D. could be any of these.
AACSB: Reflective Thinking Skills Bloom's: Understanding Difficulty: Hard Learning Objective: 6-2
Essay Questions
103. Describe the process for calculating a yield to maturity for a bond, and tell what could cause the yield to maturity to change.
The yield to maturity for a bond is calculated by finding that discount rate that equates the present value of the bond's payments to the bond's price. Because the bond's payments are fixed, the yield to maturity will change only with changes in interest rates that affect the price of the bond. When the bond is priced at par value, its yield to maturity is equal to its coupon rate and also to the current yield. When the bond is priced above par, yield to maturity is less than the coupon rate, and when the bond is priced below par, the yield to maturity is greater than the coupon rate. It is important to realize that although interest rates may change, the yield to maturity is set at the time of purchase for any investor who holds the bond until maturity (ignoring the possibility of default). Thus, while interest rates may change, it does not affect the yield to maturity for an investor that does not sell the bond prior to maturity. Difficulty: Medium
AACSB: Reflective Thinking Skills Bloom's: Understanding Learning Objective: 6-2
104. Determine the current yield, yield to maturity, and price of the following bond as of the date of purchase and on each anniversary date of its purchase until maturity: three-year bond with a 12% coupon and a purchase price of $1,100.
AACSB: Analytical Skills Bloom's: Evaluation Difficulty: Medium Learning Objective: 6-2
105. Compare the price sensitivity to changes in interest rates for the following bonds: A five- year and a ten-year bond, both with a 7% coupon. Both bonds currently sell at par. How much will the price of each bond change if interest rates increase to 8%? Why is there a difference in the price change?
The five-year bond decreases $39.27 while the 10-year bond decreases $67.10. This illustrates that longer-term bonds display more interest rate risk.
AACSB: Analytical Skills Bloom's: Evaluation Difficulty: Medium Learning Objective: 6-3
106. Why are long-term bonds more sensitive to changes in interest rates than short-term bonds?
A long-term bond is more sensitive to changes in interest rates simply because there are more coupon payments and longer time periods for each cash flow to be affected by the changed interest rate. Remembering that bond prices are determined by the sum of a present value of an annuity and the present value of a future amount, when those formulas experience different discount rates for longer periods, there is substantially more effect.
AACSB: Analytical Skills Bloom's: Analysis Difficulty: Medium Learning Objective: 6-3
107. Explain why it is the case that bond prices fluctuate in response to changing interest rates. What adverse effect might occur if bond prices remain fixed prior to their maturity? Bonds are long-term debt instruments that are issued with fixed coupon interest rates. At the time of issue, it is likely that the coupon rate was approximately equal to the expected interest rate for a bond of this rating. However, as interest rates change during the period prior to maturity, investors may be unwilling to purchase the bond in the secondary market unless its price changes such that the investor can obtain a then-current yield to maturity on the
investment. Thus, if bond prices were fixed, there may not be any opportunities for sale of the bond prior to maturity and investors would be required to make long-term, potentially
disadvantageous investment decisions.
AACSB: Analytical Skills Bloom's: Analysis Difficulty: Medium Learning Objective: 6-3
108. Describe the shape of the current yield curve. Would you consider that to be fairly typical?
This question can provide a good introduction to the topic for instructors who have discussed the current economic environment. The important facet will be for students to recognize that upward-sloping yield curves are more common than downward sloping curves.
AACSB: Reflective Thinking Skills Bloom's: Understanding Difficulty: Medium Learning Objective: 6-2
109. Explain why bond investors may be interested in TIPS rather than traditional bonds. Why have TIPS not been popular lately?
Treasury Inflation-Indexed Securities will be welcomed instruments by bond investors who wish to feel protected in their real rate of return. TIPS will lock in a real rate of return so that the purchasing power of bond investors can be maintained. Additionally, there is somewhat less price volatility in these bonds than in traditional bonds, which could prove to be an additionally welcome feature to investors who are experiencing volatility in other market segments. Since we have been in a low-inflation economic environment recently, TIPS have not received the popularity that they deserve in an inflationary economy.
