Bond Types and Features Quiz

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Questions and Answers

What characteristic distinguishes inverse floaters from standard floating-rate bonds?

Coupon payments are made annually

They are tied to specific commodities

Coupon rate increases when interest rates rise

Coupon rate falls when interest rates rise (correct)

Which type of bond uses income from a specified group of assets to service its debt?

Inverse floaters

Catastrophe bonds

Asset-backed bonds (correct)

Indexed bonds

How are coupon payments generally made for bonds in the U.S. and Canada?

Semi-annually for most bonds (correct)

Monthly for government bonds only

Quarterly for corporate bonds only

Annually for all bonds

Which types of bonds are categorized as inflation-indexed bonds?

Treasury Inflation Protected Securities and Canada Real Return Bonds Signup and view all the answers

What is the price of a 30-year, 8% coupon bond when the market rate of interest is also 8%?

$1,000 Signup and view all the answers

What is the par value of a bond?

The payment to the bondholder on the bond’s maturity date Signup and view all the answers

Which of the following best defines the coupon rate of a bond?

The annual interest payments per dollar of par value Signup and view all the answers

How are coupon payments typically disbursed to bondholders?

Semi-annual installments Signup and view all the answers

Which term refers to the contract between the bond issuer and the bondholder?

Bond indenture Signup and view all the answers

What does a Treasury bond represent?

A bond issued and guaranteed by the federal government Signup and view all the answers

Which of the following statements about bond pricing is correct?

Bond prices can be affected by default risk. Signup and view all the answers

Which of the following best describes the issuer of a bond?

The entity that borrows money and promises to pay back Signup and view all the answers

What happens at the end of the bond's life?

The bondholder receives the par value payment Signup and view all the answers

What does a Z-score below 1.2 indicate regarding a firm's financial status?

The firm is vulnerable to bankruptcy. Signup and view all the answers

Which of the following statements about Credit Default Swaps (CDS) is correct?

CDS act as an insurance policy against default risk. Signup and view all the answers

In the Altman Z-score formula, which financial characteristic contributes the most to the score?

EBIT Signup and view all the answers

What does a default premium in bonds compensate for?

The risk of default by the issuer. Signup and view all the answers

What role does a sinking fund play in bond issuance?

It requires periodic repurchase of bonds prior to maturity. Signup and view all the answers

What is a characteristic of Collateralized Debt Obligations (CDOs)?

They have legally distinct entities established for them. Signup and view all the answers

What does a Z-score above 2.90 represent for a firm?

The firm is considered safe. Signup and view all the answers

Which component is NOT typically part of bond indentures?

Debt repayment terms Signup and view all the answers

What is the maturity range for Treasury notes?

1 to 10 years Signup and view all the answers

What defines the difference between promised YTM and expected YTM?

Promised YTM assumes obligations will be met, while expected YTM factors in default risk. Signup and view all the answers

What is the primary characteristic of callable corporate bonds?

They can be repurchased by the issuer before maturity. Signup and view all the answers

Who are the natural buyers of CDS contracts?

Large bondholders or banks looking to enhance creditworthiness. Signup and view all the answers

Calculate the accrued interest for a bond with a coupon rate of 8% if 30 days have passed since the last coupon payment.

$6.58 Signup and view all the answers

What is the term used for the price that includes accrued interest on a bond?

Dirty price Signup and view all the answers

What common denomination is typically used for purchasing bonds?

$1,000 Signup and view all the answers

How is the invoice price of a bond calculated?

Quoted price plus accrued interest. Signup and view all the answers

During what period is a callable bond not callable by the issuer?

During the call protection period Signup and view all the answers

Which statement about the quoted price of a bond is accurate?

It does not represent the actual price paid by investors. Signup and view all the answers

What impact does the callable feature have on the price of a bond?

Callable bonds sell at a lower price than non-callable bonds. Signup and view all the answers

What is a key difference between preferred stock and bonds in terms of failure to pay cash flows?

Dividends on preferred stock simply cumulate, whereas bond payments lead to bankruptcy. Signup and view all the answers

Which of the following accurately describes international bonds?

Yankee bonds are a type of foreign bond sold in the U.S. Signup and view all the answers

What characterizes floating-rate bonds?

