Chapter 7 Interest Rates and Bond Valuation

Question 1

What are bonds?

Answer 1

Debt securities

Question 2

What are coupons?

Answer 2

The regular interest payments made for a bond

Question 3

What is the face value / par value of a bond?

Answer 3

The value to be paid out at the end of the loan.

A bond that sells for its par value is called a par bond

Question 4

What is the coupon rate on the bond?

Answer 4

The annual coupon divided by the face value

Coupon value / Face Value = Coupon Rate

Question 5

How do interest rates affect the price of bonds?

Answer 5

As bond interest rates rise the present value of the bond’s remaining cash flows declines.

As bond interest rates decrease the present value of the bond’s remaining cash flows increases.

Question 6

What is YTM?

Answer 6

Yield to maturity - the market interest rate that equates a bond’s present value of interest payments and principal repayment with its price

Question 7

How do we determine the Interest Rate Risk of a bond?

Answer 7

By measuring how sensitive it is to interest rate changes.

Question 8

What two factors affect the Interest Rate Risk of a bond?

Answer 8

1. The longer the time to maturity, the greater the interest rate risk
2. The lower the coupon rate, the greater the interest rate risk

Question 9

What do we usually call securities issued by a corporation?

Answer 9

Debt securities, equity securities

Question 10

What are some of the differences between debt and equity?

Answer 10

1. Debt is not an ownership interest in the firm
2. The corporation’s payment of interest on debt is considered a cost of doing business and is fully tax deductible. Dividends paid to shareholders are not tax-deductible
3. Unpaid debt is a liability of the firm. Thus one of the costs of issuing debt is the possibility of financial failure. Which does not occur with equity

Question 11

What are the two major forms of long term debt?

Answer 11

Public issue and privately placed

Question 12

What are the three responsibilities of a trustee?

Answer 12

• Make sure the terms of the Indenture are being obeyed
• Manage the sinking fund
• Represent the bondholder in the case of a default

Question 13

What are the general provisions included in an Indenture agreemnet?

Answer 13

1. Basic terms of bonds issuance
2. # of bonds issued
3. Description of property used as security if the bonds are secured
4. Repayment
5. Call Provisions
6. Portective Covenants

Question 14

What are collateral and mortgage securities?

Answer 14

Collateral is a general term taht means securities pledged as security for payment of debt.

Mortgage securities are secured by a mortgage on the real property of the borrower. The property may be real estate, transportation equipment, or other property

Question 15

What is a debenture?

Answer 15

An unsecured bond

Question 16

When do we use the term note?

Answer 16

When the maturity of the unsecured bond is less than ten years when it is originally issued

Question 17

What is a sinking fund?

Answer 17

A sink fund is an early repayment system.

It is an account managed by the bond trustee for the purpose of repaying the bonds.
The company makes annual payments to the trustee, who tehn uses the funds to retire a portion of the debt. They do this by either buying up some of the bonds in the market or calling in a fraction of the outstanding bonds

Question 18

What does seniority indicate?

Answer 18

Pereference in position over other lenders.

In the event of a default, holders of subordinated debt must give preference to other specified creditors.

Question 19

What does a sinking fund do from an inverstor’s viewpoint?

Answer 19

Reduces the risk that the company will be unable to repay the principal at maturity

Question 20

What does the call provision do?

Answer 20

Allows the company to repurchase “call” part or all of the bond issued at stated prices over a specified period.

Corporate bonds are often callable

Question 21

Is the call price generally more or less than the bond’s stated value?

Answer 21

More

This is called the call premium

Question 22

What does the Canada Call do?

Answer 22

Stipulates that, in the event of a call, the issuer must buy the bonds from holders priced at a yield of the current Canada curve plus a fixed credit spread that is usually 1/4 of the issuance spread

Question 23

What does a protective covenant do?

Answer 23

Part of the indenture or loan agreement that limits certain actions a company might otherwise wish to take during the term of the loan.

Question 24

What do protective covenants usually do?

Answer 24

Reduce the agency costs faced by bondholders. Reduce the risk of the bonds

Question 25

What are some examples of negative covenants? (Thou shalt not)

Answer 25

1. The firm must limit the amount of dividends it pays according to some formula 2. The firm cannot pledge any assets to other lenders 3. The firm cannot merge with another firm 4. The firm cannot sell or lease any major assets without approval by the lender 5. The firm cannot issue additional long-term debt

Question 26

What are some examples of positive covenants (thou shalt)

Answer 26

1. The company must maintain its working capital at or above some specified minimum level 2. The company must periodically furnish audited financial statements to the lender 3. The firm must maintain any collateral or security in good condition

Question 27

What are bond ratings?

