Monday morning quiz
Test your investment knowledge with our quick and easy Monday quiz - this week's focus is on bonds...
a) The safer the investment
b) The more the yield will fluctuate
c) The more the bond will suffer if interest rates rise
d) The cheaper it is to purchase
Answer: c) With bonds, the longer the maturity, the more the bond will suffer if interest rates rise. When interest rates rise, bond prices fall; conversely, when rates decline, bond prices rise. The longer the time to a bond’s maturity, the greater its interest rate risk. Bonds in general are considered less risky than stocks for several reasons: they carry the promise of their issuer to return the face value of the security to the holder at maturity; most bonds pay investors a fixed rate of interest income that is also backed by a promise from the issuer; and, historically, the bond market has been less vulnerable to price swings or volatility than the stock market.
2. What is the annual rate of return you will receive if you hold a
bond to its full term called?
a) Yield to maturity
b) Yield to average life
c) Yield to call
d) Yield advantage
Answer: a) Yield to maturity, or YTM, is the yield promised to the bondholder on the assumption that the bond (or other fixed-interest security such as gilts) will be held to maturity, that all coupon and principal payments will be made and coupon payments are reinvested at the bond's promised yield at the same rate as the original principal invested. It is a measure of the return of the bond and is designed to enable investors to calculate the fair value of different financial instruments. The YTM is generally given in terms of Annual Percentage Rate -- a high yield means a low price (the bond is cheap) and a low yield means a high price (the bond is expensive).
Yield to average life is a similar measure, but reflects that in the case of bonds, average life may be significantly less than the number of years until maturity because of sinking fund requirements.
Yield to call reflects the yield on a bond that is callable (can be repurchased by the issuer before the maturity) and assumed that the bondholder will call their bond, thereby the cashflow is shortened.
Yield advantage measures the advantage, in terms of returns, of buying a bond over a company's stock: it represents the difference in value of buying a company's convertible securities minus the dividend yield on its common stock.
3. What does laddering refer to?
a) Buying bonds with maturity dates spread out over a few years
b) Buying stocks at different points in time
c) Purchasing shares in a fund at regular intervals
d) Selling investments at specific times of the year to reduce taxes
Answer: a) Buying bonds with maturity dates spread out over a few years: bond laddering is a strategy that aims to minimise exposure to interest rate fluctuations. Instead of buying bonds that are scheduled to mature at the same time, investors can purchase bonds that mature at staggered future dates. The idea being that, because the investor is able to invest a portion of their money each year, the bondholder is less exposed to interest rate fluctuations.
Need to check the definition of an investment term? Click here to go to our glossary page.