Their interest rates are reset periodically according to market rates. Signup and view all the answers

Which statement about convertible bonds is accurate?

They can be exchanged for a specified number of shares of the firm’s stock. Signup and view all the answers

What type of bonds are referred to as 'Maples' in Canada?

Foreign bonds issued by a borrower from Canada. Signup and view all the answers

In terms of voting privileges, which of the following statements about preferred stock is correct?

Preferred stockholders typically do not have any voting rights. Signup and view all the answers

How are Eurobonds characterized?

They are sold in one currency but issued in another national market. Signup and view all the answers

What does YTM represent in the context of bond investments?

The bond's internal rate of return Signup and view all the answers

Which yield is lower for premium bonds?

YTM Signup and view all the answers

How is the realized compound return defined?

Rate of return over an investment period when coupons are reinvested Signup and view all the answers

What does the current yield of a bond represent?

The bond's annual coupon payment divided by its price Signup and view all the answers

What is the highest rating given by credit rating companies?

AAA Signup and view all the answers

What factor does NOT affect YTM?

Bond's price at issuance Signup and view all the answers

In which situation is the price of a callable bond flat?

When interest rates are low Signup and view all the answers

What does Default Risk refer to in bond pricing?

Risk that the bond will not make all promised payments Signup and view all the answers

What type of bonds are rated below BBB/Baa?

Speculative-grade or junk bonds Signup and view all the answers

What is the purpose of horizon analysis in bond investments?

To forecast realized compound yield over various holding periods Signup and view all the answers

What happens to the price of callable bonds when interest rates are high?

The price converges to that of a normal bond Signup and view all the answers

Which of the following is NOT a determinant of bond safety?

Currency exchange rates Signup and view all the answers

Which metric indicates the company's ability to cover its debt obligations?

Coverage ratios Signup and view all the answers

What is the Earliest calculation of a bond's future cash flows?

Present Value calculation Signup and view all the answers

Study Notes

Canadian Securities

Mohammad Safavi
November 13, 2024
safavim.com
289.33

Chapter 14: Bond Prices and Yields

Tenth Canadian Edition
Investments
Bodie et al. 10th CE
© 2022 McGraw-Hill Education Limited
Dinesh Gajurel, Ph.D., University of New Brunswick

Chapter Overview

Bond Characteristics
Bond Pricing
Bond Yields
Bond Prices Over Time
Default Risk and Bond Pricing

Bond Characteristics

A bond is a security issued in connection with a borrowing arrangement.
The issuer agrees to make specified payments to the bondholder on specified dates.
Par value (face value) is the payment to the bondholder on the bond's maturity date.
Coupon rate is the bond's interest payments per dollar of par value.
Bond indenture is the contract between the issuer and the bondholder.

Example

A bond with a 1,000parvalueanda41,000 par value and a 4% coupon rate might sell for 1,000parvalueanda41,000.
The bondholder receives $40 per year for 30 years.
Payments are typically made in two semi-annual installments of $20 each.
At the end of the 30-year period, the issuer pays the $1,000 par value to the bondholder.

Treasury Bonds and Notes

Government of Canada bonds or Canadas
Maturity: Treasury notes (1-10 yrs), Treasury bonds (10-30 yrs)
Bonds and notes can be purchased directly from the Treasury.
Denominations as small as 100,but100, but 100,but1,000 is more common.

Accrued Interest and Quoted Bond Prices

Quoted bond prices in financial pages are not the prices investors pay.
If a bond is purchased between coupon payment dates, the buyer pays accrued interest.
This is a prorated share of the upcoming coupon payment.
In a semi-annual coupon bond, accrued interest is calculated as: (Annual coupon payment / 2) * (Days since last coupon payment / Days separating coupon payments)

Example (Accrued Interest)

Suppose a bond has an 8% coupon rate, $40 semi-annual payment.
30 days have passed since last coupon payment.
Accrued interest = 40x(30/182.5)=40 x (30/182.5) = 40x(30/182.5)=6.58
If the quoted price is 990,theinvoicepriceis990, the invoice price is 990,theinvoicepriceis996.58

Corporate Bonds

Callable bonds allow the issuer to repurchase the bond before maturity at a specified price.
This is called refunding. A callable bond typically comes with a call protection period.
Example: If a company issues a bond with a high coupon rate during high interest rates and interest rates fall later, the company might want to retire the high-coupon debt to issue new bonds at a lower coupon rate to reduce interest payments.