Answer 27

They are ratings that concern only credit risk. Therefore they do not cover interest related risk for a bond

Question 28

What is the tier list for rated bonds?

Answer 28

AAA AA A BBB BB B CCC/CC/C D

Question 29

What minimum rating must a bond have to be deemed investment grade?

Answer 29

BBB

Question 30

What is another name for junk bonds?

Answer 30

High yield bonds Due to their risk they tend to have much higher rates than regular safer bonds

Question 31

What is a Stripped bond or zero-coupon bond?

Answer 31

A bond that pays no coupons

Question 32

For tax purposes must the owner pay taxes on interest accrued every year for Stripped bonds?

Answer 32

Yes, even though no interest is actually received

Question 33

Why are Stripped bonds attractive to certain investors?

Answer 33

Tax exempt investors with long term dollar denominated liabilities such as pension funds find them attractive. Aditionally people with RRSPs and TFSAs

Question 34

What are Floating-Rate Bonds?

Answer 34

Bonds with adjustable coupon rates The adjustments are tied to the Treasury bill rate or another short term interest rate

Question 35

Is there somestimes some lag when it comes to Floating Rate bonds?

Answer 35

Yes due to the adjustments being made on previous data that can span a few months sometimes

Question 36

The majority of floaters have these two traits

Answer 36

1. The holder has the right to redeem their note at par ont he coupon repayment date after some specified amount of time 2. The coupon rate has a max and min

Question 37

What are income bonds?

Answer 37

Bonds where coupon payments depend on company income

Question 38

What is a convertible bond?

Answer 38

A bond that can be swapped for a fixed number of shares of stock at any time before maturity at the holder's option

Question 39

What are asset backed bonds?

Answer 39

Bonds that are backed by illiquid assets such as , accounts receivable, credit card debt, or mortgages

Question 40

What are retractable bonds?

Answer 40

They are also called put bonds They allow the holder to force the issuer to buy the bond back at a stated price. The put feature sets a floor price for the bond

Question 41

What are CoCo bonds?

Answer 41

Contingent convertible bonds which are putable, callable and subordinated. Valuing these bonds is quite complex and using YTM is often meaningless

Question 42

Is the trading volume for bonds bigger than that of stocks?

Answer 42

Yes

Question 43

Why does bond market have little or no transparency?

Answer 43

Because most trading of bonds takes place Over the Counter (OTC)

Question 44

What are the clean and dirty prices?

Answer 44

Dirty price - price of a bond including accrued interest, the price the buyer actually pays Clean price - price of a bond net of accrued interest, this is the price that is typically quoted

Question 45

What is the difference between Real Rates and Nominal Rates?

Answer 45

Real rates - include inflation Nominal rates - do not include inflation

Question 46

What is the definition of the nominal rate?

Answer 46

The percentage change in the number of dollars you have

Question 47

What is the term structure of interest rates?

Answer 47

The relationship between nominal interest rates on default free, pure discount securities and time to maturity. Pure time value of money

Question 48

When are term structures upward sloping

Answer 48

When long term rates are higher than short term rates

Question 48

What is the Fisher effect?

Answer 48

The relationship between nominal returns, real returns, and inflation

Question 49

What is the Fisher effect formula?

Answer 49

1 + R = (1 + r) * (1 + h) R = nominal rate r = real rate h = inflation rate

Question 50

When are term structures downward sloping?

Answer 50

When short term rates are higher than long term rates

Question 51

What is the inflation premium?

Answer 51

The portion of a nominal interest rate that represents compensation for expected future inflation

Question 52

What is the interest rate risk premium?

Answer 52

The compensation investors demand for bearing interest rate risk The longer the tirm to maturity the greater the interest rate risk

Question 53

Is the shape of the yield curve a reflection of the term structure of interest rates?

Answer 53

Yes

Question 54

Default Risk Premium

Answer 54

The portion of a nominal interest rate or bond yield that represents compensation for the possibility of default

Question 55

What is a liquidity premium?

Answer 55

The portion of a nominal interest rate or bond yield that represents compensation for lack of liqudity