vocab

INTEREST RATE RISK
Click the card to flip 👆
1 / 43
Terms in this set (43)
INTEREST RATE RISK
the risk that rising interest rates will cause bond prices to fall. Long-term maturities, low coupon rate bonds and deep discount bonds are the most susceptible to this risk

MARKET RISK IS THAT INTEREST RATES WILL RISE FORCING BOND PRICES TO LOWER AND BE HARDER TO SELL

APPLIES ONLY TO FIXED RATE SECURITIES
PURCHASING POWER RISK
INFLATION RISK - its the risk that inflation will lower the value of bond interest payments and principal repayment thereby forcing prices to fall

TIPS protect against this
MARKETABILITY RISK
The risk that the security will be difficult to sell.

-issue size
-the number of traders in the market

virtually nonexistant for Treasury Bonds because the market is so large and liquid

major concern for Municipal Bonds
LIQUIDITY RISK
the risk that the security can only be sold by incurring large transaction costs.

generally, short term high quality issues are liquid

the longer the term the lower the quality and the lesser the liquidity
LEGISLATIVE RISK
the risk that the new laws reduce the value of a security such as a change in the tax laws increasing tax rates on interest received from debt investments
CALL RISK
the risk to bondholders that a bond may be called away from them before maturity, forcing reinvestment of the proceeds at a lower interest rate.
What bonds are most susceptible to call risk?
Call risks increase as interest rates fall - high coupon rates and low call premiums MOST likely to be called
What bonds are least susceptible to call risk?
bonds with low coupon rates and high call premiums.
REINVESTMENT RISK
the risk for a long-term bond investor that market interest rates are falling over that investment's time horizon - a bondholder receives semi-annual interest payments which must be "reinvested" in additional bond purchases to maintain the overall return on that bond portfolio.
What bond avoids reinvestment risk?
the only bond that avoids reinvestment risk is a zero-coupn bond
Risks of International Investing...exchange rate risk and political riskBONDa bond is a debt security which obligates the issuer to PAY INTEREST & REPAY THE PRINCIPAL when the debt matures Loan obligation of the ISSUER Issuer is borrowing capital (PRINCIPAL) that must be repaid with interest to the lender (aka investor)ISSUERSCorporations, U.S. Government, Agencies of the U.S. Government and Municipal GovernmentsSTATED INTEREST RATETypically paid semi-annually Interest paid based on par Also called a coupon, indicates the annualized rate of interest Periodic interest (usually ever 6 months) & Principal only (zero coupon bonds) Ex: 8% interest rate on $1,000 par value in 2021 M'41 8% = $80 of interest annually or $40 semi-annually to the bond holder for the next 20 years (2041-2021=20 years)REDEMPTIONAt maturity the $1000 principal amount must be repaid to the bondholder, the bond is redeemed by the issuer at parZERO-COUPON BONDA bond issued with a stated par value, usually $1000 minimum, but without a stated rate of interest, instead the bonds are purchased at a discount from par and are redeemed at maturity at par valueSERIAL BONDSA bond issue with differing maturities is a serial bond issue - different maturities require different interest rates, thus on serial bonds they differ for the bonds in the issues Most Municipal bond issues and Corporate Equipment Trust Certificates are serial bonds. Serial with "balloon payments" refers to a single larger than normal repayment of principal at one of the maturity dates - each maturity has a different interest rate on the bondSERIES BONDSA bond issue where the bonds have the same maturity but different dates of issuance is a series bond issue. -typically are used to finance long-term construction projects