Bond Fundamentals and Valuation
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Questions and Answers

What is the primary risk associated with debentures compared to bonds?

  • Debentures have shorter terms to maturity.
  • Debentures tend to offer higher coupon payments.
  • Debentures are prone to interest rate fluctuations.
  • Debentures are secured only by the corporation’s promise to pay. (correct)

    • If a bond has a par value of $1000 and a coupon rate of 5%, how much does it pay in coupon payments annually?

  • $60
  • $50 (correct)
  • $40
  • $70

    • What does the term 'coupon payment' refer to in the context of bonds?

  • The periodic interest income paid to bondholders. (correct)
  • The difference between market price and par value.
  • The total amount paid back at maturity.
  • The initial investment made by the bondholder.

    • How is a bond's market price typically expressed?

    <p>As a percentage of its par value.</p> Signup and view all the answers

    What happens to a bondholder at the bond's maturity?

    <p>They receive the par value along with any remaining coupon payments.</p> Signup and view all the answers

    What is meant by the term 'term to maturity' in bonds?

    <p>The date when the bond expires and repayment is made.</p> Signup and view all the answers

    Why might an investor prefer bonds over bank deposits?

    <p>Bonds usually provide fixed coupon payments with potentially higher returns.</p> Signup and view all the answers

    If a bond is selling for 95.21 percent of its par value of $1000, what is its selling price?

    <p>$952.10</p> Signup and view all the answers

    What does the liquidity preference theory suggest about long-term bonds?

    <p>Investors require a premium for investing in longer-term bonds.</p> Signup and view all the answers

    What does the upward slope of the yield curve typically indicate?

    <p>Interest rates are expected to rise in the future.</p> Signup and view all the answers

    According to the market segmentation theory, what primarily determines the shape of the yield curve?

    <p>Supply and demand dynamics for bonds in different market segments.</p> Signup and view all the answers

    Which of the following best describes the pure expectations theory?

    <p>The yield curve represents the market’s expectations for future interest rate movements.</p> Signup and view all the answers

    What is a common characteristic of an inverted yield curve?

    <p>It is often followed by an economic slowdown.</p> Signup and view all the answers

    The yield for a one-year bond after one year is expected to be higher than the initial one-year bond rate if:

    <p>The yield curve is sloping upward.</p> Signup and view all the answers

    In the context of interest rates, what is the likely effect of high demand for long-term bonds?

    <p>The yield for long-term bonds will fall sharply.</p> Signup and view all the answers

    What is a proposed reason for increased yields on short-term debt securities?

    <p>A need for short-term liquidity by corporations and governments.</p> Signup and view all the answers

    What is likely to happen to the principal, or face value, of a bond upon maturity?

    <p>It will be paid back to the investor.</p> Signup and view all the answers

    Which scenario would make bonds more appealing over stocks for an investor?

    <p>Need for periodic income.</p> Signup and view all the answers

    What is a callable bond?

    <p>A bond that can be redeemed by the issuer before maturity.</p> Signup and view all the answers

    What does a sinking fund do?

    <p>Sets aside funds to repurchase specific bonds over time.</p> Signup and view all the answers

    What allows an investor to convert a bond into shares of stock?

    <p>Convertible feature.</p> Signup and view all the answers

    Why do callable bonds usually offer slightly higher returns?

    <p>There is a possibility of early redemption.</p> Signup and view all the answers

    What is an advantage of owning extendible bonds?

    <p>They allow investors to extend maturity in decreasing interest rate scenarios.</p> Signup and view all the answers

    What typically happens in a company with a put feature on their bonds?

    <p>Investors can redeem bonds at face value before maturity.</p> Signup and view all the answers

    What is the effect of interest rate decreases on extendible bonds?

    <p>Investors may choose to extend their bond's maturity.</p> Signup and view all the answers

    How is the total return from Abigail's bond calculated if she holds it to maturity?

    <p>Principal plus the sum of coupon payments.</p> Signup and view all the answers

    What is a primary reason investors might accept a lower return from convertible bonds?

    <p>Convertible bonds provide flexibility by allowing conversion to stock.</p> Signup and view all the answers

    What is true regarding current yield?

    <p>It is the simplest measure of bond returns.</p> Signup and view all the answers

    How is the semi-annual coupon payment calculated for Abigail's bond?

    <p>Through the bond's face value times the coupon rate divided by two.</p> Signup and view all the answers

    If interest rates decrease, what is a possible strategy for an investor holding a put option bond?

    <p>Hold on to the bond until maturity.</p> Signup and view all the answers

    How is the current yield of a bond calculated?

    <p>By dividing the bond's annual coupon payments by its current market price.</p> Signup and view all the answers

    What happens to the yield to maturity (YTM) of a bond when it is sold at a price lower than its par value?

    <p>The YTM exceeds the coupon rate.</p> Signup and view all the answers

    What is a characteristic of a discount bond?

