Finance Chapter 16: Investing in Bonds

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Questions and Answers

What happens to the coupon payments received from bonds during the holding period?

They are taxed at the capital gains tax rate.

They are exempt from taxes.

They contribute to the principal value of the bond.

They are taxed at the ordinary income tax rate. (correct)

Which factor is directly linked to calculating the present value of a bond?

Economic conditions.

Inflation rates.

Future stock price.

Future coupon payments. (correct)

What is default risk in the context of bond investing?

The risk that interest rates will affect bond prices.

The risk of changes in the bond's principal value.

The risk of inflation impacting bond returns.

The risk that the issuer will not make coupon payments. (correct)

What typically reflects the likelihood that bond issuers will repay their debt?

Risk ratings provided by agencies. Signup and view all the answers

What is a long-term capital gain from holding bonds until maturity?

The difference between the bond's face value and the purchase price at expiration. Signup and view all the answers

What is the par value of a bond?

The face value of the bond Signup and view all the answers

Which type of bond allows the issuer to repurchase the bond before maturity?

Callable bond Signup and view all the answers

What typically affects the yield from investing in a bond?

Interest payments and repayment of par value Signup and view all the answers

Which characteristic of a convertible bond is true?

It converts into a stated number of shares at a specified price. Signup and view all the answers

What is a common characteristic of bonds that have a call feature?

They usually provide a higher return than non-callable bonds. Signup and view all the answers

How do bonds fit into a financial plan?

They can provide stable income and diversification. Signup and view all the answers

What is one reason why some bonds are considered risky?

Issuers may default on interest payments or repayment of par value. Signup and view all the answers

What is a characteristic of zero-coupon bonds?

They do not make periodic interest payments. Signup and view all the answers

What is the relationship between bond risk ratings and risk premiums?

Lower risk ratings lead to higher risk premiums. Signup and view all the answers

How does the economic condition affect the risk of default on bonds?

Economic conditions increase the risk of default. Signup and view all the answers

What type of risk is associated with a callable bond being redeemed by the issuer?

Call risk Signup and view all the answers

What happens to the yield to maturity of a bond if it sells above par value?

It is less than the coupon rate Signup and view all the answers

Which tax benefits do Treasury bonds offer?

Exempt from state and local taxes Signup and view all the answers

Which bond rating class indicates the lowest quality?

DDD Signup and view all the answers

Which type of bond is typically issued by large, stable firms?

Corporate bonds Signup and view all the answers

How does bond maturity affect interest rate risk?

Longer maturities generally increase interest rate risk. Signup and view all the answers

What is the primary risk associated with high-yield (junk) bonds?

Default risk Signup and view all the answers

What happens to the value of a bond when interest rates rise?

The value of the bond decreases Signup and view all the answers

What typically happens to a bond's price when interest rates rise?

The price declines. Signup and view all the answers

What aspect of bond trading is affected by changes in interest rates?

Bond prices Signup and view all the answers

How is interest earned from bonds taxed?

As ordinary income Signup and view all the answers

What risk often arises when a company faces financial difficulties?

Default risk Signup and view all the answers

Which of the following is NOT a typical aspect of corporate bond quotations?

State tax rate Signup and view all the answers

Which of the following is true regarding a bond with a rating of 'BBB'?

It is categorized as medium-low quality. Signup and view all the answers

If a bond is sold at a higher price than its purchase price, what is the result?

A capital gain occurs Signup and view all the answers

If a bond sells below par value, what can be inferred about its yield to maturity?

It exceeds the coupon rate Signup and view all the answers

What is the coupon payment from bonds paying a coupon rate of 8% on a par value of $10,000?

$800 per year Signup and view all the answers

What tax applies to gains earned from selling bonds held longer than a year?

Long-term capital gains tax Signup and view all the answers

Which feature makes Treasury bonds appealing to investors?

Issuer's guaranteed payments Signup and view all the answers

What impact do falling interest rates have on the value of bonds?

The value increases Signup and view all the answers

If a bondholder sells their bonds after eight months, what type of tax implications might they encounter?

Ordinary income tax and short-term capital gain tax Signup and view all the answers

What is the coupon payment received every six months for bonds with a total coupon of $800 per year?

