I-Bonds and Bond Valuation
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Questions and Answers

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

  • The present value increases.
  • The present value remains unchanged.
  • The present value becomes equal to the face value.
  • The present value decreases. (correct)

    • Which statement correctly defines the time to maturity?

  • The number of years until the principal amount of the bond is repaid. (correct)
  • The date on which the last coupon payment is made.
  • The amount of time the bondholder must hold the bond to receive all payments.
  • The total number of coupon payments made until the bond matures.

    • When a bond’s Yield to Maturity (YTM) is less than its coupon rate, what can be said about the bond's price?

  • The bond price equals the face value.
  • The bond is selling at a discount.
  • The bond price cannot be determined.
  • The bond is selling at a premium. (correct)

    • What is the current yield of a bond and how is it calculated?

    <p>The annual coupon divided by the market price of the bond.</p> Signup and view all the answers

    Which of the following statements accurately describes a discount bond?

    <p>Its price is less than the face value.</p> Signup and view all the answers

    Which factor does NOT affect the bond's current market value?

    <p>The credit rating of the issuer.</p> Signup and view all the answers

    What is the primary characteristic of T-bills compared to T-notes and T-bonds?

    <p>T-bills have an original maturity of one year or less.</p> Signup and view all the answers

    Why are municipal bonds generally more attractive to high-income investors?

    <p>Coupon payments from municipal bonds are exempt from federal income taxes.</p> Signup and view all the answers

    At what tax rate would an investor be indifferent between a taxable bond yielding 8% and a municipal bond yielding 6%?

    <p>25%</p> Signup and view all the answers

    What is the bid price in bond transactions?

    <p>The price at which you can sell a bond to the dealer.</p> Signup and view all the answers

    Which statement about the U.S. Treasury market is true?

    <p>It is the largest securities market in the world.</p> Signup and view all the answers

    What is a discount bond?

    <p>A bond that sells for a price below the par value.</p> Signup and view all the answers

    What typically happens when buying a bond between coupon payment dates?

    <p>You pay more than the quoted price due to accrued interest.</p> Signup and view all the answers

    Which of the following factors increases interest rate risk for a bond?

    <p>Having a lower coupon rate.</p> Signup and view all the answers

    Which statement is true regarding debt and equity?

    <p>Interest payments on debt are tax-deductible.</p> Signup and view all the answers

    How does the time to maturity affect interest rate risk?

    <p>It increases risk when maturity time is long.</p> Signup and view all the answers

    What typically happens to a premium bond's yield to maturity compared to its coupon rate?

    <p>It is lower than the coupon rate.</p> Signup and view all the answers

    What is the primary consequence of excessive debt for a firm?

    <p>Potential financial distress and bankruptcy.</p> Signup and view all the answers

    In what way do creditors differ from equity holders regarding voting rights?

    <p>Creditors do not have voting rights.</p> Signup and view all the answers

    What determines the sensitivity of a bond's price to interest rate changes?

    <p>The time to maturity and the coupon rate.</p> Signup and view all the answers

    What does the term 'collateral' typically refer to?

    <p>Any asset pledged on a debt</p> Signup and view all the answers

    What describes the nature of a sinking fund?

    <p>An account for redeeming bonds early</p> Signup and view all the answers

    What does a call provision allow an issuer to do?

    <p>Repurchase the bond at a predetermined price before maturity</p> Signup and view all the answers

    Which of the following statements correctly describes a protective covenant?

    <p>It limits the actions a firm can take while a bond is outstanding</p> Signup and view all the answers

    Which bond rating indicates a very low probability of default?

    <p>Aaa</p> Signup and view all the answers

    What characterizes a deferred call provision?

    <p>Prohibits repurchase for a set period after issue</p> Signup and view all the answers

    What is true about bonds rated BBB (S&P) or Baa (Moody's)?

    <p>They are considered investment grade</p> Signup and view all the answers

    What does seniority indicate in terms of debt repayment?

