Question

. Please answer the following conceptual questions related to factors affecting bond yields.

a. Write out an equation for the nominal interest rate on any debt security. Briefly explain each factor and why is affects interest rate.

b. Differentiate between interest rate risk and reinvestment rate risk. To which type of risk are holders of long-term bonds more exposed? Short-term bondholders? Explain. c. Why are U.S. Treasury bonds not riskless? To what types of risk are investors of foreign bonds exposed?

Explain. d. List some factors that affect bond ratings. How are bond ratings correlated with default risk premium?

e. Which bond usually will have a higher liquidity premium: one issued by a large company or one issued by a small company? Explain.

f. Why do convertible bonds and bonds with warrants have lower coupons than similarly rated bonds that do not have these features? Explain.

Answer 1

(a)

(b) INTEREST RATE RISK - Exposure is to rising interest rates and inflation, since the investor is locked into a fixed rate of return on the bond. Price inflation will reduce the purchasing power of future cash flows on the bond. As a result, the bond will sell for a lower price.

Interest rate risk increases with maturity. Interest rate risk is greater for longer maturities because the investor is committed to the coupon rate for a longer period of time, and thereby suffers greater opportunity costs when interest rates rise.

REINVESTMENT RISK

The risk that coupon PMTs will have to be reinvested in the future at lower rates, reducing income and ‘realized yield’ below the promised YTM.

This reinvestment risk is greatest for shorter maturities relative to the investment period (as the investor will have to reinvest face value when bond matures)

(c) US Treasury bonds are indeed free of credit risk, but they are still subject to three other risks: inflation, interest rate risk, and opportunity costs.

INFLATION - T-bonds have a low yield, or return on investment. A little bit of inflation can erase that return, and a little more can effectively eat into your savings.

INTEREST RATE RISK - When interest rates rise, the market value of debt securities tends to drop. This makes it difficult for the bond investor to sell a T-bond without losing on the investment. If an investor holds a Treasury security until its maturity, this isn’t a factor.

OPPORTUNITY COSTS - All financial decisions, even T-bond investments, carry opportunity costs. That is, the investor might have gotten a better return elsewhere, and only time will tell.

Because investing in foreign bonds involves multiple risks, foreign bonds typically have higher yields than domestic bonds.

Just like any other bond, Foreign bonds carry interest rate risk, inflation risk etc. But apart from these, there are some specific risks associated with foreign bonds only:

Currency risk is also an issue for foreign bonds. When income from a bond yielding 7% in a European currency is turned into dollars, the exchange rate may decrease the yield to 2%.

For political risk, investors should consider whether the government issuing the bond is stable, what laws surround the bond’s issuance, how the court system works and additional factors before investing.

Foreign bonds face repayment risk. The country issuing the bond may not have enough money to cover the debt. Investors may lose some or all of their principal and interest.

(d)

Corporate bonds receive ratings from significant agencies, like Moody’s, S&P, and Fitch. These ratings are based on the revenues the issuers can generate to meet principal and interest payments, along with any assets (equipment or financial assets) they can pledge to secure the bond(s). The higher the credit rating, the lower a company’s default premium. For higher-rated issuances, investors will not receive as high of a yield.

Investors often measure the default premium as the yield on an issuance over and above a government bond yield of similar coupon and maturity. For example, if a company issues a 10-year bond, an investor can compare this to a U.S. Treasury bond of a 10-year maturity.

(e) A bond issued by a relatively small and unknown company can be rather difficult to find a buyer for on the open market. When the asset is illiquid, the liquidity premium is high and investors demand additional compensation for the added risk of investing their assets over a more extended period since valuations can fluctuate with market effects.

(f) Convertible bonds and bonds with warrants have lower coupons because they derive their value not just from the associated cash flows but also from the options associated with them.

Owners of convertible bonds have the option to convert the bond into a fixed number of shares of common stock . Convertibles offer investors the chance to share in the upside if a company does well , so investors are willing to accept a lower coupon rate on convertibles than on an otherwise identical but nonconvertible bond .

Bonds with warrants are options that permit the holder to buy stock at a fixed price , thereby providing a gain if the price of the stock rises . Therefore as with convertibles , bonds with warrants have a lower coupon rate because it offers a chance to make gain if the price of the stock rises.