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Questions and Answers

What happens to bond prices as market interest rates increase?

Bond prices increase due to higher demand.

Bond prices decrease because of the inverse relationship. (correct)

Bond prices remain unchanged.

Bond prices fluctuate randomly based on market speculation.

Which factor contributes to a bond's price sensitivity to interest rate changes?

Time to maturity of the bond. (correct)

Credit quality of the issuer.

The volume of bonds in circulation.

The type of bond, such as municipal or corporate.

What is the Yield to Maturity (YTM) of a bond?

The overall return on investment calculated over the lifecycle of the bond.

The interest rate that equates the present value of a bond's payments to its price. (correct)

The annual coupon payment divided by the bond's price.

The rate of return an investor can expect if the bond is sold before maturity.

If a bond with a 30-year maturity has a price of $810.71, what market interest rate is it likely associated with?

10% Signup and view all the answers

Which of the following statements about bond yields is correct?

A bond's yield measures the average rate of return if held to maturity. Signup and view all the answers

What can be inferred about the price curve of bonds as interest rates rise?

The curve flattens, indicating reduced price sensitivity. Signup and view all the answers

Why are interest rate fluctuations a significant risk in fixed-income markets?

They inversely affect bond prices and yield relationships. Signup and view all the answers

What is the price of a bond at a 6% interest rate with a 20-year maturity?

$1,231.15 Signup and view all the answers

What happens to the coupon rate of an inverse floater when general interest rates rise?

It decreases. Signup and view all the answers

Which type of bond utilizes income from a specific group of assets for servicing debt?

Asset-backed bonds Signup and view all the answers

How often are coupon payments typically made in the U.S. and Canada?

Semi-annually 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 a defining characteristic of catastrophe bonds?

Final payment depends on whether a specific catastrophe occurs. Signup and view all the answers

What is the maturity range of Treasury notes?

1 to 10 years Signup and view all the answers

What is the common denomination for bonds purchased directly from the Treasury?

$1,000 Signup and view all the answers

What term refers to the price that includes accrued interest on a bond?

Dirty price Signup and view all the answers

How is accrued interest calculated for a semi-annual coupon bond?

Semi-annual coupon amount multiplied by days since last payment Signup and view all the answers

If the quoted price of a bond is $990 and the accrued interest is $6.58, what is the invoice price?

$996.58 Signup and view all the answers

What characteristic does a callable corporate bond have?

The issuer can repurchase the bond at a specified price. Signup and view all the answers

What is the purpose of refunding in the context of callable bonds?

To retire high-coupon debt and replace it with new bonds at a lower rate. Signup and view all the answers

What is the typical call protection period for callable bonds?

A set period after issuance before it can be called. Signup and view all the answers

What factor primarily causes a callable bond to sell at a lower price compared to a non-callable bond?

The issuing firm retains the option to reclaim it at call price Signup and view all the answers

Which statement correctly describes convertible bonds?

They can be converted into a specified number of shares of stock Signup and view all the answers

How does the treatment of dividends for preferred stock differ from that of company bonds?

Preferred stock dividends do not affect corporate debt obligations Signup and view all the answers

What distinguishes foreign bonds from Eurobonds?

Foreign bonds are denominated in the currency of the market where they are sold Signup and view all the answers

Which type of bond commonly demonstrates its interest rate being reset periodically?

Floating-rate bond Signup and view all the answers

What is a key characteristic of preferred stock compared to traditional equity?

Preferred stock must be paid before common stock in case of liquidation Signup and view all the answers

Which of the following best describes a Maple bond?

A bond issued by a Canadian borrower denominated in Canadian dollars Signup and view all the answers

What is one potential advantage of Eurobonds over foreign bonds?

They are issued in a single currency but sold in multiple markets. Signup and view all the answers

What does the Altman Z-Score indicate about a firm?

The firm is creditworthy if the score exceeds a certain cutoff value. Signup and view all the answers

What is the implication of a Z-score below 1.2?

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

Which component is not part of the Altman Z-Score calculation?

Total Revenue Signup and view all the answers

What is the purpose of the default premium in bond pricing?

To compensate investors for the risk of potential default. Signup and view all the answers

What role does a credit default swap (CDS) play in bond investment?

It acts as an insurance policy against default risk. Signup and view all the answers

Who would likely be a natural buyer of credit default swaps?

Large bondholders or banks wanting to mitigate risk. Signup and view all the answers

How are Collateralized Debt Obligations (CDOs) structured?

They are divided into tranches with varying seniority levels. Signup and view all the answers

What is the significance of sinking fund provisions in bond indentures?

They require the issuer to repurchase bonds periodically. Signup and view all the answers

Which statement is accurate about the expected YTM of a bond?

It accounts for the possibility of default. Signup and view all the answers

During the financial crisis of 2007-2009, how were CDS contracts utilized?

For speculating on the financial health of particular issuers. Signup and view all the answers

What does YTM represent in terms of bond investments?

