchased a bond at a discount, will have a profit since she paid less for the bond than its face value. An investor who purchased the bond at a premium will have a loss since she paid more than the bond's par value. Yield to maturity also assumes an investor reinvests any coupon payrnents at the yield to maturity rate, compounding the investor's return


The term basis is sometimes used to express a bond's

yield to maturity


In the previous example, the bondholder purchased a 10% Lemon County bond with a par value of $1,000 for $800. Assume that the bond matures in 10 years. The investor's yield to maturity will include

1. The bond's semiannual interest payments for the next 10 years, plus 2. The $200 gain that the bondholder will receive when the bond matures ($1,000 par value - $800 market price), plus 3. Interest earned from reinvesting the semiannual coupon payments. Since the investor purchased this bond at a discount, her yield to maturity will be greater than both her nominal interest rate and her current yield


Assume now that the bondholder purchased the same 10% Lemon County bond with a par value of $1,000 for $1,200 {at a premium). In that case, her yield to maturity, would include both

"1. The bond's semiannual interest payments for the next 10 years, minus 2.The $200 loss that the investor will incur when the bond matures ($1,200 market value - $1,000 par value), plus
3. Interest earned from reinvesting the semiannual coupon payments. Since the bondholder purchased the bond at a premium, her yield to maturity will be less than both her nominal rate of interest and her current yield. If she had purchased the bond at par, then her yield to maturity would be the same as her nominal yield and her current yield."


nominal yield: 10%, dollar price: $1000

current yield: 10%, yield to maturity: 10%


nominal yield: 10%, dollar price: $800

current yield: 12.5%, yield to maturity: greater than 12.5%


nominal yield: 10%, dollar price: $1200

current yield: 8.3%, yield to maturity: less than 8%

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