What are the characteristics of a “Zero coupon bond”?
- Stated par value with no stated interest rate
- Purchased at a DISCOUNT, and mature at PAR
- They are the most volatile price-wise
What combination makes a bond’s price very volatile?
Long maturity and low interest rate
Term bond characteristics and 1 example:
Issued and Mature on the same date
Example: US gov’t bonds
Serial bond characteristics and 1 example:
Issued on the same date, but mature on different date
Examples: Municipal bonds and corporate ETC’s
Series bond characteristic and 1 example:
All issued on different dates, but mature on the same date
Example: Long term construction
How are term bonds quoted?
At percentage of par (dollar bonds)
How are corporate bonds quoted?
Percent of par in 1/8ths
How are US Govt. bonds quoted?
Percent of par in 1/32nds
How are municipal bonds quoted?
On a yield basis
Where does most of a bond’s value lie?
In the final principal repayment
List of bond prices from highest to lowest for DISCOUNT bonds:
- YTC
- YTM
- CY
- Coupon/Nominal
List of bond prices from highest to lowest for a PREMIUM bond:
- Coupon
- CY
- YTM
- YTC
Define interest rate risk:
Risk that rising interest rates will call bond prices to fall (also called market risk)
Define Purchasing power risk:
Risk that inflation will lower the value of a bond (especially long term ones)
Marketability risk:
Risk that something will be hard to sell
Note: Not a risk for treasuries, but a big risk for munis
Liquidity risk:
Risk that security can only be sold by incurring large costs
Reinvestment risk:
Risk that when interest is received and reinvested, it has to be reinvested at a lower yielding security because interest rates have fallen
Exchange rate risK
Risk that value of foreign currency in which the investment is denominated will weaken
What does the yield curve show?
Market rates of interest for bonds of different maturities and similar credit rankings
When is a yield curve normal?
- when monetary policy is LOOSENED
- economic expansion
- when maturities lengthen, yields increase
When is the yield curve flat?
- monetary policy is tightened
- occurs when economy is peaking
When is the yield curve inverted?
- short term rates rise ABOVE long term rates (inverted)
- severely tightened economic policy
What are the 3 theories for yield curve shape?
- liquidity preference
- Market segmentation
- Expectations (positive - rates rise, negative - rates fall)
What is the yield spread, and what does it mean?
Yield spread is the difference between Government and AAA rated corporate yields:
Widening spread means coming recession (Widen = Worry)
Narrowing spread means coming expansion (Narrow = No worry)
