Question

-understand how bond prices change as they approach maturity.
- should have a basic understanding of credit default swaps and yield spreads.
- be able to understand the effects of common bond features such as the call feature, convertibility and sinking fund provisions on bond yields.

Answer 1

As a bond moves closer to its maturity date, its price will move closer to par. The break down on the three scenarios is as follows:

1. If a bond is at a premium, the price will decline over time towards its par value.
2. If a bond is at a discount, the price will increase over time towards its par value
3. If a bond is at par, its price will remain the same.

a.credit default swap

A CDS is the most highly utilized type of credit derivative. In its most basic terms, a CDS is similar to an insurance contract, providing the buyer with protection against specific risks. Most often, investors buy credit default swaps for protection against a default, but these flexible instruments can be used in many ways to customize exposure to the credit market.

CDS contracts can mitigate risks in bondinvesting by transferring a given risk from one party to another without transferring the underlying bond or other credit asset. Prior to credit default swaps, there was no vehicle to transfer the risk of a default or other credit event, from one investor to another.

In a CDS, one party “sells” risk and the counterparty “buys” that risk. The “seller” of credit risk – who also tends to own the underlying credit asset – pays a periodic fee to the risk “buyer.” In return, the risk “buyer” agrees to pay the “seller” a set amount if there is a default (technically, a credit event). CDS are designed to cover many risks, including: defaults, bankruptcies and credit rating downgrades.

'Yield Spread'

A yield spread is the difference between yields on differing debt instruments of varying maturities, credit ratings and risk, calculated by deducting the yield of one instrument from another.

----sinking fund is a means of repaying funds borrowed through a bond issue through periodic payments to a trustee who retires part of the issue by purchasing the bonds in the open market. Rather than the issuer repaying the entire principal of a bond issue on the maturity date, another company buys back a portion of the issue annually and usually at a fixed par value or at the current market value of the bonds, whichever is less.

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