    <p>Priority of payment to creditors in bankruptcy situations</p> Signup and view all the answers

    What is a call premium?

    <p>The amount by which the call price exceeds the par value</p> Signup and view all the answers

    Which statement describes the role of bond-rating firms?

    <p>They analyze the likelihood of default and creditor protection</p> Signup and view all the answers

    What distinguishes T-bills from T-notes and T-bonds?

    <p>T-bills are pure discount bonds with a maturity of one year or less.</p> Signup and view all the answers

    Which statement about municipal bonds is accurate?

    <p>Coupon payments from municipal bonds are often lower due to tax exemption.</p> Signup and view all the answers

    What is the primary benefit for high-income investors in purchasing municipal bonds?

    <p>Exemption from both state and federal taxes.</p> Signup and view all the answers

    What does the bid-ask spread represent in bond transactions?

    <p>The dealer's profit from buying and selling a bond.</p> Signup and view all the answers

    What factor influences the price paid for a bond when purchased between coupon payment dates?

    <p>The accrued interest included in the price.</p> Signup and view all the answers

    Which option correctly states the nature of T-bonds?

    <p>They are coupon debt with an original maturity greater than ten years.</p> Signup and view all the answers

    What is a defining characteristic of an all-equity firm?

    <p>It does not have any debt obligations.</p> Signup and view all the answers

    Which of the following instruments typically matures in less than ten years?

    <p>Note</p> Signup and view all the answers

    What type of debt instrument is typically secured by specific property?

    <p>Bond</p> Signup and view all the answers

    In what form are interest payments made directly to the owner of record?

    <p>Registered form</p> Signup and view all the answers

    What is the main purpose of an indenture?

    <p>To outline the terms of a debt issue.</p> Signup and view all the answers

    Which characteristic is true about a debenture?

    <p>It generally matures in ten years or more.</p> Signup and view all the answers

    What determines whether a bond is classified as a public issue?

    <p>It is sold to the general public.</p> Signup and view all the answers

    Which of the following provisions is typically found in an indenture?

    <p>Details about the protective covenants.</p> Signup and view all the answers

    What differentiates bearer bonds from registered bonds?

    <p>Interest payments for bearer bonds are made to holders.</p> Signup and view all the answers

    What is typically included in the provisions of an indenture regarding repayment?

    <p>Repayment arrangements and timing.</p> Signup and view all the answers

    What characteristic defines a discount bond?

    <p>It sells for a price below par value.</p> Signup and view all the answers

    What happens to interest rate risk as the time to maturity increases, assuming all other factors remain constant?

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

    Which of the following statements about par value bonds is true?

    <p>They have a market price equal to the face value.</p> Signup and view all the answers

    What is one advantage of debt over equity for a firm?

    <p>Interest payments on debt are tax-deductible.</p> Signup and view all the answers

    In what way does a premium bond differ from a par value bond?

    <p>It sells for a price above the face value.</p> Signup and view all the answers

    Which factor increases interest rate risk for a bond, assuming all else is equal?

    <p>Lower coupon rate.</p> Signup and view all the answers

    What characteristic of equity distinguishes it from debt financing?

    <p>Equity represents ownership interest.</p> Signup and view all the answers

    What is an essential risk factor associated with bond investments?

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

    What happens to a bond's present value when interest rates in the market increase?

    <p>The present value of the bond decreases.</p> Signup and view all the answers

    Which of the following correctly states the relationship between Yield to Maturity (YTM) and bond pricing?

    <p>If the YTM is greater than the coupon rate, the bond sells at a discount.</p> Signup and view all the answers

    What is a key characteristic of a bond known as a premium bond?

    <p>The bond price is higher than the face value.</p> Signup and view all the answers

    Which component is NOT necessary for estimating a bond's current market value?

    <p>Credit rating of the issuer</p> Signup and view all the answers

    How does the coupon rate affect a bond when interest rates fall in the market?