Question

Suppose Telus issues two identical bonds. One is callable, the other is not.
The callable bond will sell at a lower price, as investors know the firm can reclaim the bond if interest rates fall.

Convertible Bonds

Give holders the option to exchange the bond for a specified number of shares of the firm's stock.

Floating-Rate Bonds

Have interest rates that are reset periodically according to a specified market rate.

Preferred Stock

Considered equity but often in the fixed-income universe.
Like bonds, it promises a specified cash flow stream.
Unlike bonds, its failure to pay the promised dividend doesn't lead to bankruptcy.
Preferred stock commonly pays a fixed dividend and rarely gives holders full voting privileges in the firm.

Foreign Bonds

Issued by a borrower from a different country than where the bond is sold.
Denominated in the currency of the country where it's marketed.
Called "Maples," "Yankees," "Samurai," or "Bulldogs" in respective countries.

Eurobonds

Denominated in a currency, usually of the issuer, but sold in other markets.
Examples include Eurodollars, Euroyen, Eurosterling, EuroCanadian bonds.
Not regulated by US federal agencies.

Innovation in the Bond Market

Inverse floaters are like floating-rate bonds, but the coupon rate falls when interest rates rise.
Asset-backed bonds use proceeds from a specified group of assets to service the debt.
Catastrophe bonds' payments depend upon whether a catastrophe occurred.
Indexed bonds tie payments to a general price index or commodity price.
Examples: TIPS (Treasury Inflation Protected Securities), Canada Real Return Bonds (RRBs).

Principal and Interest Payments for an Inflation-Indexed Bond (TIPS)

Table showing inflation and corresponding par value, coupon, principal, and total payment over time.

Bond Pricing

Bond value is the sum of the present values of all future coupon payments and the par value.
- Note: Coupons are generally paid semi-annually in the US and Canada, annually in Europe.

Bond Pricing: Example

Price of a 30-year 8% coupon bond (market rate 8%) = $1,000
Price of a 30-year 8% coupon bond (market rate 10%) = $810.71

Bond Prices and Yields

Inverse relationship between bond price and yield.
Interest rate fluctuations are the main risk in the fixed-income market.
Price curve is convex and becomes flatter at higher interest rates.
The longer the bond's maturity, the more sensitive its price is to changes in interest rates.

The Inverse Relationship Between Bond Prices and Yields

Graph showing the inverse relationship between bond prices and interest rates.
Price of a 30-year 8% coupon bond with semi-annual payments at varying interest rates (8%, 10%, 2%)

Table 14.2: Bond Prices at Different Interest Rates

Table showing bond prices at different interest rates for various maturity periods. The bond has an 8% coupon with semi-annual payments.

Bond Yields: Yield-to-Maturity (YTM)

YTM is the interest rate that makes the present value of a bond's payments equal to its price.
Interpreted as an average return over the bond's life, assuming all coupons are reinvested.

Yield-to-Maturity Example

8% coupon 30-year bond selling for $1,276.76
YTM is 3% per half year (6% bond equivalent yield)
EAR is 6.09%

Bond Yields: YTM versus Current Yield

Yield to maturity is a bond's internal rate of return, compound rate.
Current yield is the bond's annual coupon payment divided by its price.
Premium bonds (coupon rate > current yield > YTM)
Discount bonds (coupon rate < current yield < YTM)

Bond Yields: Yield to Call

Low interest rates: Callable bond price is flat, high risk of repurchase or call.
High interest rates: Callable bond price converges to a normal bond price, negligible call risk.

Bond Prices: Callable and Straight Bond

Graph showing the difference in price of callable versus straight bonds over time, with varying interest rates

Bond Yields: Realized Compound Return vs YTM

YTM equals the realized rate of return if all coupons are reinvested.
Realized compound return considers the reinvestment of coupon payments.
Horizon analysis forecasts realized compound yield over various holding periods (time).

Figure 14.5 Growth of Invested Funds

Graph illustrating the growth of invested funds at different rates.

Prices Path of Two 30-Year Maturity Bonds

Graph showing how the price of bonds with 12% and 4% coupons, with 30-year maturity, differs over time.