The internal rate of return of the bond assuming reinvestment of coupons Signup and view all the answers

Which bond is likely to have a current yield greater than the yield to maturity?

Premium bond Signup and view all the answers

Under what circumstances does the price of a callable bond remain stable?

Low interest rates Signup and view all the answers

What determines if YTM equals the realized return over a bond's life?

Coupon payments are reinvested at the bond's YTM Signup and view all the answers

What factors affect the yield to maturity (YTM) of a bond?

The coupon rate, maturity, and par value Signup and view all the answers

Which type of bond has the highest default risk?

Speculative-grade bond Signup and view all the answers

How is the current yield of a bond calculated?

Annual coupon payment divided by the bond’s market price Signup and view all the answers

Which financial ratios are essential in determining bond safety?

Coverage, leverage, liquidity, and cash flow ratios Signup and view all the answers

What characterizes a zero-coupon bond compared to other bonds?

It does not make periodic coupon payments Signup and view all the answers

What does the bond equivalent yield (BEY) provide?

Comparison of different bonds on an annual basis Signup and view all the answers

Which rating represents the highest bond quality?

Aaa Signup and view all the answers

What does horizon analysis assess?

Yield to maturity over various holding periods Signup and view all the answers

What impact does a high debt-to-equity ratio have on a bond's safety?

Decreases the bond's safety Signup and view all the answers

What is the primary difference between yield to maturity (YTM) and holding period return (HPR)?

YTM is based on future cash flows; HPR is historical Signup and view all the answers

Study Notes

Canadian Securities

Mohammad Safavi
Date: November 13, 2024
Website: safavim.com
Figure: 289.33

Chapter 14: Bond Prices and Yields

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

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 at maturity
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 1,000bondwitha41,000 bond with a 4% coupon rate might sell for 1,000bondwitha41,000
The bondholder is entitled to a 40annualpayment(or40 annual payment (or 40annualpayment(or20 semi-annually) for 30 years
At the end of 30 years, the issuer pays the $1,000 par value

Treasury Bonds and Notes

Bonds issued and guaranteed by the federal government are called Government of Canada bonds or Canadas.
Treasury notes: 1 to 10 years
Treasury bonds: 10 to 30 years
Both 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 publications are not the actual prices investors pay
If purchased between coupon payment dates, the buyer must pay accrued interest
Accrued interest is the prorated share of the upcoming coupon payment
In a semi-annual coupon bond, accrued interest = (Annual coupon payment / 2) × (Days since last coupon payment / Days separating coupon payments)

Example (Accrued Interest)

If the coupon rate is 8%, annual coupon is 80andsemi−annualpaymentis80 and semi-annual payment is 80andsemi−annualpaymentis40
30 days have passed since the last coupon payment, accrued interest = 40×(30/182.5)=40 × (30/182.5) = 40×(30/182.5)=6.58
If the quoted price is 990,invoiceprice/dirtyprice=990, invoice price/dirty price = 990,invoiceprice/dirtyprice=990 + 6.58=6.58 = 6.58=996.58

Corporate Bonds

Callable bonds allow the issuer to repurchase the bond before maturity at a specified price

Question

Telus issues two bonds with identical coupon rates and maturity dates. One is callable, the other isn't. Which sells at a higher price?
The non-callable bond sells at a higher price. Investors will not pay as much for the callable bond because the issuer can repurchase at a lower price if interest rates fall.

Convertible Bonds

Convertible bonds give holders the option to exchange each bond for a specified number of shares of the firm's stock

Floating-Rate Bonds

Floating-rate bonds have interest rates reset periodically based on a specified market rate

Preferred Stock

Considered equity but often in fixed-income
Like bonds, preferred stock promises a specified cash flow stream
Unlike bonds, failure to pay preferred dividends does not lead to bankruptcy
Preferred stock commonly pays a fixed dividend
Rarely gives holders full voting privileges

International Bonds

Foreign bonds are issued by a borrower in one country, but sold in another, denominated in the currency of the market
Examples: Maple bonds in Canada, Yankee bonds in the U.S., Samurai bonds in Japan, and Bulldog bonds in the U.K.
Eurobonds are denominated in one currency, sold in other national markets, and not regulated by U.S. federal agencies

Innovation in the Bond Market

Inverse floaters are like floating-rate bonds, but their coupon rate drops when interest rates rise
Asset-backed bonds use specific asset income to service the debt
Catastrophe bonds' final payment depends on whether a catastrophe occurs
Indexed bonds make payments tied to a general price index or commodity price (e.g., TIPS, RRBs)

Principal and Interest Payments for an Inflation-Indexed Bond or TIPS

Table shows example payments for an inflation-indexed bond showing increase due to inflation.