    <p>The bond's price rises above its face value.</p> Signup and view all the answers

    Which statement accurately describes the cash flows from a bond?

    <p>They are fixed and remain the same over the life of the bond.</p> Signup and view all the answers

    Study Notes

    Bonds and Bond Valuation

    • Bonds function as long-term debt securities, representing a promise to repay borrowed funds plus interest.
    • Bonds typically feature interest-only payments with principal repaid at maturity; known as level-coupon bonds.

    Bond Features

    • Maturity Date: The date the principal is paid back alongside the last interest payment.
    • Time to Maturity: Reduces over time until the bond matures.

    Bond Values and Yields

    • Cash flows from bonds remain constant; however, market interest rate changes impact their present value.
    • An inverse relationship exists between interest rates and bond prices.
    • Bond value is calculated as the present value of future coupon payments and the principal, discounted at the yield to maturity (YTM).
    • YTM reflects the market-required return and the bond's current price.
    • Current yield equals the annual coupon divided by the market price of the bond.

    Bond Pricing Relationships

    • YTM = Coupon Rate: Bond price equals face value.
    • YTM > Coupon Rate: Bond price is below face value (discount bond).
    • YTM < Coupon Rate: Bond price is above face value (premium bond).
    • A par value bond's price equals its face value and YTM matches the coupon rate.

    Interest Rate Risk

    • Defined as the risk associated with fluctuating interest rates affecting bond prices.
    • Longer time to maturity leads to greater interest rate risk.
    • Lower coupon rates also increase interest rate risk.

    More on Bond Features

    • Bonds denote liabilities for the borrower and do not confer ownership rights to creditors.
    • Differences between debt and equity include tax-deductibility of interest versus dividends and legal recourse for missed payments.

    Repayments

    • Bonds may be repaid at maturity or partially before maturity, often via a sinking fund.
    • A Sinking Fund is an account for redeeming bonds early.
    • Call provisions allow issuers to repurchase bonds at predetermined prices before maturity.

    Protective Covenants

    • Protective covenants limit a firm's actions, such as dividend payments and issuance of additional long-term debt.

    Bond Ratings

    • Major rating agencies include Moody's and Standard & Poor's (S&P).
    • Bonds are rated based on default risk; AAA rating is best, while lower ratings indicate higher risk (junk bonds).

    Government Bonds

    • Treasury Securities: Include T-bills, T-notes, and T-bonds with different maturities and default risk.
    • Treasury securities are exempt from state taxes but subject to federal income taxes.
    • Municipal Securities: Issued by state and local governments with tax-exempt coupon payments appealing to high-income investors.

    How Bonds are Bought and Sold

    • Most transactions occur over-the-counter (OTC) with dealers connected electronically; trades are less frequent than in stocks.

    Bond Price Reporting

    • The bid price is what a dealer pays to buy a bond, while the asked price is what they sell it for.
    • The bid-ask spread is the dealer's profit.

    Bond Price Quotes

    • The clean price excludes accrued interest, while the dirty price includes it, being the total amount paid by the buyer.

    Real versus Nominal Rates

    • Real interest rates are adjusted for inflation, indicating the actual purchasing power changes.
    • Nominal rates reflect the stated interest before inflation adjustment.

    Term Structure of Interest Rates

    • Explains the relationship between prevailing interest rates on default-free securities and time to maturity.
    • Components include the real rate of return, inflation premium, and interest rate risk premium.
    • The Treasury yield curve depicts yields across different maturities, using graphical representation for clarity.

    Bonds and Their Valuation

    • Bonds are long-term debt instruments issued by various entities, including corporations and governments, with a promise to repay the principal and interest.
    • Usually considered interest-only loans, bonds feature consistent interest payments and principal repayment at maturity.

    Key Bond Features

    • Maturity Date: The specified date when the bond's principal is repaid and the final interest payment is made.
    • Time to Maturity: The remaining years until the bond matures, decreasing over time.

