Chapter 4 - Bonds Flashcards

Question

What’s the name of the formula you would you use to work out the price of a bond and what is the components of the formula?

Answer 1

Annuity formula plus PV = Coupon x 1/r (1-1/(1+r)^n) + Cap / (1+r)^n ## Footnote The ‘Cap’ represents the capital, so either the £100NV from the bond redemption, or if it’s higher, the conversion value of the convertible bond.

Answer 2

PV = Annual cash flow / Required yield

Answer 3

Bond yields increase, Bond prices fall

Answer 4

Pay gross coupons Unsecured In Immobilised form (bearer) Electronic trading

Answer 5

Represents the total return to an investor from a fixed income security if held to maturity, taking into account coupon payments and loss/gain at redemption. ## Footnote A bond’s price and its GRY are inversely related. Aka the discount rate for bonds.

Answer 6

Higher interest rates -> therefore bonds need to offer a higher yield so prices fall

Answer 7

Increased gilt issuance to over budget deficit so, increased supply reduces bond prices and increases yields

Answer 8

Gov buys gilts from institutions, reducing supply so pushing prices up and yields fall.

Answer 9

Investors want safer investments so they sell corp bonds for gov bonds. Increases demand, means higher prices and so lower yields

Answer 10

They are all yields of bonds GRY = average of spot rates Spot rates are a geometric mean of forward rates ## Footnote They can all be used to calculate a bond’s price

Answer 11

(Macaulay Duration) The sensitivity of a bonds price to a change in interest rates. It measures how long it takes in years for an investor to be repaid a bonds price through cash flows. ## Footnote Answer is given in years, eg 3.76years Duration will tell you how much a bonds price will change if interest rates change so you can determine if it’s worth more or less.

Answer 12

Relative measure of a bonds sensitivity. The time it takes where whatever maybe lost on the bond’s price is offset by gains of the reinvested coupons. The point in a bonds life when price risk and reinvestment risk balance and it's the weighted average of the present value of all the bonds payments, measured in years

Answer 13

7 / (1.09) = 6.42 7 / (1.09)^2 = 5.89 107 / (1.09)^3 = 82.62 = 94.93 6.42 * 1 =6.42 5.89 * 2 =11.78 82.62 * 3 =247.86 = 266.06 266.06 / 94.93 =2.81 years

Answer 14

Longer dated Lower coupon Lower yield Fixed coupon ## Footnote Longer dated = price moved to NV closer to maturity, longer it is the more cash flows so more volatility Lower coupon/yield = payback period of the initial outflow of bond is longer if there’s low coupon/yield Fixed interest = if IR goes up yields increase, but as coupon is fixed the price moves more

Answer 15

It’s a measure of sensitivity of a bonds price to interest rates. It is the curvature in the connection between bond prices and interest rates. ## Footnote If interest rates are going up prices fall but more slowly. If rates go down then prices increase but more quickly

Answer 16

They are both measures of a bonds price sensitivity to interest rate changes but while duration measures the linear sensitivity of a bonds price to interest rate changes, convexity measures the non-linear curved relationship.

Answer 17

The approximate percentage change in a bonds price for a 1% change in yield ## Footnote Eg for a bond with a modified duration of 3.2%, a 1% change in yield will result in a change of 3.2% in the bonds price

Answer 18

Macaulay duration / 1 + r

Answer 19

It will typically underestimate the new price ## footnote If interest rates fall, prices rise, modified duration will underestimate the price rise. If interest rates rise, prices fall, modified duration will overestimate the price fall.

Answer 20

Duration effect = - Duration(change in yield) Convexity effect = 1/2(convexity)(change in yield)^2 Duration effect + convexity effect

Answer 21

Flat yield looks at the annual coupon payment as a percentage of current price Gross redemption yield is a more accurate measure as it includes the profit/ loss from holding the bond until maturity

Answer 22

Duration = (Macaulay Duration) weighted average time in years it takes to recover the initial investment via cash flows Modified Duration = percentage change in bonds price for 1% change in interest rates.

Answer 23

Annual coupon / price

Answer 24

7 / (1.09) = 6.42 7 / (1.09)^2 = 5.89 107 / (1.09)^3 = 82.62 = 94.93 6.42 * 1 =6.42 5.89 * 2 =11.78 82.62 * 3 =247.86 = 266.06 6.42 * 2 =12.84 11.78 * 3 =35.34 247.86 * 4 =991.44 = 1039.62 1039.62 / 94.93(1.09)^2 = 9.22%

Answer 25

The longer duration (in years), the longer the average maturity is and therefore the greater the sensitivity of the bond to interest rate changes

Answer 26

8/(1.04) + 8/(1.045)^2 + 108/(1.05)^3 = £108.3

Answer 27

8/(1.04) + 8/(1.04)(1.05) + 8/(1.04)(1.05)(1.06) = £108.3

Answer 28

•Limiting further debt with higher priority. •Restricting the payment of dividends •Restricting sale of assets

Answer 29

• Holders will only exercise if convertible share price is better than prevailing one in the market • They react to changes in the market yields and interest rates • Issuers consider them deferred shares, with expectation of being converted • they are subordinated debt instruments, below vanilla bonds • pay lower coupon due to equity exposure • Offer upside of equity but downside protection of a bond

Answer 30

• Put rights can enable holder to force early redemption • Call rights enable issuer to redeem early • When establishing their terms, issuers will avoid complicated language to make bonds more attractive

Answer 31

The bonds that credit agencies have deemed the least likely to default and offer the greatest liquidity AAA - BBB (or Baa).

