Question 1

As a general rule, a company's debentures have higher required interest rates than its mortgage bonds because mortgage bonds are backed by specific assets while debentures are unsecured.

Accepted Answer

This is because mortgage bonds have collateral backing them up, which reduces the risk for investors. Debentures do not have this collateral, making them a higher risk for investors and thus requiring a higher interest rate.

Question 2

You are considering 2 bonds that will be issued tomorrow. Both are rated triple B (BBB, the lowest investment- grade rating), both mature in 20 years, both have a 10% coupon, neither can be called except for sinking fund purposes, and both are offered to you at their $1,000 par values. However, Bond SF has a sinking fund while Bond NSF does not. Under the sinking fund, the company must call and pay off 5% of the bonds at par each year. The yield curve at the time is upward sloping. The bond's prices, being equal, are probably not in equilibrium, as Bond SF, which has the sinking fund, would generally be expected to have a higher yield than Bond NSF.

Accepted Answer

The statement at the end is incorrect. Bond SF, which has the sinking fund, would generally be expected to have a lower yield than Bond NSF. This is because the sinking fund reduces the risk of default by ensuring that a portion of the bonds will be paid off each year, making the remaining bonds less risky. As a result, investors are willing to accept a lower yield on Bond SF. Therefore, Bond NSF may have a higher yield.

Question 3

Floating-rate debt is advantageous to investors because the interest rate moves up if market rates rise. Since floating-rate debt shifts price risk to companies, it offers no advantages to corporate issuers.

Accepted Answer

Floating-rate debt offers advantages to corporate issuers as well because they can avoid locking in a fixed rate and may enjoy lower borrowing costs as investors are willing to accept lower yields for the flexibility of a floating rate. Additionally, floating-rate debt may be easier to sell to investors during times of rising interest rates.

Question 4

Because short-term interest rates are much more volatile than long-term rates, you would, in the real world, generally be subject to much more price risk if you purchased a 30-day bond than if you bought a 30-year bond.

Accepted Answer

The answer of Because short-term interest rates are much more...

Question 5

If the required rate of return on a bond (rd) is greater than its coupon interest rate and will remain above that rate, then the market value of the bond will always be below its par value until the bond matures, at which time its market value will equal its par value. (Accrued interest between interest payment dates should not be considered when answering this question.)

Accepted Answer

This is because investors will only be willing to purchase the bond at a discount to compensate for the lower interest payments. As time passes and the bond approaches maturity, the discount narrows until it reaches zero at maturity, when the bond's market value equals its par value.

Question 6

If a firm raises capital by selling new bonds, it could be called the "issuing firm," and the coupon rate is generally set equal to the required rate on bonds of equal risk.

Accepted Answer

This is generally true as the coupon rate is the interest rate that the issuing firm promises to pay to the bondholders, and it is typically set to be equal to the required rate of return on bonds of similar risk in the market.

Question 7

Restrictive covenants are designed primarily to protect bondholders by constraining the actions of managers. Such covenants are spelled out in bond indentures.

Accepted Answer

Restrictive covenants are included in bond indentures in order to protect bondholders by limiting the actions of managers.

Question 8

A bond has a $1,000 par value, makes annual interest payments of $100, has 5 years to maturity, cannot be called, and is not expected to default. The bond should sell at a premium if market interest rates are below 10% and at a discount if interest rates are greater than 10%.

Accepted Answer

This is because the bond's fixed interest payment of $100 is more valuable when market interest rates are lower, making the bond more attractive to investors than newly issued bonds that have a lower interest rate. As demand for the bond increases, its price will rise, causing it to sell at a premium above its par value. Conversely, when market interest rates are higher than the bond's interest rate of $100, investors will be less interested in the bond, and it will sell at a discount below its par value.

Question 9

Junk bonds are high-risk, high-yield debt instruments. They are often used to finance leveraged buyouts and mergers, and to provide financing to companies of questionable financial strength.

Accepted Answer

Junk bonds are indeed high-risk, high-yield debt instruments that are commonly used for financing leveraged buyouts and mergers, as well as providing funding to companies with weaker financial positions.

Question 10

The prices of high-coupon bonds tend to be less sensitive to a given change in interest rates than low-coupon bonds, other things held constant.

Accepted Answer

This is because high-coupon bonds pay a higher interest rate, so they provide a greater stream of cash flows. Therefore, investors are willing to pay more for them and their prices are less sensitive to changes in interest rates. On the other hand, low-coupon bonds provide a lower stream of cash flows and are more sensitive to interest rate changes.