    Bond Values and Yields

    • Bond cash flows remain constant, but fluctuating market interest rates affect the present value of bonds.
    • There is an inverse relationship between interest rates and bond prices; higher rates decrease bond value and vice versa.
    • The bond's value equals the present value of future coupon payments plus the principal payment, discounted using the Yield to Maturity (YTM).
    • YTM is the market interest rate for bonds of similar characteristics, and it reflects the bond's implied return based on current price.
    • Current yield is calculated as the annual coupon payment divided by the market price of the bond.

    Bond Price and Yield Relationships

    • If YTM equals the coupon rate, bond price is at par (face value).
    • If YTM exceeds the coupon rate, bond price is below par (discount bond).
    • If YTM is less than the coupon rate, bond price is above par (premium bond).
    • Terms:
      • Par Value Bond: Market price equals face value.
      • Discount Bond: Sells below par with YTM greater than the coupon rate.
      • Premium Bond: Sells above par with a coupon rate exceeding YTM.

    Interest Rate Risk

    • Interest rate risk refers to the impact of fluctuating interest rates on bond prices.
    • Longer maturity and lower coupon rates increase interest rate risk.

    Differences Between Debt and Equity

    • Debt: No ownership interest, fixed interest payments, tax-deductible interest, and legal recourse for missed payments.
    • Equity: Ownership interest, voting rights, non-deductible dividends, and no legal claim on unpaid dividends.

    Long-Term Debt Overview

    • Long-term debt instruments have maturities greater than one year, while short-term debt has shorter maturities.
    • Types of corporate debt include notes, debentures, and bonds, with debentures being unsecured and bonds often secured by specific assets.

    Indenture Agreement

    • The indenture is the contract detailing bond terms, including:
      • Basic terms and total amount of bonds issued.
      • Description of secured property and repayment arrangements.
      • Call provisions and protective covenants.

    Government Bonds

    • Treasury Securities: Include T-bills (maturity ≤ 1 year), T-notes (maturity 1-10 years), T-bonds (maturity > 10 years).
    • U.S. Treasury securities carry no default risk and are exempt from state taxes.
    • Municipal Bonds: Issued by state/local governments; coupon payments are exempt from federal taxes, making them attractive to high-income investors.

    Other Bond Types

    • Zero Coupon Bonds: Bonds sold at a discount, no periodic interest payments.
    • Floating Rate Bonds: Pay interest tied to a benchmark interest rate, adjusting periodically.

    Bond Transactions

    • Most bond trades occur in the over-the-counter market, which operates electronically, with lower volume compared to stocks.

    Bond Price Reporting

    • Bid Price: Price a dealer pays to buy a bond.
    • Ask Price: Price a dealer charges to sell a bond.
    • Bid-Ask Spread: Difference which represents the dealer's profit.

    Bond Price Quotes

    • Clean Price: Price excluding accrued interest; the quoted price.
    • Dirty Price: Total price including accrued interest, typically paid by the buyer.

    Real vs. Nominal Rates

    • Real Rates: Adjusted for inflation, reflecting actual purchasing power changes.
    • Nominal Rates: Stated rates before adjustments for inflation.

    Term Structure of Interest Rates

    • The term structure reflects the relationship between nominal interest rates and time to maturity for default-free securities, represented graphically by the yield curve.
    • The yield curve captures components like real rates, inflation premium, and interest rate risk premium.
    • Additional premiums:
      • Default Risk Premium: Compensation for potential non-payment.
      • Taxability Premium: Extra yield demanded for corporate bonds over municipal bonds.
      • Liquidity Premium: Compensation for the inability to readily sell the bond.

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    Test your understanding of bonds and their valuation processes through this quiz. Explore key features such as maturity dates, coupon payments, and the different types of bonds available. Perfect for finance students looking to solidify their knowledge in this area.

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