Question 1

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 statement is true as the bond's coupon interest rate is fixed and cannot change, whereas the required rate of return on the bond may change depending on market conditions. If the required rate of return is greater than the coupon rate, investors will demand a lower market price for the bond in order to achieve a higher yield. However, as the bond approaches maturity, its market value will converge towards its par value, as there is less uncertainty about future interest rates and the return of principal.

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 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 3

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 interest rates are below 10% and at a discount if interest rates are greater than 10%.

Accepted Answer

This is because if interest rates are below 10%, the bond's fixed annual interest payment of $100 will be relatively more attractive compared to the interest payments offered by newly issued bonds in the market, which would have lower interest payments. Therefore, investors would be willing to pay more than the bond's par value to purchase it, creating a premium. On the other hand, if interest rates are greater than 10%, the bond's fixed annual interest payment of $100 would be relatively less attractive compared to newly issued bonds in the market, which would have higher interest payments. Therefore, investors would demand a discount to purchase the bond instead, bringing its price below the par value.

Question 4

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 reflects the origin of the increased usage of floating-rate bonds.

Question 5

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 being sold at a discount, which means that the yield to maturity is higher than the coupon rate. If the required return on bonds with this risk is 12%, and the bond's yield to maturity is higher than 12%, then buying the bond at a discount would result in a higher rate of return than the required return, making it a good investment. In this case, the bond's yield to maturity is approximately 14.5%, which is higher than the required return of 12%, so buying the bond would be a good investment.

Question 6

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

Accepted Answer

This statement is false. Floating-rate debt offers advantages to issuers as well, such as the ability to borrow at lower initial rates and the flexibility to refinance at lower rates if market rates fall. Additionally, floating-rate debt may be more attractive to investors in certain market conditions, leading to increased demand for the issuer's debt.

Question 7

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 bond's prices being equal, Bond SF would actually be expected to have a lower yield than Bond NSF due to the added security of the sinking fund. Therefore, the prices are likely in equilibrium.

Question 8

Other things equal, a firm will have to pay a higher coupon rate on its subordinated debentures than on its second mortgage bonds.

Accepted Answer

Subordinated debentures are lower in priority than second mortgage bonds in terms of repayment in case of bankruptcy or default, which makes them more risky for investors. To compensate for this higher risk, the firm will have to offer a higher coupon rate on its subordinated debentures compared to its second mortgage bonds.

Question 9

A bond that is callable has a chance of being retired earlier than its stated term to maturity. Therefore, if the yield curve is upward sloping, an outstanding callable bond should have a lower yield to maturity than an otherwise identical noncallable bond.

Accepted Answer

Callable bonds typically offer a higher yield to maturity compared to noncallable bonds to compensate investors for the risk of the bond being called away before maturity, especially in an environment where the yield curve is upward sloping.

Question 10

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

Accepted Answer

This statement is true. The coupon rate on new bonds issued by a firm is typically set based on the current market interest rates for bonds with similar risk characteristics. This ensures that the bonds are appropriately priced and competitive with other similar investments.

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 statement is true. The concept of determining the value of an asset based on future cash flows and discounting them back to the present is called discounted cash flow (DCF) analysis and is a commonly used valuation method in finance.

Question 12

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 statement is true as debentures do not have specific assets backing them, making them riskier for investors. Therefore, they typically offer higher interest rates than mortgage bonds, which have specific assets (such as real estate) backing them.

Question 13

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 interest rate 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 that their prices are more volatile in response to interest rate fluctuations. This is because the present value of the bond's future cash flows is more affected by changes in interest rates when those cash flows are further in the future.

Question 14

A bond that had a 20-year original maturity with 1 year left to maturity has more interest rate 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), so their interest rate price risk is essentially the same, regardless of their original maturity lengths.

Question 15

Sinking funds are devices used to force companies to retire bonds on a scheduled basis prior to their maturity. Many bond indentures allow the company to acquire bonds for a sinking fund by either purchasing bonds in the market or selecting the bonds to be acquired by a lottery administered by the trustee through a call at face value.

Accepted Answer

This statement accurately describes sinking funds and how they work.

Question 16

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

Accepted Answer

A zero coupon bond is a bond that pays no interest but is sold at a deep discount to its face value, providing compensation to investors through capital appreciation, not at par.

Question 17

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

This is a correct statement about junk bonds.

Question 18

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 quality bonds are perceived as less risky, so investors are willing to accept a lower return, while lower quality bonds are perceived as riskier, so investors demand a higher return to compensate for the additional risk.

Question 19

For bonds, price sensitivity to a given change in interest rates is generally greater the longer before the bond matures.

Accepted Answer

This is called duration risk, meaning that as the time to maturity increases, the bond's price will be more sensitive to changes in interest rates.

Question 20

A call provision gives bondholders the right to demand, or "call for," repayment of a bond. Typically, calls are exercised if interest rates rise, because when rates rise the bondholder can get the principal amount back and reinvest it elsewhere at higher rates.

Accepted Answer

A call provision gives the issuer of the bond the right, not the bondholder, to repay the bond before its maturity date, typically when interest rates fall, allowing the issuer to refinance at a lower cost.

Quiz 5: Bonds, Bond Valuation, and Interest Rates