Question 1

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 coupon rate (annual interest payment divided by par value) is 10%, which is higher than the market interest rate if it is below 10%. Therefore, investors will be willing to pay more than the par value for this bond, resulting in a premium. On the other hand, if market interest rates are greater than 10%, the bond's coupon rate becomes less attractive, and investors will demand a discount to compensate for the lower market rates.

Question 2

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 3

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 because higher quality bonds are considered less risky, so investors are willing to accept lower rates of return. As bond ratings decrease, the perceived risk increases, and investors require higher returns to compensate for that risk.

Question 4

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 out more in interest payments, so investors are less likely to sell them in response to a decrease in interest rates. Therefore, their prices are less sensitive to changes in interest rates compared to low-coupon bonds.

Question 5

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 high levels and thus caused sharp declines in the prices of outstanding bonds.

Accepted Answer

This statement accurately reflects the history and development of floating-rate bonds.

Question 6

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 require companies to retire bonds on a scheduled basis prior to their final maturity, and many indentures allow the company to acquire bonds for sinking fund purposes through the methods stated above.

Question 7

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 corporate issuers.

Accepted Answer

This statement is false. Floating-rate debt can offer advantages to corporate issuers. It can provide them with more flexibility in managing their debt and can also potentially lower their borrowing costs compared to fixed-rate debt. Additionally, for companies operating in volatile industries or with uncertain cash flows, floating-rate debt can help mitigate interest rate risk.

Question 8

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 9

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. The coupon rate is set based on the required rate of return for bonds with similar risk characteristics, in order to make the bonds attractive to investors.

Question 10

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 considered high-risk because they are issued by companies with weaker credit ratings, but they offer higher yields to compensate for that risk. They are often used to finance leveraged buyouts and mergers, and to provide financing to companies that may not be able to secure funding through traditional means.

Question 11

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 discounted price of the bond is $800, and the face value (or par value) of the bond is $1,000. This means that the bond is selling at a discount, which is attractive to investors. Additionally, the coupon rate of 10% means that the bond will pay $100 per year in interest (10% of the $1,000 face value).

To determine whether the bond is a good investment at a required return of 12%, we need to calculate the bond's yield to maturity (YTM). The YTM is the rate of return that an investor would earn if they held the bond until maturity and received all the promised interest payments and the face value payment.

Using a financial calculator or spreadsheet, we can calculate the YTM of the bond based on its current price, coupon rate, and time to maturity. The YTM of the bond turns out to be approximately 13.4%.

Since the YTM of the bond is higher than the required return of 12%, this means that the bond is offering a higher return than what the investor requires for this level of risk. Therefore, it would be a good investment to buy the bond at the discounted price of $800, and hold it until maturity to receive the full face value payment of $1,000.

Question 12

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 designed to protect bondholders by restricting the actions of managers. These covenants are included in bond indentures to ensure that the company does not make decisions or take actions that could negatively impact the bondholders' investments.

Question 13

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 is incorrect as the sinking fund would generally be expected to result in a lower yield compared to a similar bond without a sinking fund. This is because the sinking fund reduces the company's default risk, making the bond a safer investment, and therefore, the market would demand a lower yield for such a bond.

Question 14

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 15

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 concept of valuation in finance. By estimating future cash flows and adjusting for factors such as risk and time, the present value of an asset can be calculated.

Question 16

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 17

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

Debentures are unsecured bonds that do not have a specific asset or collateral backing them up, so they have a higher risk of default compared to mortgage bonds which are secured by an asset or property. Hence, to compensate for this higher risk, debentures usually have a higher interest rate compared to mortgage bonds.

Question 18

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

When the required rate of return on a bond is greater than its coupon interest rate, investors will require a discount on the bond's price to compensate for the lower interest payments. This will result in the market value of the bond being below its par value until the bond matures, at which point it will be redeemed for the par value.

Question 19

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 the longer the bond's remaining maturity, the more opportunities there are for the interest rates to change, which affects the present value of the future cash flows. In contrast, short-term bonds have fewer remaining payments and are less affected by interest rate changes.

Question 20

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.

Quiz 7: Bonds and Their Valuation