Bond Prices Over Time: YTM versus HPR

YTM equals average return if bonds are held to maturity; depends on coupon rate, maturity, and par value. All are easily calculated.
HPR equals the rate of return over a particular investment period; depends on the bond's price at the end of the holding period. This is an unknown future value, and can only be forecasted.

The Price of a 30-Year Zero-Coupon Bond Over Time

Graph illustrating the price of a 30-year zero-coupon bond over time at a 10% yield to maturity (YTM).

Default Risk and Bond Pricing

Credit risk (default risk): Risk that a bond issuer will not make all promised payments.
Rating companies: Moody's, Standard & Poor's, and Fitch.
Rating categories: AAA (or Aaa) is highest; investment-grade bonds (BBB/Baa and above), speculative-grade/junk bonds (below BBB/Baa)

Default Risk and Bond Pricing (continued)

Determinants of bond safety:
- Coverage ratios
- Leverage ratios (debt-to-equity ratio)
- Liquidity ratios
- Profitability ratios
- Cash flow-to-debt ratio.

Financial Ratios and Default Risk by Rating Class, Long-Term Debt

Table detailing financial ratios (e.g., EBITDA/Assets, Operating profit margin, Debt/EBITDA) and their relationship to default risk, by rating class (Aaa-C).

Discriminant Analysis

Financial ratios can be used to predict default risk.
Edward Altman used discriminant analysis to predict bankruptcy.
Firms are assigned a score based on financial characteristics. If the score exceeds a cut-off value, the firm is deemed creditworthy.

Altman Z-Score

Formula: Z = [3.1(EBIT/Assets)] + [1.0(Sales/Assets)] + [0.42(Equity/Assets)] + [1.2(Retained Earnings/Assets)] + [0.72(Working Capital/Assets)]
Z-scores below 1.2 indicate vulnerability to bankruptcy.
Scores between 1.23 and 2.90 are a gray area.
Scores above 2.90 are considered safe.

Bond Indentures

Sinking fund: Periodically repurchase some proportion of outstanding bonds before maturity.
Subordination clauses: Restrict the amount of additional borrowing by the firm.
Dividend restrictions: Limit dividend payments by firms.
Collateral: Particular asset given to bondholders if the firm defaults.

YTM and Default Risk

Distinguish between promised yield-to-maturity (YTM) and the expected YTM.
Promised YTM is realized if the firm meets obligations; expected YTM considers the possibility of default.
Default premium: Differential in promised yield that compensates the investor for the risk of default.

Yield Spreads

Graph showing the yield spreads between corporate and 10-year Treasury bonds over time.

Default Risk and CDS

Credit default swaps (CDSs) act like insurance against default risk for bonds or loans.
CDSs can be used to speculate on the financial health of entities. This can be seen in the 2008 mortgage crisis.

Default Risk and CDS (continued)

Natural buyers of CDSs would be large bondholders or banks.
Speculation may occur on the financial health of entities (e.g., the 2008 mortgage crisis).

Credit Risk and Collateralized Debt Obligations (CDOs)

CDOs reallocate credit risk within fixed-income markets.
Bonds are pooled and divided into tranches with different seniority, reflecting relative risk levels.
Mortgage-backed CDOs were a significant factor in the 2007-2009 financial crisis.

Collateralized Debt Obligations (CDOs) (Table)

Table detailing typical terms for different tranches in a CDO structure.

Summary

Fixed-income securities are defined by their promise to pay a fixed or variable stream of income.
Bonds are usually issued at or close to par value with prices quoted net of accrued interest.
Callable bonds generally offer higher promised yields than extendable/retractable bonds.
Convertible bonds often include an option to exchange for shares of stock.

Summary (second page)

Floating-rate bonds adjust coupon rates based on a short-term interest rate.
Bond prices and yields have an inverse relationship.
For bonds with default risk, the stated yield-to-maturity is a maximum possible return.
Financial ratio analysis is often used to assess bond safety.
Credit default swaps, or CDSs, provide insurance against bond defaults.
Collateralized debt obligations (CDOs).

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Test your knowledge on the characteristics of various bond types, including inverse floaters and inflation-indexed bonds. This quiz covers topics like coupon payments, pricing, and the usage of asset income. Perfect for students studying finance or investment principles.