Question 1

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

The coupon rate on new bonds is typically set equal to the required rate on bonds of equal risk in order to be competitive with other similar investments in the market. The issuing firm is the one selling the bonds in order to raise capital.

Question 2

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 a higher risk of not receiving interest payments compared to regular bonds, where interest payments are more assured.

Question 3

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 4

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 bond is selling at a discount ($800 instead of $1,000), so the yield to maturity is higher than the coupon rate. If the required return on bonds with this risk is 12%, and the bond pays a 10% coupon rate, then the yield to maturity must be greater than 12%. This means that the bond is undervalued and offers a higher return than what the investor requires, making it a good investment at the current price.

Question 5

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 provide a relatively larger fixed income stream, which reduces the bond's duration and sensitivity to changes in interest rates. In contrast, low-coupon bonds have a larger duration and are therefore more sensitive to interest rate changes.

Question 6

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 often used for such purposes.

Question 7

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

Both bonds have the same duration to maturity (1 year left), which means their price sensitivity to interest rate changes is similar, regardless of their original maturity lengths.

Question 8

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 because they do not have to worry about the potential negative impact on their debt values caused by rising interest rates. It also allows them to take advantage of lower interest rates if the rates fall, potentially resulting in a lower cost of borrowing.

Question 9

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. Bonds with higher credit ratings are considered less risky and therefore require a lower rate of return compared to bonds with lower credit ratings, which are considered more risky and require a higher rate of return.

Question 10

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

The bond's coupon rate is 10% ($100 annual interest on a $1,000 par value). If market interest rates are below 10%, the bond offers a higher return than current market rates, making it more valuable and causing it to sell at a premium. Conversely, if market rates are above 10%, the bond's return is less attractive, leading it to sell at a discount.

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 discounted cash flow analysis, which is commonly used to value assets in finance and investing.

Question 12

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

As the bond prices are equal and the yield curve is upward sloping, the bond with the sinking fund would have a lower yield compared to the bond without the sinking fund. Therefore, Bond NSF would generally be expected to have a higher yield than Bond SF. Thus, the prices being equal could be in equilibrium.

Question 13

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 generally true as longer-term bonds have more uncertainty and are subject to more inflation risk, credit risk, and interest rate risk, which makes them more sensitive to changes in interest rates than shorter-term bonds.

Question 14

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 are secured by specific assets such as property, whereas debentures are unsecured and therefore perceived as riskier by investors. Therefore, to compensate for this perceived higher risk, companies typically offer higher interest rates on debentures compared to mortgage bonds.

Question 15

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 indeed included in bond indentures to protect bondholders by limiting the discretion of managers, ensuring that the company continues to meet its obligations to bondholders.

Question 16

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

Long-term bonds are generally more sensitive to interest rate changes than short-term bonds, meaning their prices are more volatile in response to interest rate fluctuations.

Question 17

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

This statement is true. Sinking funds are provisions included in bond indentures that require companies to retire bonds on a scheduled basis prior to their final maturity. Companies can acquire bonds for sinking fund purposes by either purchasing bonds on the open market at the going market price or 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.

Question 18

If the required rate of return on a bond (r_d)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

When the required rate of return on a bond is greater than its coupon interest rate, the bond is considered to be trading at a discount. As interest rates remain above the coupon rate, investors have less demand for the bond, causing the market value to remain below the par value. However, at maturity, the bond will be redeemed at its par value, regardless of its market value.

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

A call provision gives the issuer of the bond the right to repay the bond before its maturity date, typically when interest rates decline, allowing them to refinance at a lower rate. Bondholders do not have the right to demand repayment; this right belongs to the issuer.

Question 20

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

A zero coupon bond does not pay interest (true), but it is sold at a deep discount to its face value rather than at par. The investor's compensation comes from the difference between the purchase price and the face value at maturity, which represents the capital appreciation.

Quiz 8: Bonds and Their Valuation