where all of the money is not needed at once -staggered issue dates with the entire offering maturing on the same dateMUNICIPAL SERIAL BONDSMunicipal bond issues are generally serial bonds, in a serial bond offering each maturity has a different interest rate, this means that each maturity has a different value and different market price. Quoted on a YIELD BASIS OR BASIS QUOTE 1 basis point = .01% on a bond 10 basis points =.1% 100 basis points = 1% When bonds are originally issued the interest rate placed on the bonds is set at the current market rate so that the issue will be priced at par, if market interest rates stay the same after the issuance date, the bonds will trade at par. COUPON / BASIS = YIELD BASIS EX: a municipal bond dealer quotes a 30 year 4% GO bond on a 5.00 basis, the approximate price of this bond is: 4% COUPON / 5% BASIS = 80% of $1000 Par = $800 IF THE BASIS IS HIGHER THAN THE COUPON THE BOND IS TRADING AT A DISCOUNT EX: a municipal bond dealer quotes a 30 year 6% GO bond on a 5.00 basis the approximate price of this bond is: 6% COUPON / 5% BASIS = 120% of $1,000 Par = $1,200 IF THE BASIS IS LOWER THAN THE COUPON THE BOND IS TRADING AT A PREMIUM.DISCOUNT BONDA bond sells at a discount when PAR is HIGHER than the bonds PURCHASE PRICE -ex: a $1000 par corporate bond quoted @ 90 is selling at DISCOUNT of 10 pts ($100) from par -PRICE BELOW PARPREMIUM BONDThere is an INVERSE relationship between the bonds price and market interest rates. If MARKET RATES are LOWER than the bond's COUPON RATE the PRICE INCREASES (more attractive to investors) WHEN INTEREST RATES FALL BOND PRICES RISE If MARKET RATES are HIGHER than the bond's COUPN RATE the PRICE DECLINES (less attractive to investors) WHEN INTEREST RATES RISE BOND PRICES FALLVOLATILITYLonger maturity the greater the volatility, shorter maturity the lower the volatility -LONG MATURITY BOND PRICES MOVE MORE RAPIDLY than do short maturity issues. -SHORT MATURITY BOND PRICES MOVE LESS RAPIDLY than do lonf maturity issues. -LOW COUPON (DISCOUNT) BOND PRICES MOVE MORE RAPIDLY than do high coupon (premium) bond prices. -HIGH COUPON (PREMIUM) BOND PRICES MOVE LESS RAPIDLY than do low coupon (discount) bond prices. -LONG TERM ZERO-COUPON ISSUES ARE THE MOST VOLATILE% OF DOWNWARD PRICE MOVEMENT WHEN INTEREST RATES MOVE UP (HIGHEST TO LOWEST)-Large Discount Bond (lowest coupon & greatest % movement) -Small Discount Bond -Par Bond -Small Premium Bond -Large Premium Bond (highest coupon % lowest % movement)DURATIONA formalized measure of bond price volatility is called duration - the longer the maturity & the lower the coupon the greater the duration -zero-coupon bond duration is the time to maturityNOMINAL YIELDThe stated rate of interest on the bond or NY = ANNUAL INCOME / PARCURRENT YIELDRate of return for that coupon based on the current price of the bond in the market place, CY = ANNUAL INCOME / CURRENT MARKET VALUEYIELD TO MATURITY (DISCOUNT)YTM = ANNUAL INCOME + ANNUAL CAPITAL GAIN / (PURCHASE PRICE + REDEMPTION PRICE)/2 -example: a discount price of 90% of $1,000 par, or $900, the bond will mature @ par in 10 years. The discount of $100 is being earned over 10 years so each $10 of the discount is earned (aka ANNUAL ACCRETION OF THE BOND DISCOUNT) $100 + $10 ($100/10 years= $10) / ($900 + $1,000)/2 --> $110 / $950 = 11.58%YIELD TO MATURITY (PREMIUM)TM = ANNUAL INCOME - ANNUAL CAPITAL LOSS / (PURCHASE PRICE + REDEMPTION PRICE)/2DISCOUNT BOND YIELD ORDERNOMINAL, CURRENT YIELD, YTM (BASIS) --> YTC > YTMPREMIUM BOND YIELD ORDERYTM (BASIS), CURRENT YIELD, NOMINAL YIELD --> YTC < YTMCALLWhen a bond is callable the issuer has the right to redeem (to "call in") the bond at a predetermined price at a date prior to maturity -CALLS OCCUR WHEN INTEREST RATES DROP subsequent to the bond's issuance - the cost