Bond Pricing

Bond value = Σ (Coupon / (1+r)^t) + (Par Value / (1+r)^T)
The first term is the present value of an annuity
The second term is the present value of a single amount (final payment)
Coupons are generally paid semi-annually in the U.S. and Canada, and annually in Europe

Bond Pricing: Example

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

Bond Prices and Yields

Inverse relationship between bond price and yield: higher yield leads to lower price
Interest rate fluctuations are the main risk in fixed-income markets
Price curve is convex, becoming flatter at higher interest rates. The maturity of a bond affects its sensitivity to changes in interest rates

The Inverse Relationship Between Bond Prices and Yields

Graph shows the inverse relationship between interest rate and the price of a bond

Table 14.2: Bond Prices at Different Interest Rates

Shows how bond price changes with different maturity and interest rates.

Bond Yields: Yield to Maturity

Yield to maturity (YTM) is the interest rate that makes PV of bond = Current Price
Interpreted as average return if held to maturity
Calculated by solving the bond price equation for the rate

Yield to Maturity Example

Suppose an 8% coupon, 30-year bond is selling for $1,276.76. What is the YTM?
YTM= 3% per half year
Bond equivalent yield = 6%
EAR = 6.09%

Bond Yields: YTM vs Current Yield

Yield to maturity (YTM): Bond's internal rate of return, reflects expected compound return over the bond's life, assuming reinvestment of coupons at the same rate
Current yield: Bond's annual coupon payment divided by its price; a proxy for the average return
Premium bonds: Coupon rate > current yield > YTM
Discount bonds: Coupon rate < current yield < YTM

Bond Yields: Yield to Call

Lower interest rates: The price of a callable bond stays flat or low as the risk of a call is high.
Higher interest rates: The price of a callable bond converges to that of a normal bond, as the risk of a call is low

Bond Prices: Callable and Straight Bond

Graph illustrating how the price of a callable bond is typically lower than a straight bond at any given interest rate.

Bond Yields: Realized Compound Return vs YTM

YTM equals the realized rate of return if all coupons are reinvested at that rate
Realized compound return is the compound rate of return if coupons are reinvested at variable rates, or until maturity
Horizon analysis is forecasting realized compound yield over various holding periods.

Figure 14.5 Growth of Invested Funds

Simple example of a future value calculation, emphasizing the effect of different reinvestment rates.

Prices Path of Two 30-Year Maturity Bonds

Graph showing the price path of two 30-year bonds (4%, 12%) over time; the price approaches par value as the maturity date nears.

Bond Prices Over Time: YTM versus HPR

YTM: average return if the bond is held to maturity, depends on coupon rate, maturity, and par value
HPR: rate of return over a particular investment period, depends on the bond's price at end of holding period; can only be forecasted

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

Chart of zero-coupon bond prices over time. Price rises to the par value at time T

Default Risk and Bond Pricing

Credit risk (default risk): Risk that the bond issuer will not make all promised payments
Rating companies: Moody's, Standard & Poor's, and Fitch
Rating categories: Highest is AAA (or Aaa), others rated BBB/Baa (investment grade), those rated below are speculative/junk

Default Risk and Bond Pricing (continued)

Bond safety determinants: Coverage ratios, leverage ratios (debt-to-equity), liquidity, profitability, and cash flow-to-debt ratio

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

Table of financial ratios for different bond ratings (Aaa, Aa, A, Baa, Ba, B, C)

Discriminant Analysis

Financial ratios can predict default risk (Altman used discriminant analysis to predict bankruptcy)
Firms are assigned a score based on financial characteristics; if scores are above an established cut-off, they are considered more creditworthy.

Altman Z-Score

Formula for calculating the Z-score
Z-scores below 1.2 indicate bankruptcy vulnerability
Z scores between 1.23 and 2.90 are in a gray area.
Z-scores above 2.90 indicate safety

Bond Indentures

Sinking fund: Issuer periodically repurchases some proportion of outstanding bonds prior to maturity.
Subordination clauses limit additional borrowing.
Dividend restrictions limit dividends paid by a firm.
Collateral is a particular asset that bondholders receive if the firm defaults.

YTM and Default Risk

The YTM only considers the bond's promise to repay in the future.
The expected YTM considers the default risk; this is found by adding a default premium
A default premium compensates the investor for the risk of default.

Yield Spreads

Graph showing the spread between high yield, Baa-rated, and Aaa-rated bonds over time

Default Risk and CDS

Credit default swaps (CDS) act like insurance against bond default risk
Allows lenders to protect against default risk
Risk structure of rates and prices are closely tied for CDS contracts

Summary

Fixed-income securities are distinguished by their promise to pay a fixed stream of income.
Bonds are issued at or near their face value. Callable bonds offer higher promised yield to maturity.
Extendable and retractable bonds give the bondholder option over the bond duration.
Convertible bonds can be traded for equity shares.

Summary (part two)

Floating-rate bonds pay a coupon rate linked to a short-term interest rate.
Bond prices and yields have inverse relationships. Bond safety is evaluated using financial ratio analysis.
Credit default swaps provide risk protection against bond defaults.
Collateralized debt obligations (CDOs) allocate credit risk from a pool of loans.

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