Questions and Answers
As bond maturity increases, the bond's risk increases.
True
A bond's classification based on the likelihood of fulfilling its obligations is related to its credit quality.
True
A bond rating of CCC is considered a high-yield bond.
True
The possibility of not finding a buyer at the current market price refers to liquidity.
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The risk for a given change in interest rates is generally classified as low for long-term bonds.
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Both BBB and A ratings are classified as medium quality.
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U.S. government bond funds invest only in U.S. government bonds.
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High yield bonds are typically referred to as junk bonds.
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Municipal bonds are issued by the federal government.
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Inflation indexed bonds have rates that vary with inflation.
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Emerging market bonds are typically less speculative than government bonds.
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Floating rate bonds adjust to market rates.
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Corporate bond funds aim for lower yields compared to government bonds.
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Zero-coupon bond funds pay out interest at regular intervals.
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The risk premium is equal to liquidity risk plus maturity risk plus default risk.
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Bond coupons are fixed contractual payments that are affected by changes in market rates over time.
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The amount due at bond maturity is called the face value.
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The coupon yield is calculated based on the annual coupon and the market value of the bond.
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The current yield is calculated as annual coupon divided by face value of bond.
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Changes in interest rates do not affect bond valuations.
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Liquidity risk is one of the components included in the risk premium.
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The yield to maturity represents the return if the bond is sold before maturity.
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A premium bond has greater fluctuation in price than a discount bond.
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Both discount and premium bonds do not fluctuate in price.
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A discount bond has a greater fluctuation in price than a premium bond.
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U.S. Government bonds are subject to federal but not state taxes.
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A callable corporate bond may be retired if interest rates decrease sharply.
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Preferred shares are considered less risky than bonds.
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As bond maturity increases, the bond's risk sometimes increases and sometimes decreases.
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The ability to convert an asset into cash quickly and at a relatively low transaction cost is known as liquidity.
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A bond rating of CCC is regarded as a high-quality bond with a low chance of default.
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Short-term bonds generally carry a higher risk for a given change in interest rates compared to long-term bonds.
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The risk associated with a bond is inversely related to its value.
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Study Notes
Bond Maturity and Risk
- Longer bond maturity generally increases risk due to higher potential for changes in repayment ability and market interest rates.
- Long-term bonds are more affected by broad changes in interest rates compared to short-term bonds.
Bond Categories and Ratings
- Risk classification of bonds is based on ability to fulfill obligations: credit quality is key.
- Bonds rated below BBB are considered high-yield or junk bonds, with possible default risk.
- Medium quality bonds typically include ratings of B and BBB.
Liquidity
- Liquidity refers to the ability to quickly convert an asset into cash with minimal transaction costs.
Types of Bond Funds
- Government Securities: Invest in U.S. government bonds and GNMA mortgage-backed securities.
- Corporate: Aim for higher yields via investment quality corporate bonds.
- High Yield: Focus on junk bonds with higher risks but also higher potential returns.
- Municipal: Tax-favored bonds issued by local authorities.
- International: Government and other bonds from non-U.S. entities.
- Emerging Market: Invest in speculative bonds from developing countries.
- Floating Rate: Bonds with interest rates that adjust to market rates.
- Inflation Indexed: Bonds whose value varies with inflation rates.
- Other Funds: Includes zero-coupon, convertible securities, and multi-sector funds.
Fund Loads
- A Type Load: Front-end charge upon purchase.
- B Type Load: Charges increase if redeemed early, but none if held until a specified period.
- C Type Load: Small front-end charges, annual sales charges, typically no long-term redemption charges.
- No Load: No sales commissions for purchases.
Risk Premium
- The risk premium is calculated as liquidity risk + risk-free rate + maturity risk + default risk.
Bond Coupons
- Fixed contractual payments provided throughout the bond's life, typically unaffected by changes in market rates.
Bond Maturity Value
- Amount due at bond maturity is known as par value or face value.
Yield Calculations
- Coupon Yield: Based on annual coupon divided by the bond's face value; it reflects the bond's return if held to maturity.
- Current Yield: Annual coupon divided by market value of the bond.
Treasury Bonds and Taxes
- Maturity of Treasury bonds is typically 10 years or more.
- U.S. government bonds are generally exempt from state tax but may be subject to federal tax.