Question 11

The market value of any real or financial asset, including stocks, bonds, or art work purchased in hope of selling it at a profit, may be estimated by determining future cash flows and then discounting them back to the present.

Accepted Answer

This is the basic principle of asset valuation, commonly known as the discounted cash flow (DCF) method. By estimating expected future cash flows, accounting for risk and uncertainty, and then discounting them back to their present value using an appropriate discount rate, investors can determine the current fair value of an asset.

Question 12

The price sensitivity of a bond to a given change in interest rates is generally greater the longer the bond's remaining maturity.

Accepted Answer

This is because longer-term bonds have more future cash flows that are subject to interest rate risk, making them more sensitive to changes in interest rates. Shorter-term bonds have fewer future cash flows and therefore are less sensitive to interest rate changes.

Question 13

The desire for floating-rate bonds, and consequently their increased usage, arose out of the experience of the early 1980s, when inflation pushed interest rates up to very high levels and thus caused sharp declines in the prices of outstanding bonds.

Accepted Answer

The statement accurately describes the historical context that led to the increased usage of floating-rate bonds.

Question 14

Sinking funds are provisions included in bond indentures that require companies to retire bonds on a scheduled basis prior to their final maturity. Many indentures allow the company to acquire bonds for sinking fund purposes by either (1) purchasing bonds on the open market at the going market price or (2) selecting the bonds to be called by a lottery administered by the trustee, in which case the price paid is the bond's face value.

Accepted Answer

Sinking funds are provisions included in bond indentures that require companies to retire bonds on a scheduled basis prior to their final maturity, as well as the methods for acquiring bonds for this purpose.

Question 15

A bond that had a 20-year original maturity with 1 year left to maturity has more price risk than a 10-year original maturity bond with 1 year left to maturity. (Assume that the bonds have equal default risk and equal coupon rates, and they cannot be called.)

Accepted Answer

The answer of A bond that had a 20-year original...

Question 16

There is an inverse relationship between bonds' quality ratings and their required rates of return. Thus, the required return is lowest for AAA-rated bonds, and required returns increase as the ratings get lower.

Accepted Answer

This statement is true. Higher rated bonds are considered less risky, so investors require a lower rate of return. On the other hand, lower rated bonds are considered riskier and thus require a higher rate of return to compensate investors for the added risk.

Question 17

A zero coupon bond is a bond that pays no interest and is offered (and initially sells) at par. These bonds provide compensation to investors in the form of capital appreciation.

Accepted Answer

The answer of A zero coupon bond is a bond...

Question 18

Income bonds pay interest only if the issuing company actually earns the indicated interest. Thus, these securities cannot bankrupt a company, and this makes them safer from an investor's perspective than regular bonds.

Accepted Answer

Income bonds pay interest only if the issuing company earns enough profit, which might make them seem safer for the company but not necessarily for the investor. Investors face higher risk since they might not receive interest payments if the company doesn't perform well. Regular bonds obligate the company to make interest payments regardless of its financial state, providing more predictable income for investors.

Question 19

A call provision gives bondholders the right to demand, or "call for," repayment of a bond. Typically, companies call bonds if interest rates rise and do not call them if interest rates decline.

Accepted Answer

The answer of A call provision gives bondholders the right...

Question 20

You have funds that you want to invest in bonds, and you just noticed in the financial pages of the local newspaper that you can buy a $1,000 par value bond for $800. The coupon rate is 10% (with annual payments), and there are 10 years before the bond will mature and pay off its $1,000 par value. You should buy the bond if your required return on bonds with this risk is 12%.

Accepted Answer

The current market price of the bond is $800, which is lower than its par value. This means that the bond is selling at a discount. Since the bond has a coupon rate of 10%, it will provide an annual interest income of $100 (=$1,000 x 10%) until it matures. If the bond is purchased at $800, the yield to maturity (YTM) will be higher than the coupon rate. In this case, the YTM can be calculated using a financial calculator or Excel. Alternatively, the YTM can be estimated by trial and error method. By assuming different interest rates, the present value of the bond can be calculated, and the rate that makes the present value equal to $800 can be considered as the YTM. For example, if the YTM is 12%, the present value of the bond will be $800.34, which is close to the market price. Therefore, the bond is undervalued and should be bought, as the required return on bonds with this risk is 12%.

Quiz 7: Bonds and Their Valuation