# Chap007 - Chapter 7 Interest Rates and Bond Valuation How...

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Chapter 7 Interest Rates and Bond Valuation

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How big? Over \$33T Source: SIFMA http://apps.finra.org/investor_information/smart/bonds/401000.asp
Government Bonds Treasury Securities Federal government debt—no default risk T-bills (<2 years); T-notes (2-10 years); T- bonds (>10 years) Federal Agency Securities GNMA, FNMA, SLMA, others; very low risk Municipal Securities Debt of state and local governments; varying risk Interest received is tax-exempt at the federal level, some also exempt at state, local level

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Municipal bond example A taxable bond has a yield of 8% and a municipal bond has a yield of 6% If you are in a 40% tax bracket, which bond do you prefer? 8%(1 - .4) = 4.8% The after-tax return on the corporate bond is 4.8%, compared to a 6% return on the municipal At what tax rate would you be indifferent between the two bonds? 8%(1 – T) = 6% T = 25%
Other Bond Types Corporate bonds Risk determined by strength of company; judged by rating agencies Mortgage bonds (includes CMOs, Fan/Fred bonds, etc.) “Pass-through” securities. Mortgage payment becomes bond interest or principal. Risk of prepayment. Risk of collateral, as seen in sub- prime crisis. Asset-backed bonds (includes CDO, ABCP, etc.) Similar in structure to mortgage bonds, but with different cash flows (credit cards, e.g.). MBS, ABS examples of “structured finance”. Money market Short-term corporate bonds, commercial paper

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The Bond-Pricing Equation t t r) (1 F r r) (1 1 - 1 C Value Bond + + + = Where C is the coupon, F is the face value, r is the YTM and t is the number of periods. Face value of most bonds is \$1000.
Example 7-year bond with coupon rate of 14% and YTM of 16%. Coupons paid semi- annually How many coupon payments are there? What is the semiannual coupon payment? What is the semiannual yield? B = 70{[1 – 1/(1.08) 14 ] / .08} + 1000 / (1.08) 14 = 917.56 Or PMT = 70; N = 14; I/Y = 8; FV = 1000; CPT PV = -917.56

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Present Value of Cash Flows as Rates Change Bond Value = PV of coupons + PV of par Bond Value = PV annuity + PV of lump sum Remember, as interest rates increase present values decrease So, as interest rates increase, bond prices decrease and vice versa
Valuing a Discount Bond with Annual Coupons Consider a bond with a coupon rate of 10% and annual coupons. The par value is \$1000 and the bond has 5 years to maturity. The yield to maturity is 11%. What is the value of the bond? Using the formula: B = PV of annuity + PV of lump sum B = 100[1 – 1/(1.11) 5 ] / .11 + 1000 / (1.11) 5 B = 369.59 + 593.45 = 963.04 Using the calculator: N = 5; I/Y = 11; PMT = 100; FV = 1000 CPT PV = -963.04 Note: if coupon<YTM, price<par

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Valuing a Premium Bond with Annual Coupons Suppose you are looking at a bond that has a 10% annual coupon and a face value of \$1000. There are
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## This note was uploaded on 01/09/2010 for the course HADM 2225 taught by Professor Wellman, j during the Winter '08 term at Cornell University (Engineering School).

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Chap007 - Chapter 7 Interest Rates and Bond Valuation How...

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