Callable Bonds
- Callable corporate bonds can be retired if interest rates decrease sharply, allowing companies to refinance at lower rates.
Preferred Shares vs. Bonds
- Preferred shares are riskier than bonds due to lower asset priority in bankruptcy and lack of guaranteed principal return.
Investment Approaches
- Momentum investing involves buying stocks that have grown significantly in value relative to market trends.
Dividend Discount Model
- Current security value is calculated using the annual dividend divided by the difference of the required rate of return and projected growth rate in dividends.
Mutual Fund Classification
- A mutual fund with both stocks and bonds is categorized as a balanced fund.
Load Funds
- A load fund provides sales commissions to brokers, distinguishing it from no-load funds which do not incur these fees.
Underperformance of Actively Managed Funds
- Actively managed mutual funds often underperform due to high operating expenses and trading costs, impacting overall returns.
Bond Maturity and Risk
- As bond maturity increases, risk typically increases due to potential changes in a company's ability to meet debt obligations.
- Longer-term bonds are more sensitive to interest rate changes compared to shorter-term bonds.
Bond Categories and Ratings
- Low risk associated with interest rate changes is common in money market and short-term bonds.
- Bond classifications like risk, quality, and credit assess the likelihood of fulfilling payment obligations.
- High-yield or junk bonds are rated below CCC, indicating a higher chance of default.
- Medium quality bonds are typically rated BBB or A.
Liquidity Definition
- Liquidity refers to the ease of converting an asset into cash quickly and at low transaction costs.
- It involves the risk of not being able to find a buyer at the current market price.
Types of Bond Funds
- Government Securities: Invests in U.S. government bonds and GNMA mortgage-backed securities.
- Corporate Bonds: Seeks higher yields in investment-quality bonds.
- High Yield: Invests in riskier, below investment-quality or junk bonds.
- Municipal Bonds: Issued by local governments and are often tax-favored.
- International Bonds: Invests in government and other bonds from foreign countries.
- Emerging Market Bonds: More speculative, sourced from developing nations.
- Floating Rate Bonds: Adjusts to market rates, typically through adjustable-rate mortgages.
- Inflation Indexed Bonds: U.S. government bonds that vary with inflation.
Fund Load Characteristics
- A Type Load: Has front-end charges, no annual sales charge, and a possible 12b-1 fee.
- B Type Load: No front-end charge but includes annual sales charges and redemption charges.
- C Type Load: No front-end charge, annual sales charges apply, possible redemption charge in the first year.
- No Load: No front-end, annual, or redemption charges, potential small 12b-1 fee.
Risk Premium
- The risk premium incorporates liquidity risk, maturity risk, and default risk along with the risk-free rate.
Bond Coupons and Yields
- Bond coupons are fixed contractual payments not influenced by market rate changes.
- Amount due at maturity is termed as par value, face value, and maturity value interchangeably.
- The coupon yield is calculated based on annual coupon payments versus bond face value.
- Current yield is the ratio of annual coupon payment to market value of the bond.
Yield to Maturity Calculations
- Yield to maturity can be approximated using coupon payments, face value, and market price over the years remaining until maturity.
Mutual Funds and Taxes
- Mutual funds can maintain cash reserves to manage sizeable redemptions and costs.
- Shareholders may incur capital gains taxes even if fund shares are not sold.
Mutual Funds vs. Managed Accounts
- Large difference: mutual funds pool investor funds; separately managed accounts have individual ownership of securities.
Unit Investment Trusts
- Portfolios set up at a specific time, generally unmanaged, akin to mutual funds but typically limited to fixed investments.
Specialized Funds
- Sector Funds: Focused on specific sectors like Utility and Technology.
- Industry Funds: Target particular industries, such as Pharmaceuticals or Real Estate Investment Trusts (REITs).
- Commodity Funds: Invest in tangible goods like Gold or Oil.
- Regional Funds: Concentrate on specific geographical areas like the Midwestern U.S.
- Balanced Funds: Mix of stocks and bonds for diversification.
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Description
Test your understanding of bond maturity and risk with this quiz based on Chapter 16. The questions explore the relationship between bond maturity and risk, helping you grasp important financial concepts. Perfect for finance students looking to reinforce their knowledge.