AACSB: Analytical Skills Bloom's: Analysis Difficulty: Medium Learning Objective: 6-3
110. What is meant by "default risk" in bonds, and how do investors respond to it?
Default risk refers to the probability of default by bond issuers. In the case of default, cash payments to bond investors may be delayed or omitted. Thus, investors walk a tightrope between wanting to receive as much yield as possible while still willing to bear the possibility of default. Rating agencies such as Standard & Poor's or Moody's evaluate the
creditworthiness of bond issuers, and offer ratings of each issue. The lower the rating, the higher the likelihood of default and, therefore, the more of a default premium will be demanded by investors. Although bond ratings can change dramatically, it is often a case of gradual change such that investors have the opportunity of being forewarned.
AACSB: Reflective Thinking Skills Bloom's: Understanding Difficulty: Medium Learning Objective: 6-4
111. Why should many investors be cautious when relying on yield to maturity? Is it a convenient measure of rate of return for investors who might not hold their bonds to maturity?
Yield to maturity is an extremely popular metric and is highly quoted among investors and analysts. However, many bond investors do not intend or, even if they do intend, will not be able, to hold their bonds until maturity. In this case it is worthwhile to remember that a yield to maturity is promised only if: a) the bond is held until maturity, and b) the issuer does not default. Many investors might be better off in calculating or forecasting a total return based upon the time period they expect to hold the bond. While this calculation is obviously made with risk, it reminds investors that bond prices can change dramatically and, if you need to raise cash quickly, the once-calculated yields to maturity can be long forgotten.
AACSB: Analytical Skills Bloom's: Analysis Difficulty: Medium Learning Objective: 6-2
112. Why might a bond's current yield offer an incomplete idea of what return the investor is receiving?
The current yield is only synonymous with yield to maturity in the coincidence that the bond price is selling at par. Therefore, capital gains and capital losses are a critical part of bond investors' analysis. A high current yield can draw suspicions that capital losses will be posted during the year. Unexpected changes in interest rates can render current yields to be of much less significance next to changes in the price of the investment itself.
AACSB: Analytical Skills Bloom's: Analysis Difficulty: Medium Learning Objective: 6-2
113. What are some new types of bonds? List and describe at least two of them.
Bond issuers are always trying to invent new types of bond that they hope will appeal to a particular clientele of investors. So, in addition to these fairly common types of bond, you may also encounter some more peculiar beasts. Here are a couple examples.
Managers of insurance companies constantly worry about the possibility of a major hurricane or earthquake that could prompt a flood of costly claims. Some companies therefore shed part of the risk by issuing catastrophe (or Cat) bonds. Cat bonds promise relatively high returns, but the payments on the bond are reduced if a specified type of disaster occurs. Therefore the bondholders help to provide insurance against catastrophes.
Most of us hope for a long life. But longevity can create a problem for pension funds that are committed to paying out a regular sum each year until we die. Therefore, pension funds might value an opportunity to protect themselves against an increase in life expectancy. That is the idea behind the longevity bond issued by a French bank in 2004. Each year payments on the bond are higher if more of the population survive the extra year. If life expectancy increases, a pension fund may have to pay out for longer than it planned. But, if it also owned a longevity bond, it would have the consolation of a boost to its investment income.
Cat bonds are fairly rare and longevity bonds even rarer; most corporate bonds are of the common or garden variety. But bond issuers are always on the lookout for innovative forms of debt that they hope will attract investors.
AACSB: Communication Abilities Bloom's: Knowledge
Difficulty: Medium Learning Objective: 6-1
114. What are catastrophe (or Cat) bonds?
Managers of insurance companies constantly worry about the possibility of a major hurricane or earthquake that could prompt a flood of costly claims. Some companies therefore shed part of the risk by issuing catastrophe (or Cat) bonds. Cat bonds promise relatively high returns, but the payments on the bond are reduced if a specified type of disaster occurs. Therefore the bondholders help to provide insurance against catastrophes.
115. What is a longevity bond? Should a pension fund invest in such bonds?
Most of us hope for a long life. But longevity can create a problem for pension funds that are committed to paying out a regular sum each year until we die. Therefore, pension funds might value an opportunity to protect themselves against an increase in life expectancy. That is the idea behind the longevity bond issued by a French bank in 2004. Each year payments on the bond are higher if more of the population survive the extra year. If life expectancy increases, a pension fund may have to pay out for longer than it planned. But, if it also owned a longevity bond, it would have the consolation of a boost to its investment income.