$400 Signup and view all the answers

What is a key consideration when selecting the maturity of a bond?

Your expectations of future interest rates Signup and view all the answers

What type of strategy involves purchasing long-term bonds when expecting interest rates to fall?

Interest rate strategy Signup and view all the answers

What describes a passive bond investment strategy?

Holding a diversified portfolio of bonds long-term Signup and view all the answers

How does the maturity matching strategy aid investors?

It matches bond payments with upcoming expenses Signup and view all the answers

Which of the following indicates a challenge of the interest rate strategy?

It can complicate your tax returns Signup and view all the answers

What should investors do if they find it difficult to forecast interest rates?

Adopt a passive investment strategy Signup and view all the answers

For a parent aiming to cover a future education expense, which bond investment strategy is most suitable?

Selecting bonds that mature when tuition is due Signup and view all the answers

What is the primary objective of determining whether to invest in bonds?

To evaluate cost efficiency and investment suitability Signup and view all the answers

Study Notes

Chapter 16: Investing in Bonds

Bonds are long-term debt securities issued by government agencies or corporations.
Par value is the face value of a bond, the amount returned to the investor at maturity.
Most bonds have maturities between 10-30 years.
Bond issuers are required to make interest payments and repay par value.

Bond Characteristics

Call feature: allows the issuer to repurchase the bond from the investor before maturity. These bonds offer a slightly higher return.
Convertible bond: a bond that can be converted into a stated number of shares of the issuer's stock if the stock price reaches a specified price. These bonds tend to offer a slightly lower return.

Bond Yield to Maturity

Bond's yield to maturity is the annualized return on a bond if it is held until maturity.
If a bond sells at par value, its yield to maturity equals the coupon rate.
If a bond sells below par value, its yield to maturity would exceed the coupon rate.
If a bond sells above par value, its yield to maturity would be less than the coupon rate.

Bond Trading in the Secondary Market

Investors can sell their bonds to other investors before maturity.
Bond prices change in response to interest rates.
Brokerage firms facilitate bond trading.

Types of Bonds

Treasury bonds: long-term debt securities issued by the U.S. Treasury. Payments are guaranteed by the federal government. Interest is subject to federal income tax, but exempt from state and local taxes. Easily traded in the secondary market.
Corporate bonds: long-term debt securities issued by large firms. Subject to default risk. High-yield (junk) bonds are issued by smaller, less stable corporations with a higher degree of default risk.
Corporate bond quotations: include coupon rate, maturity date, current yield, volume, closing price, and net change compared to the previous day.

Return from Investing in Bonds

Interest rate movements impact bond returns: rising rates decrease bond value; falling rates increase bond value.
Tax implications: interest is taxed as ordinary income (unless exempt); selling bonds above purchase price results in a capital gain.

Valuing a Bond

Time value of money is used to determine bond value (present value of future coupon payments and principal payment).
Economic conditions can affect bond values. Healthy firms are more likely to make payments, which is crucial to sustaining high bond return.

Risk from Investing in Bonds

Default risk: risk that a borrower won't repay the loan: risk premium is the extra yield investors need to be compensated for the risk of default. Risk ratings assess default risk (e.g, AAA, BBB, etc.) from agencies like Moody's and Standard & Poor's.
Impact of financial crisis: firms may have trouble meeting their bond payment obligations in unfavorable economic conditions.
Call (prepayment) risk: the risk that a callable bond will be redeemed by the issuer before its maturity, hence the risk of missing out on expected returns.
Interest rate risk: the risk of a bond's price declining due to rising interest rates; affects bonds with longer maturities more.

Bond Investment Strategies

Interest rate strategy: selecting bonds based on interest rate expectations. Purchase long-term bonds if you expect rates to fall.
Passive strategy: invest in a diversified portfolio of bonds held for a long time.
Maturity matching strategy: investment in bonds that have maturities aligning with future expenses, e.g., college tuition.

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Description

This quiz covers the essential concepts related to investing in bonds, including bond characteristics, par value, and yield to maturity. Understand different types of bonds such as callable and convertible bonds, and how they impact investment decisions. Test your knowledge of bond investments and their features.