Introduction to Corporate Bonds

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Questions and Answers

What causes bond values to decrease when market interest rates rise?

Increased demand for safer investments

Higher yields offered by alternative investments (correct)

Increased default risk of the bond issuer

Bonds become less liquid

What does liquidity risk in the context of bonds refer to?

The potential for negative yields on the bond

The inability to sell the bond without significant losses (correct)

The risk of interest rates changing

The issuer's inability to make interest payments

What is the primary function of a Credit Default Swap (CDS)?

To increase the overall yield of a bond

To insure against changes in market interest rates

To provide liquidity to bondholders

To protect against the risk of bond issuer default (correct)

What is a characteristic of government bonds?

They are often used to finance budgetary deficits Signup and view all the answers

Which of the following accurately describes the relationship between gross and net price of a bond?

Net price is calculated by deducting accrued interest from gross price Signup and view all the answers

What distinguishes private debt from public debt?

Private debt includes loans from banks, while public debt involves bonds traded in markets. Signup and view all the answers

What is a potential consequence for a firm if it fails to make promised payments on its bonds?

The bond trustee can force the firm into bankruptcy. Signup and view all the answers

Why do larger firms often rely on the bond market for financing?

Bonds allow for long-term funding compared to short-term bank loans. Signup and view all the answers

Which of the following features does NOT describe a bond?

Ownership stake Signup and view all the answers

What happens to a firm’s assets after it issues bonds?

Assets include cash and the new debt from the bonds issued. Signup and view all the answers

What is the function of the coupon in a bond?

To represent the interest payments made to bondholders. Signup and view all the answers

How does a firm benefit from issuing bonds for funding new equipment?

By generating income from the new asset to pay back bondholders. Signup and view all the answers

What is par value in relation to a bond?

The original principal amount that must be repaid at maturity. Signup and view all the answers

What type of coupon bond does not provide any interest payments?

Zero-coupon bond Signup and view all the answers

Which statement is true regarding an undervalued bond?

Market price is less than intrinsic value. Signup and view all the answers

What is the relationship between a bond's coupon rate and the expected return for a premium bond?

The coupon rate is higher than the expected return. Signup and view all the answers

What does a bond rating of 'CCC' indicate?

Actual threat of default Signup and view all the answers

If a bond's market price is equal to its intrinsic value, what type of bond is it considered?

Par bond Signup and view all the answers

Which of the following represents the least creditworthy bond rating?

D Signup and view all the answers

How is the expected return on a bond generally calculated?

By using the risk-free rate plus a spread Signup and view all the answers

What characteristic defines a floating coupon rate bond?

The interest payment changes based on a benchmark. Signup and view all the answers

Study Notes

Introduction to Bonds

Bonds are a crucial source of borrowing for corporations, often seen as public debt due to trading in financial markets.
Smaller firms favor loans from banks due to higher costs associated with issuing bonds.
Larger firms predominantly use bond markets for long-term financing.
Corporations also raise funds by selling debt securities to individual investors and financial institutions like mutual funds.
Issuing firms must meet legal requirements set by securities laws.

Definition of Bonds

A corporate bond is a debt security promising future payments with a maturity date.
Failure to fulfill promised payments (interest and principal) can lead to the firm being classified as insolvent and forced into bankruptcy.
Bonds are an important part of external debt financing.

Impact of Bond Issuance

Issuing bonds increases cash holdings and debt on a corporation's balance sheets.
Equity remains unchanged.
Bond issuance is often used to finance new equipment.

Bond Features

Face value (par value): The principal amount repaid to bondholders at maturity.
Coupon: Regular interest payments throughout the bond's life.
Types of coupons
- Zero-coupon: No interest payments, payout at maturity.
- Fixed coupon rate: Pre-determined interest payments.
- Floating coupon rate: Interest changes based on a pre-set benchmark (e.g., inflation, base rate, LIBOR).
Maturity: The date when the principal is due to be repaid.
Intrinsic value: Present value of future cash flows (interest and principal), calculated using a risk-adjusted interest rate.
Market value: The price at which bonds trade in secondary markets.
Undervalued and overvalued bonds: Classification depending on whether the market value is lower or higher than the intrinsic value.
Bond rating: A measure of a bond's riskiness, assigned by rating agencies (Moody's, Standard & Poor's, Fitch), influencing expected return and risk premium.
Bond rating (example codes):
- AAA: Best creditworthiness.
- BBB: Good creditworthiness but recession risks could be a concern.
- CCC: Defaul risk is likely.
- D: Actual default or delay of payment .

Bond Pricing

Gross price includes accrued interest since the last coupon payment.
Net price is the actual price paid after considering accrued interest.

Types of Bonds

Discount bonds: Trade below par value with lower coupon rates than expected returns.
Premium bonds: Trade above par value with higher coupon rates than expected returns.
Par bonds: Trade at par value with coupon rates equal to expected returns.

Market Price vs Intrinsic Value

Intrinsic value represents the present worth of future cash flows from the bond, calculated with a risk-appropriate interest rate.
The market price is the current price at which bonds are traded on secondary markets.

Bond Risks

Market risk: Interest rate changes impact bond prices.
Liquidity risk: Difficulty in selling bonds without incurring significant losses.
Default risk: Risk that the bond issuer may not be able to pay back the bond.

Credit Default Swaps (CDS)

A CDS is a contract where a buyer pays a premium to an insurance provider (seller).
If the issuer defaults, the seller pays the bondholder.
Used mainly for government bonds to reduce risk of default.

Government Bonds

Issued by governments.
Used to finance budget deficits.
Bondholders lend money to the government.

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Description

This quiz covers the essentials of corporate bonds, including their definition, purpose, and impact on company finances. Learn about how corporations utilize bonds for funding and the implications of bond issuance on balance sheets. Test your knowledge on the borrowing mechanisms of different-sized firms and legal compliance in bond markets.