    <p>It offers a higher yield to maturity than the coupon rate.</p> Signup and view all the answers

    What is the yield to maturity (YTM) of a bond with a par value of $1000, a coupon rate of 6 percent, and a market price of $1000?

    <p>6 percent</p> Signup and view all the answers

    What does the yield to call (YTC) measure?

    <p>The income generated by a bond until it is called.</p> Signup and view all the answers

    Which scenario results in a yield to maturity lower than the coupon rate?

    <p>The bond is sold at a price above par value.</p> Signup and view all the answers

    What does a normal yield curve represent?

    <p>Yields rise with longer maturities.</p> Signup and view all the answers

    What is the yield to maturity of Courtney's bond which she purchased for $9000, has a coupon rate of 4%, and matures in 3 years?

    <p>7.8 percent</p> Signup and view all the answers

    What factors can affect bond prices in the secondary market?

    <p>Interest rate movements.</p> Signup and view all the answers

    What is a characteristic of an inverted yield curve?

    <p>Indicates market caution regarding long-term borrowing.</p> Signup and view all the answers

    How often are coupon payments made for a bond with an annual payment structure?

    <p>Annually.</p> Signup and view all the answers

    What does a steep yield curve indicate?

    <p>Short-term rates are significantly lower than long-term rates.</p> Signup and view all the answers

    In what circumstance might an investor decide to sell bonds in the secondary market?

    <p>To cover upcoming expenses.</p> Signup and view all the answers

    What is the relationship observed in the term structure of interest rates?

    <p>It displays yields relative to various bond maturities.</p> Signup and view all the answers

    What is the primary reason for bonds to trade in the secondary market?

    <p>To liquidate for cash or invest in attractive alternatives.</p> Signup and view all the answers

    Study Notes

    Bond Fundamentals

    • Bonds are long-term debt securities issued by governments or corporations, backed by assets. They often yield more than bank deposits.
    • Bonds typically pay fixed, periodic interest (coupon) payments.
    • Debentures are similar to bonds, but backed only by the issuer's promise to pay, making them riskier.

    Bond Valuation

    • Par value (face value) is the amount returned to the investor at maturity.
    • Market price is expressed as a percentage of par value (e.g., 95.21 means 95.21% of $1000 par value = $952.10).
    • Coupon rate is the annual interest rate as a percentage of par value (e.g., 6% on a $1000 bond = $60 annual interest). Payments are often semi-annual.
    • Term to maturity is the time until the bond expires, when par value and any remaining coupons are returned. Maturities can range from 1 to 30 years.

    Bond Returns and Investment Considerations

    • Initial bond prices may be below par value, offering a return beyond coupon payments.
    • Bonds are a good choice for investors seeking regular income.
    • Investors often diversify portfolios with a mix of stocks and bonds.

    Bond Features

    • Callable Bonds: Allow the issuer to buy back the bond before maturity, often at a higher price than the current market rate. An incentive for lower interest rates.

    • Sinking Fund: A mandatory repayment plan where the issuer sets aside funds to repurchase a specified amount of bonds over time. It's a mandatory and limited call provision.

    • Convertible Bonds: Can be exchanged for a set number of issuer shares at a fixed price. Higher potential return with stock price increases, potentially lower initial return.

    • Extendible Bonds: Allow investors to extend maturity dates when rates fall, potentially offering lower initial yields.

    • Put Bonds (Retractible Bonds): Allow investors to redeem at face value before maturity, if interest rates rise. Slightly lower initial return than without put option, protects investors from rising rates.

    Bond Yield Measures

    • Current Yield: Annual coupon payments divided by current market price.
    • Yield to Maturity (YTM): Annualized return if held to maturity. If the bond trades at a discount to par, YTM > coupon rate. If the bond is trading at a premium to par, YTM < coupon rate.

    TVM Calculations- Bond Value

    • Time Value of Money (TVM) calculations are used to determine the yield to maturity given the bond details (present value, coupon payments, maturity).

    Yield to Call (YTC)

    • Yield to call measures return for callable bonds, until the call date, adjusted by call value.

    Bond Trading

    • Bonds are traded in a secondary market. If an investor needs funds, or if other securities are more appealing, they can sell their bonds in the secondary market.
    • Prices change due to interest rate and other market factors.

    Term Structure of Interest Rates

    • Term structure (yield curve) plots bond yield to maturity against time to maturity.
    • Provides insights into expected future interest rate movements.
    • Inverted yield curves (short-term rates > long-term rates) may signal economic slowdown.
    • Common shapes: Normal (upward-sloping), steep, flat.

    Theories on Yield Curve Formation

    • Liquidity Preference Theory: Investors require higher returns for bonds with longer maturities.
    • Pure Expectations Theory: Curve reflects expected future interest rate changes.
    • Market Segmentation Theory: Curve is driven by supply and demand for bonds in relevant market segments.

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    Description

    This quiz covers the essential aspects of bond fundamentals, including how they are structured, valued, and the factors influencing their returns. Key concepts such as par value, market price, coupon rates, and maturity are explored to enhance your understanding of bond investments.

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