5. Bonds

Question 1

Bond =

Answer 1

a debt instrument (AKA Fixed Interest Security) whereby an investor lends money to an entity (such as a company or government) that borrows the funds or a defined period of time at a fixed interest rate – IOU

Question 3

who issues bonds

Answer 3

Companies
Governments

Question 4

what are UK gov bonds known as

Answer 4

Gilts

Question 5

why do governments used bonds

Answer 5

Total receipts (taxes) < Total expenditure
- difference needs to be funded through issuing bonds

Question 6

what are green and blue bonds

Answer 6

green = bonds issues to fund activities that are environmentally responsible
blue (subset of green) = conserve oceans

Question 7

why do longer-dated bonds have higher interest payment

Answer 7

more risky (company more like to go wrong in 30yrs than 5) - investors want greater returns
- function of risk + reward

Question 8

why not borrow from banks (3 + reason)

Answer 8

• Cheaper :
  
  • companies can borrow at lower rates of interest compared with borrowing from bank loan
• Greater Control & Freedom :
  
  • companies can make multiple bond issues for **difference amounts, different lengths of time to repay
  • companies do not have to meet a banks’ requirement e.g. restrictions on borrowing from other sources
• More achievable :
  
  • companies can borrow very large sums of money - banks may be reluctant to take on that much risk

Question 9

what is the nominal value

Answer 9

• amount on which interest will be paid
• amount that will eventually be repaid at maturity
• original amount of bond purchased
• not necessarily the same as the bond price

Question 10

what is the maturity date

Answer 10

• the year with the nominal amount will be repaid
• repayment will take place at the same time as the final interest payment is made

Question 11

what are bond prices

Answer 11

• quoted by how much it is to buy £100 nominal of the bond

Question 12

coupon =

Answer 12

• the interest rate paid to the bondholder every year or half-yearly
• Coupons are calculated on the nominal value of the bond

Question 13

what if the bondholder wants to sell the bond before it matures?

Answer 13

Bonds can be traded between investors vias an exchange before a bond matures

The amount the new bondholder pays for the bond (it’s price), may not be the same as the nominal value i.e. they may pay more of less than £100 for £100 nominal of that bond

Question 14

What is the relationship between interest rates and bond prices?

Answer 14

INVERSE relationship between INTEREST RATES and BOND PRICE when bonds are traded

Question 15

why do bonds respond to changes in INTEREST RATES

Answer 15

• Because for their yield (return), to be attractive to investors it must remain competitive (when compared to the return available on alternative investment instruments)
• If the bank increases the rate on interest, then alternative investments may appear to have more competitive return
• In response to this the bond price decreases to make the bond appear cheaper to purchase
• Bonds pay fixed coupons
• When interest rates rise, other investments give better returns.
• To compete, bonds must offer a higher yield.
• Yield rises only if price falls
• Lower price = same coupon = higher % return/yield

Question 16

are yields and coupons the same thing?

Answer 16

NO
- Coupon is fixed from the day the bond is issued.
- Yield changes depending on the bond price

Question 17

what are yields expressed as

Answer 17

ANNUAL PERCENTAGE

Question 18

what are flat yields

Answer 18

coupon paid on a bond as a percentage of its market price

Question 19

Flat Yield = (eq)

Answer 19

Annual Coupon / Bond’s Market price x 100

Question 20

Yield to maturity =

Answer 20

a bonds flat yield plus or minus any gains or loss if help until repayment

Question 21

What is the relationship between the bond prices and their yield?

Answer 21

INVERSE relationship between BOND PRICE and BOND YIELDS when a bond is traded

Question 22

why is there an inverse relationship between bond prices and yields

Answer 22

INTEREST DOWN
- Interest rates fell to 4%, so the 5% bond became more attractive.
- Its price rose to £11,000, but since it still only pays £500
- New yield DOWN: (5%/110) x100 = 4.54%

INTEREST UP
- interest rates 6%, 5% less attractive , sell
- bond price decreased from £100 per £100 nominal to £90 per £100 nominal
- sells at £9,000
- New yield UP: (5%/90) x 100 = 5.55%

Question 23

what relationship between interest rates, bond price, bond yield

Answer 23

basically bond price inverse to both
interest + yield = proportional

Question 24

What are the advantages of bonds for investors?

Answer 24

• A regular and certain flow of income through regular, fixed coupons (1/2 or yearly fixed coupon)
• nominal amount to be repaid at fixed maturity date (safe)
• A range of income yields to suit different investment and tax situations
• Relative security of capital for more highly rated bonds

Question 25

What are the disdvantages of bonds for investors?

Answer 25

* Inflation risk: if inflation rises, the ‘real’ value of the bond’s coupon and redemption payment are eroded * Price risk/Market risk: Fluctuations in **interest rates** cause bond prices to change accordingly when they are traded * Default risk: there is a possibility that the issue will not be able to pay the coupon or redemption back * Seniority Risk: some bonds may rank behind more recently issued bonds in terms of being repaid of the issuer is unable to that the bond back (company may go into liquidation) * Exchange rate risk: bonds denominated in a currency different from that of the investor’s home currency are potentially subject to adverse exchange rate movements * Liquidity Risk: the ease with which security can be converted into cash. Some bonds are more easily sold at a fair market price than others

Question 26

What is meant by security when it comes to bonds?

Answer 26

Security refers to the **guarantee provided to the investor that the bond will be repaid**

Question 27

how does bond security work?

Answer 27

- Security usually means a **legal charge** over some or all the **bond issuer’s assets** e.g. Properties (offices and factories), unsold goods or uncollected debts - If the issuer fails to pay the requires coupons are the principal of the bonds, the **bondholders can claim those assets** in order to recoup the money that is owned to them - Bondholders regard their borrowing as **safer** than if there were no security

Question 28

What are Credit Rating Agencies?

Answer 28

Credit Rating Agencies will look at bond issuers and **assess the risk involved** (some Corporate and most Government bonds)

Question 29

There are three dominant credit rating agencies globally :

Answer 29

* Moody’s * Standard & Poor’s (S&P) * Fitch Ratings

Question 30

what is the rating system for these credit rating agencies

Answer 30

All three have an alphabetical system where issuers with the **LEAST credit risk** are termed **“Triple A”** * S&P and Fitch use an identical scale * Moody’s uses their own scale

Question 31

what are Investment and Non-Investment grade bonds

Answer 31

- Investment (Less Credit risk) - more appropriate for prudent investors, - Non-Investment (More Credit risk) - less appropriate for prudent investors

Question 32

where is the dividing line between investment grade bonds and non-investment grade bonds

Answer 32

just **below Standard & Poor’s BBB** and **Moody’s Baa** levels