the issuer for doing this is the call premium The issuer can then sell the bonds to replace the old at a lower interest rate CALL PRICE SETS CEILING ON MARKET PRICE Zero-coupon bonds callable at accreted value plus call premium (PURCHASE PRICE + COMPOUNDED GROWTH TO DATE)PUTThis gives the investor the right to tender the bond (they can "put" the bond) to the issuer after a specified date for a bond contract - the price is usually par -PUT/TENDER OPTION GIVEN TO BONDHOLDER WHEN INTEREST RATES ARE LOW AND EXERCISED WHEN INTEREST RATES RISE PUT PRICE SETS FLOOR ON MARKET PRICEWIDENING YIELD SPREADINDICATES COMING RESESSION - typically investors will sell corporate bonds (raising yields) and buy government bonds (lowering yields). WIDENINDENTUREBonds are issued under a bond contract called an indenture, spells out the interest rate, maturity, collateral, call /put provisions, and all other relevant features of the bonds - may also call for the corporation to maintain specific protections for bondholders such as: insurance coverage, audit by an independent accountant, and certain ratios of assets to liabilities.TRUST INDENTURETo insure the corporation adheres to the indenture, an independent trustee is appointed to monitor compliance with the provisions of the indenture - the trustee reports annually to the bondholders and is expected to inform the bondholders if he finds non-compliance TRUSTEE IS USUALLY A COMMERCIAL BANKFUNDED DEBTLong-term corporate debt is referred to as "funded" debt since the issuer has use of the funds for a long time period before repayment is dueSECURED CORPORATE DEBTSpecific collateral is pledged to back the bond issue, if the corporation defaults the bondholders have claim to the collateral, because of the extra protection afforded by the collateral secured bonds can be sold at lower interest rates long-term maturities these bonds are: -MORTGAGE BOND/ LIEN ON REAL ASSETS -OPEN END/ADDITIONAL BONDS TEST -CLOSED-END, SENIOR/JUNIOR LIEN -MORTGAGE BONDS ISSUED BY UTILITIES -MOST UTILITY FINANCING COMES FROM MORTGAGE BONDS -EQUIPMENT TRUST CERTIFICATES -SERIAL ISSUES -COLLATERAL TRUST CERTIFICATEMORTGAGE BOND/LIEN ON REAL ASSETSReal estate such as a factory is pledged as collateral for the bond issue, the bondholder has a LIEN ON the REAL ESTATE. Meaning the bondholder has the legal right to sell the mortgaged property if the bondholders' claims are not satisfiedOPEN END / ADDITIONAL BONDS TESTIf the trust indenture is open-end the corporation can sell additional bonds having equal status against the real estate, typically include an additional bonds test requirement that must be met before new bonds may be soldCLOSED-ENDIf the trust indenture is closed-end, new bonds can be issued against the real estate only if they are junior (have lower status in a liquidation) to existing bonds.MORTGAGE BONDS ISSUED BY UTILITIESMortgages are the most common form of corporate debt, and are the principal financing source for public utilities. These issues generally get high credit ratings due mainly to the quality of the collateral backing the issue and can be sold at lower interest rates than unsecured debt. -MOST UTILITY FINANCING COMES FROM MORTGAGE BONDSEQUIPMENT TRUST CERTIFICATESCommonly issues by transportation companies, ETCs are equipment owned by the corporation that is pledged as collateral this is the typical form of financing for common carries such as airlines, trucking companies and railroads. (For example, United Airlines ETCs use planes as collateral) -issued in serial form, which obligate the issuer to repay a portion of principal each year until the bonds retired, if the issuer defaults the equipment can be easily sold to repay the bondholders.COLLATERAL TRUST CERTIFICATEA portfolio of marketable securities is placed in trust as collateral