Debt Instruments - CH2

Question 1

What is Nominal / Par Value?

Answer 1

Amount to be paid back at maturity of the bond from the issuer / borrower to the lender / owner of the bond.

Question 2

What is an FRN?

Answer 2

Floating Rate Notes - bonds who’s coupons are linked to a published interest rate (e.g. SONIA, SOFR, LIBOR).

Question 3

What is an Index Linked Bond?

Answer 3

A bond whose coupons and principal are adjusted in reference to the prevailing inflation rate.

Question 4

What are the main inflation references Index Linked Bonds pay attention to?

Answer 4

RPI and CPI.

Question 5

What is meant by Yield?

Answer 5

This is the percentage return of an investment.

Question 6

What are the 3 types of Yields?

Answer 6

• Flat yield.
• Gross redemption yield.
• Net redemption yield.

Question 7

What is the formula for Flat Yield?

Answer 7

(Annual Coupon / Price) x 100

Question 8

What are characteristics of Flat Yield?

Answer 8

Only takes into account the coupon rate, and ignores any capital gains / changes in price.

Question 9

What are limitations of Flat Yield?

Answer 9

• As it only takes into account the coupons, it doesn’t show the complete picture of a bond.
• Ignores timings of cash flows and the time value of money.
• If bonds coupons are variable (like FRNs), then the calc may not be accurate - the coupon chosen for the calc may just be best fit.

Question 10

What are characteristics of Gross Redemption Yields?

Answer 10

Takes into account the coupons and price changes of a bond.

Question 11

What are the limitations of Gross Redemption Yields?

Answer 11

They ignore taxation (good for not tax paying assets, i.e. pension funds).

Question 12

What are characteristics of Net Redemption Yields?

Answer 12

They take into account annual coupons, gains/losses of the bonds, and after-tax cash flows.

Question 13

What is the benefit of Net Redemption Yields over the other 2 types of yields?

Answer 13

They take into account after-tax cash flows, making them suitable for tax paying investors.

Question 14

What is TVM?

Answer 14

Time Value of Money - money is worth more now than it is in the future due to its earnings potential.

Question 15

How is interest calculated on a corporate bond?

Answer 15

Nominal x coupon rate.

Question 16

What is Accrued Interest?

Answer 16

It is the interest earned but not paid.

Question 17

What is the calculation for Accrued Interest?

Answer 17

Coupon payment x (num days since last payment / num of days between payment).

Question 18

What is the Clean Price?

Answer 18

Bond price that doesn’t include accrued interest.

Question 19

What is the Dirty Price?

Answer 19

This is the clean price + accrued interest.

Question 20

What is the Spread?

Answer 20

The difference in yields between 2 bonds, expressed in basis points.

Question 21

What is the purpose in calculating the Spread?

Answer 21

To compare the yields of 2 bonds, or compare a bond against a benchmark.

Question 22

What are bonds compared against?

Answer 22

• Gov’t bond yields (most recently issued, close to maturity).
• Swap rates.
• Published reference rates (e.g. SOFR).

Question 23

What are the 3 types of yield curves?

Answer 23

• Normal yield curve.
• Inverted yield curve.
• Negative yield curve.

Question 24

What do yield curves show?

Answer 24

Shows bond yields available to investors over different time horizons. The longer-dated bonds have greater risk.

Question 25

What does the Normal yield curve show?

Answer 25

Show that investors have a liquidity preference - they’d rather pay for shorter-dated bonds for less return (higher prices than long-dated ones with higher returns).

Question 26

What does the Inverted yield curve show?

Answer 26

Shows when short-term bond yields (returns) are greater than yields on longer-dated bonds.

Question 27

Why do Inverted yield curves show what they do?

Answer 27

Investors anticipate economic downturn, thus expect interest rates to fall (as a pre-emptive measure).

Question 28

What are Negative yields?

Answer 28

When banks pay to keep their cash reserves in banks. This is to encourage lending and economic activity.

Question 29

What are the Implications of Negative yields?

Answer 29

• Takes money out of the banking system (systemic risk).
• Yield-chasing - investors become speculative and purchase more risky higher-yielding bonds to get a positive return (asset bubbles).
• Impacts longer-term investments - e.g. pension funds and insurers who are restricted in how much risk they can take (harder to get a return).

Question 30

What is the link between yields and inflation?

Answer 30

Nominal and Real yield curves capture inflation in bond prices. When inflation is expected to rise, the Fed raise rates in short-term, meaning medium and long-term bond yields fall.

Question 31

What is the Present Value?

Answer 31

The value in a present sum of money, in contrast to some future value it’ll have when it’s been invested.

Question 32

What is the Calculation for the Present Value?

Answer 32

PV = FV x 1/(1+r)n

F = being Future Value.
r = interest rate.
n = time (in years).