Answer 32

‘Junk’ bonds that are perceived as more likely to default and therefore borrowers have to compensate lenders with a higher coupon payment. Bonds with a rating of BB+.

Answer 33

•Failed to correctly assess the risk of Mortgage Backed Securities, which combined prime and ‘junk’ mortgages (bad methodologies). •Subjective judgements on ratings •Influence of governments/corporations •Conflicts of interest due to issuers paying agencies for ratings •Lack of well paid staff - unable to properly assess every security ## Footnote As a result, there is now increased oversight by regulators of the credit rating function, which caused the number of countries with the highest credit rating to fall.

Answer 34

The downgrading of credit rating makes it more expensive for governments to raise money requiring the issuer to offer a higher interest rates to compensate for the higher perceived risk. This strains national budgets, reduces fiscal flexibility and so potentially lead to higher taxes hindering economic growth.

Answer 35

CoCos are a fixed income instrument that converts into equity if a trigger event occurs (eg solvency ratios of firm fall below a specified level) As the bond converts to equity it improves the firms solvency ratio. CoCos are therefore the riskiest bonds, and demand higher returns Another example is ‘principal write-down CoCos where investors absorb company losses through cancellation of their entitlements.

Answer 36

Similar to the GRY in that it takes both coupons and profit/loss at redemption into account re the total yield of a bond - the NRY considers after tax cash flows rather than gross cash flows.

Answer 37

• as it only considers coupon, not redemption, it’s suited to short-term investors and irredeemable bonds • Shows how change in interest rates impacts price of a bond - if IR increases yields need to rise, and as the coupon is fixed, the price needs to fall. • Ignored timing of cash flows, time value of money is overlooked • if the coupon isn’t fixed then flat yield is not suitable (FRNs)

Answer 38

Bonds that offer an alternative to investors concerned with the Ethical, Environmental and Social impact of how their money is used. Eg: Green bonds Social bonds Sustainability bonds Blue bonds Social impact bonds

Answer 39

Conventional debt instruments where funds raised are used to finance eligible ‘green projects’ Eg. Energy efficiency, Clean Transportation ## Footnote Issues involve extra transaction costs due to monitoring the effects, and lack of standardisation meaning chance of greenwashing.

Answer 40

Conventional debt instruments where funds raised are used to finance beneficial social objectives. Eg. Basic infrastructure, health services, affordable housing

Answer 41

Bonds where funds raised are used to finance a combination of beneficial social objectives and environmental objectives .

Answer 42

It looks at the RPI at (-3 months) date of coupon and RPI (-3 months) at date of issue and from this ratio the coupon/redemption of the index-linked bond is adjusted ## Footnote Eg. £2 coupon 1.04 index ratio £2 x 1.04 = £2.08 coupon to be paid

Answer 43

RPI on date of cash flow / RPI on date of issue ## Footnote Actual date is calculated from 3 months prior

Answer 44

Spreads are used as indicators of changes in risk sentiment - on the basis that the wider the spread becomes Vs the government bond yield, the greater perceived risk.

Answer 45

Clean price + (period coupon x days / days in period)

Answer 46

(Flat yield) + (profit/loss @ redemption/ years to redemption) / market price ##Footnote Eg 7%, 3yr bond, trading at £93 FY = 7/93 =0.0753 RY = (7/3) / 93 =0.0251 7.5% + 2.5% = 10% (if loss would have minus instead of plus)

Answer 47

Theory states investors prefer to hold money (keep liquidity) therefore the rate of interest is an incentive to part with their money ( reduce liquidity). ## Footnote Hence a standard upward yield curve explains longer maturity bonds offering higher yields

Answer 48

Yield curves vary according to investors expectations of future interest rates ## Footnote An upwards curve suggests investors expect rate rises so there is a demand for short-term bonds, pushing prices up and therefore yields low.

Answer 49

States that there are different categories of investor who are interested in different segments of maturity ## Footnote Pension funds/life assurance want long dated bonds, retail focuses on liquidity so want short dated. This can explain humped yield curves

Answer 50

Stock availability in certain maturity ranges could lean to an excess/ shortage of stock and consequently an irregular yield ## Footnote Quantitative Easing reduces long dates stock thus pushing prices up, and yields down

Answer 51

PV of future CF x n x (n+1) ————————————- Price (1+r)^2

Answer 52

It’s the rate of change of duration ## Footnote convexity correctly shows a curved relationship (rather than linear) between price and yield, which differs at the edges to Modified Duration - whereas MD becomes less accurate for larger interest rate moves.

Chapter 4 - Bonds Flashcards

(76 cards)