Chapter 7 Learning Objectives

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Learning Objectives

Describe the market for corporate bonds and three types of corporate bonds

The market for corporate bonds is a very large market in which the most important investors are large institutions. Most trades take place through dealers in the OTC market , making the corporate bond market relatively thin. Prices of corporate bonds tend to be more volatile than prices of securities that trade more frequently, such as stock and money market instruments, and the corporate bond market tends to be less efficient than markets for these other securities.

A vanilla bond pays fixed regular coupon payments over the life of the bond, and the entire principle is repaid at maturity. A zero coupon bond pays all interest and all principal at maturity. Since there are no payments before maturity, zero coupon bonds are issued at prices below their face value. Convertible bonds can be exchanged for common stock at a predetermined ratio.

Explain how to calculate the value of a bond and why bond prices vary negatively with interest rate movements

the value of a bond is equal to the present value of the future cash flows (coupon payments and principal repayment) discounted at the market rate of interest for bonds similar risk. Bond prices vary negatively with interest rates because the coupon rate on most bonds is fixed at the time the bond is issued. As market interest rates go up, the prices of bonds with fixed coupon payments will be bid down by investors, driving up the yield of those bonds to market levels. When interest rates decline, the yield on fixed-income securities will be higher relative to yield on similar securities price to market; the favourable yield will increase investor demand for these securities, increasing their price and lowering their yield to the market yield.

Distinguish between a bond's coupon rate, yield to maturity, and effective annual yield

A bond's coupon rate is the interest rate on the bond, relative to its face value, when it is issued. US bonds pay once a year. The yield to maturity is the expected return on a bond of it held to its maturity date. The effective annual yield is the yield an investor actually earns in one year, adjusting for the effects of compounding. If the bonds pays coupon payment more often then annually, the effective annual yield will be higher than the simple annual yield because of compounding.

Explain why investors in bonds are subject to interest rate risk an why it is important to understand the bond theorems

Because interest rates are always changing in the market, all investors who hold bonds are subject to interest rate risk Interest rate risk is uncertainty about future bond values caused by fluctuations in interest rates. Three of the most important bod theorems can be summarised as follows:

1. Bond prices are negatively related to interest rate movements

2. For a given change in interest rates, the pries of long-term bonds will change more that the prices of short-term bonds

3. For a given change in interest rates, the prices lower-coupon bonds will change more than the prices of higher-coupon bonds

Understanding these theorems is important because it helps investors better understand why bond prices change and, thus, make better decisions regarding the purchase or sale of bonds and other fixed-income securities.

Discuss the concept of default risk and know how to compute a default risk premium

Default risk is the risk that the issuer will be unable to pay its debt obligation. Since investors are risk averse, they must be paid a premium to purchase a security that exposes them to default risk. The default risk premium has two components: (1) compensation for the expected loss if a default occurs and (2) compensation for bearing the risk that a default could occur. All factors held constant, the degree of default risk a security possesses can be measured as the difference between the interest rate on a risky security and the interest rate on a default-free security. The default risk is also reflected in the company's bond rating. The highest-grade bonds, those with the lowest default risk, are rated Aaa ( or AAA). The default risk premium on corporate bonds increases as the bonds rating becomes lower.

Describe the factors that determine the level and shape of the yield curve

The level and shape of the yield curve are determined by three factors: (1) the real rate of interest, (2) the expected rate of inflation, and (3) interest rate risk. The real rate of interest is the base interest rate in the economy and varies with the business cycle. The real rate of interest affects only the level of the yield curve and not its shape. The expected rate of inflation does affect the shape of the yield curve. If investors believe inflation will be increasing in the future, for example, the curve will be upward sloping, as long-term rates will contain a larger inflation premium than short-term rates. Finally, interest rate risk, which increases with a security's maturity, adds and upward bias to the slope of the yield curve.