Congratulations. You have been promoted to vice president and director of your m

Question

Congratulations. You have been promoted to vice president and director of your mid-size firm’s pension fund management team located in Cincinnati, OH. Before you have even had the opportunity to settle into your new office, your senior vice president tapped you to take her place and present an investment seminar to "a group of investment decision-makers" comprised of government analysts from all over the tri-state area but that is the extent of the information you’ve been provided. After doing some quick research, you’ve identified that the specific target audience for this presentation is composed primarily of individuals with little or no professional investment experience who are attending this seminar to build their skills.

In order to address the range of information these individuals need to know and the likely range of questions that may crop up, you’ll need to be able to:

Describe the essential characteristics of a bond and how these characteristics interact to determine bond value, inclusive of how both the interest rate and coupon rate influence bond value and pricing.

Summarize call provisions and sinking fund provisions. Explain how these types of provisions individually make bonds more or less risky for a) an investor, and b) the issuer.

The value of an asset whose value is based on expected future cash flows is determined by the present value of all future cash flows the assets will generate. Given the case scenario and target audience provided, select and discuss a simple asset situation that could apply to exemplify this concept.

Define what it means when a bond is callable. Provide two measures you can review to understand what type of returns to expect if the bond is called or if it is not called.

Describe the type of returns one could one expect with a callable bond trading at a premium price and provide your rationale. Explain the significance of the designation "premium price." Discuss why or why not a callable bond trading at a premium price would be an appropriate investment for the target audience’s organizations.

Select an example scenario appropriate to the seminar’s target audience Write a general expression for the yield on a probable debt security (rd) and define these terms in regards to that hypothetical security: real risk-free rate of interest (r*), inflation premium (IP), default risk premium (DRP), liquidity premium (LP), and maturity risk premium (MRP).

Define the nominal risk-free rate (rRF) and provide an example relevant to your target audience of a specific security that can be used as an estimate of rRF.

Describe interest rate risk and reinvestment rate risk and how these relate to the maturity risk premium. Based on reinvestment rate risk, provide an example on how a 1-year bond or a 10-year bond would be a better investment for a typical community as represented by those attending your seminar.

Select an example appropriate to your seminar target audience to explain the concepts of a) term structure and interest rates and b) yield curve.

Review corporate bankruptcy law. If a firm were to default on its bonds, describe how the company assets could be/would be liquidated. What is a likely outcome for bondholders? Select and describe an example scenario that applies to your seminar attendees’ organizations.

Prepare this assignment according to the guidelines found in the APA Style Guide, located in the Student Success Center. An abstract is not required.

Explanation / Answer

Answer

Answer 1

Describe the essential characteristics of a bond and how these characteristics interact to determine bond value, inclusive of how both the interest rate and coupon rate influence bond value and pricing.

Bonds have a number of characteristics. All of these factors play a role in determining the value of a bond and the extent to which it fits in your portfolio.

Face Value/Par Value
The face value (also known as the par value or principal) is the amount of money a holder will get back once a bond matures. A newly issued bond usually sells at the par value. Corporate bonds normally have a par value of $1,000, but this amount can be much greater for government bonds.
A bond's price fluctuates throughout its life in response to a number of variables. When a bond trades at a price above the face value, it is said to be selling at a premium. When a bond sells below face value, it is said to be selling at a discount.

Coupon (The Interest Rate)
The coupon is the amount the bondholder will receive as interest payments. It's called a "coupon" because sometimes there are physical coupons on the bond that you tear off and redeem for interest. However, this was more common in the past. Nowadays, records are more likely to be kept electronically. As previously mentioned, most bonds pay interest every six months, but it's possible for them to pay monthly, quarterly or annually. The coupon is expressed as a percentage of the par value. If a bond pays a coupon of 10% and its par value is $1,000, then it'll pay $100 of interest a year. A rate that stays as a fixed percentage of the par value like this is a fixed-rate bond. Another possibility is an adjustable interest payment, known as a floating-rate bond. In this case the interest rate is tied to market rates through an index, such as the rate on Treasury bills.
All things being equal, a lower coupon means that the price of the bond will fluctuate more.

Maturity
The maturity date is the date in the future on which the investor's principal will be repaid. Maturities can range from as little as one day to as long as 30 years (though terms of 100 years have been issued).
A bond that matures in one year is much more predictable and thus less risky than a bond that matures in 20 years. Therefore, in general, the longer the time to maturity, the higher the interest rate. Also, all things being equal, a longer term bond will fluctuate more than a shorter term bond.

Issuer
The issuer of a bond is a crucial factor to consider, as the issuer's stability is your main assurance of getting paid back. The U.S. government is far more secure than any corporation. Its default risk (the chance of the debt not being paid back) is extremely small - so small that U.S. government securities are known as risk-free assets. The reason behind this is that a government will always be able to bring in future revenue through taxation. A company, on the other hand, must continue to make profits, which is far from guaranteed. This added risk means corporate bonds must offer a higher yield in order to entice investors - this is the risk/return tradeoff in action.

The bond rating system helps investors determine a company's credit risk. Blue-chip firms, which are safer investments, have a high rating, while risky companies have a low rating.

Return with Yield
Yield is a figure that shows the return you get on a bond. The simplest version of yield is calculated using the following formula: yield = coupon amount/price. When you buy a bond at par, yield is equal to the interest rate. When the price changes, so does the yield. If you buy a bond with a 10% coupon at its $1,000 par value, the yield is 10% ($100/$1,000). But if the price goes down to $800, then the yield goes up to 12.5%. This happens because you are getting the same guaranteed $100 on an asset that is worth $800 ($100/$800). Conversely, if the bond goes up in price to $1,200, the yield shrinks to 8.33% ($100/$1,200).

Yield To maturity

YTM is a more advanced yield calculation that shows the total return you will receive if you hold the bond to maturity. It equals all the interest payments you will receive (and assumes that you will reinvest the interest payment at the same rate as the current yield on the bond) plus any gain (if you purchased at a discount) or loss (if you purchased at a premium).

Relationship between Price and Yield
The relationship of yield to price can be summarized as follows: when price goes up, yield goes down and vice versa. Technically, the bond's price and its yield are inversely related.

Price and interest rate In the Market
The factor that influences a bond more than any other is the level of prevailing interest rates in the economy. When interest rates rise, the prices of bonds in the market fall, thereby raising the yield of the older bonds and bringing them into line with newer bonds being issued with higher coupons. When interest rates fall, the prices of bonds in the market rise, thereby lowering the yield of the older bonds and bringing them into line with newer bonds being issued with lower coupons.

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