Business Finance Homework Help

1) Please explain why bond prices are subject to changes in interest rates.   

2) Describe the characteristics of a bond and provide an example of a firm or government entity that has recently issued (sold) these securities.

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A diverse portfolio can maximize gains with a combination of shares and bonds. They can also reduce the exposure of the risk or even compensate for additional risks. But the calculation of bond prices might be somewhat tricky. Bond prices drop when rates of interest rise. Prices of Bond increase when rates of interest fall. Investors can get a higher rating of return elsewhere if interest rates rise, therefore downwards adjusting the cost of original bonds to the current rate of return.

The investor, in return, generally receives semi-annually fixed income, which remains the same despite the possible changing market interest rates. In terms of interest incomes, bonds compete against one another. New bonds are offered more excellent rates and give more significant revenue when interest rates increase. When new bonds are issued, the rates are lower, not as attractive as old bonds. The bad news is that bondholders cannot raise their rates at the same level as new bonds when rates climb. Under the original agreements, older bond rates are fixed. (Connett, 2016)

2)

Fixed-income bonds are securities issued for collecting funds by companies and governments. The issuer borrows the bondholder’s capital and provides set payments for a particular time at a fixed rate.

Features of Bonds:

Here are the features of bonds that certain similar fundamental features, including:

1. Face value is the sum of money in which the bond will be valued at maturity, and the bond issuer will also use the reference amount to calculate payments of interest.
2. The coupon rate is the percentage interest rate paid by the bond issuer on the bond’s face value.
3. The dates at which the issuer of the bond makes interest payments are coupon dates. Payments can be made at any time, though semi-annual payments are typical.
4. The date of maturity is when the bond matures, and the issuer pays the bondholder the bond’s face value.
5. The issue price of issuance is the original price of the bond. (Zou & Chen, 2017)

Examples: United States Department of the Treasury has recently issued its bonds.

The US bond market the world’s largest and one of the most stable and liquid markets. The market maturity range is between 1 and 30 years. Notes from the treasury represent the medium-term market category, tenors not exceeding ten years of age. The lengthy segment is composed of 20- and 30-year maturities in treasury bonds.

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Bond prices and interest rates are negatively related, that means they have inverse relationship, if one goes up, the other will come down and one goes down, the other will go up. This happens because of concept of “opportunity cost”. The investor will look for more return from his/her investments, therefore he constantly keeps watch on prevailing market interest rates (Hegde, 2017). If market interest rate increases, he will prefer to invest into market rather than bonds. And hence the price of bonds into market will fall. Pricing alternative bonds for delivery purposes is known as factor pricing.

The price of a low coupon bond is more sensitive to changes in interest rates. This is because, the interest rate increase, the gap between market yield and your bond yield will widen to that extend, and hence this will lower your bond price. This sensitivity is more about High coupon bond.

As the time to maturity of a bond increases sensitivity of bond price to change in interest rate increases. Hence short-term bond prices are less sensitive to interest rate changes than are long-term bond prices.

Let us take an example (Short term bond),

Bond face value = $1000

Annual coupon = 1000 * 10% = $100

Time to maturity = 1 year

Current interest rate = 10%

Hence bond price = $1,000

Let us assume interest rate increases to 11%

Bond price = PV (rate, nper, pmt, fv, type) = PV (11%, 1, -100, -1000, 0) = $990.99

So, in case of this short-term bond an increase of interest from 10% to 11%, has decreased the bond price from $1000 to $990.99.

Characteristics of Bonds

When we use a cross-sectional regression to control for general bond characteristics that can impact returns, we find that callable Treasury bond market are more negatively affected than noncallable bonds (Klein & Tirtiroglu, 2017). Additionally, the drop-in returns is greater for bonds most likely to be called, i.e., shorter-term callable bonds and higher-coupon callable bonds that are closer to maturity.

Most bonds share some common basic characteristics including:

Bond carries a fixed coupon rate to be paid annually.

The interest amount payable on the interest rate is tax deductible.

Bond holders don’t have any voting rights unlike any equity shareholders.

The maturity date is the date on that the bond can mature and also the bond institution can pay the investor the face value / price of the bond.

The issue price is the worth at that the bond institution originally sells the bonds.

The variability of the cheapest-to-deliver bonds over the life of a futures contract is limited; uncertainty about which bond is the cheapest to deliver gives rise to “quantity and quality risk” in hedging (Hegde, 2017). Several company and government bonds square measure in public listed; others square measure traded solely over the counter (OTC) or in private between the receiver and loaner.

The coupon rate is the speed of interest the bond institution can pay on the face price of the bond, expressed as a share. For instance, a five-hitter coupon rate implies that bondholders can receive five-hitter x $1000 face price = $50 each year.

Li et. al (2016) mentions that, since 2014, repo market interest rate moved from high to low, holding Treasury yields turned from negative to positive, driven by the treasury bonds futures basis on the whole from negative to positive. Similarly, being restricted by investor structure and other factors, in the process of the main contract handover, differences between the near month contract net bases with that of the next near month contract net basis has expanded, treasury bond futures bulls bear higher shift warehouse cost, storage cost to about ¥0.3 (Chinese yuan).

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