AACSB: Reflective Thinking Skills Bloom's: Understanding Difficulty: Medium Learning Objective: 6-1
116. What are the differences between the bond's coupon rate, current yield, and yield to maturity?
A bond is a long-term debt of a government or corporation. When you own a bond, you receive a fixed interest payment each year until the bond matures. This payment is known as the coupon. The coupon rate is the annual coupon payment expressed as a fraction of the bond's face value. At maturity the bond's face value is repaid. In the United States most bonds have a face value of $1,000. The current yield is the annual coupon payment expressed as a fraction of the bond's price. The yield to maturity measures the average rate of return to an investor who purchases the bond and holds it until maturity, accounting for coupon income as well as the difference between purchase price and face value.
AACSB: Reflective Thinking Skills Bloom's: Understanding Difficulty: Medium Learning Objective: 6-1
117. How can one find the market price of a bond given its yield to maturity and find a bond's yield given its price? Why do prices and yields vary inversely?
Bonds are valued by discounting the coupon payments and the final repayment by the yield to maturity on comparable bonds. The bond payments discounted at the bond's yield to maturity equal the bond price. You may also start with the bond price and ask what interest rate the bond offers. The interest rate that equates the present value of bond payments to the bond price is the yield to maturity. Because present values are lower when discount rates are higher, price and yield to maturity vary inversely.
AACSB: Analytical Skills Bloom's: Analysis Difficulty: Medium Learning Objective: 6-2
118. Why do bonds exhibit interest rate risk?
Bond prices are subject to interest rate risk, rising when market interest rates fall and falling when market rates rise. Long-term bonds exhibit greater interest rate risk than short-term bonds.
AACSB: Reflective Thinking Skills Bloom's: Understanding Difficulty: Medium Learning Objective: 6-3
119. Why do investors pay attention to bond ratings and demand a higher interest rate for bonds with low ratings?
Investors demand higher promised yields if there is a high probability that the borrower will run into trouble and default. Credit risk implies that the promised yield to maturity on the bond is higher than the expected yield. The additional yield investors require for bearing credit risk is called the default premium. Bond ratings measure the bond's credit risk.
120. Why might have caused investors to rationally stay away from long-term bonds even when the yield curve is upward-sloping?
Even when the yield curve is upward-sloping, investors might rationally stay away from long-term bonds for two reasons. First, the prices of long-term bonds fluctuate much more than prices of short-term bonds. Long-term bond prices are more sensitive to shifting interest rates. A sharp increase in interest rates could easily knock 20 or 30 percent off long-term bond prices. If investors don't like price fluctuations, they will invest their funds in short-term bonds unless they receive
a higher yield to maturity on long-term bonds.
Second, short-term investors can profit if interest rates rise. Suppose you hold a 1-year bond. A year from now when the bond matures you can reinvest the proceeds and enjoy whatever rates the bond market offers then. Rates may be high enough to offset the first year's relatively low yield on the 1-year bond. Thus you often see an upward-sloping yield curve when future interest rates are expected to rise.
AACSB: Analytical Skills Bloom's: Analysis Difficulty: Medium Learning Objective: 6-3
121. One-year Treasury bonds yield 5%, while 2-year bonds yield 6%. You are quite confident that in 1 year's time 1-year bonds will yield 8%. Would the higher yield on 2-year bonds cause you to prefer them?
If you invest in a 2-year bond, you will have $1,000 x 1.07 2 = $1,123.60. If you are right in
your forecast about 1-year rates, then an investment in 1-year bonds will produce $1,000 x 1.05 x 1.08 = $1,134.00 by the end of 2 years. You would do better to invest in the 1-year bond.
AACSB: Analytical Skills Bloom's: Analysis Difficulty: Easy Learning Objective: 6-2
122. What are mortality bonds?
Bond issuers are always trying to invent new types of bonds that they hope will appeal to a particular clientele of investors.
Managers of life insurance companies agonize about the possibility of a pandemic or other disaster that results in a sharp increase in the death rate. In 2006 the French insurance company Axa sought to protect itself against this danger by issuing nearly €350 million of mortality bonds. Axa's bonds offered a tempting yield but the bondholders will lose their entire investment if death rates for 2 consecutive years are 10% or more above expectations.
AACSB: Communication Abilities Bloom's: Knowledge
Difficulty: Easy Learning Objective: 6-1