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Unformatted text preview: Chapter 10
Chapter 10
Bond Prices and Yields Bond Characteristics
Bond Characteristics Face or par value
Coupon rate
→ Zero coupon bond
Zero coupon bond
Compounding and payments
Indenture Bond Provisions
Bond Provisions Secured or unsecured
Call provision
Convertible provision
Put provision
Floating rate bonds Innovations in the Bond Market
Innovations in the Bond Market Reverse floaters
Catastrophe bonds
Treasury inflation protected securities (TIPS) Bond Valuation Principle
Bond Valuation Principle Intrinsic value → Is an estimated value Is an
→ PV of expected cash flows (CFs)
PV of expected cash flows (CFs) Required to compute intrinsic value » Expected CFs » Timing of expected CFs » Discount rate (rate required by investors) Bond Pricing
Bond Pricing
T P B= ∑
t= 1 PB = C t T + Par Value T
T
(1+ r )
(1+ r ) price of the bond Ct = interest or coupon payments T = number of periods to maturity
r = semiannual discount rate or semiannual yield to maturity Bond Valuation Examples
Bond Valuation Examples
Bonds have $1000 face value and pay semiannual interest.
Coupon Yield to
Years to Rate Maturity
Maturity
Value Bond Prices
Bond Prices Bond prices move inversely to interest rates
Bond prices are directly related to time to maturity Interest Rates
Interest Rates
Rates and basis points » 100 basis points are equal to one percentage point Shortterm riskless rate » Provides foundation for other rates » Approximated by rate on Treasury Bills » Other rates differ because of
→ Maturity differentials
Maturity differentials
→ Security risk premiums
Security risk premiums Interest Rates
Interest Rates
Maturity differentials » Term structure of interest rates
− Accounts for the relationship between time and Accounts for the relationship between yield for bonds the same in every other respect Risk premium » Yield spread or yield differential » Associated with issuer’s particular situation Yields on LongTerm Bonds
Yields on LongTerm Bonds Yield Spreads on 10year Bonds
Yield Spreads on 10year Bonds Bond Ratings
Bond Ratings Rating companies
− Moody’s Investor Service
Moody’s
− Standard and Poor’s
Standard
− Fitch
Fitch
Rating categories
− Investment grade
Investment
− Speculative grade
Speculative Definitions of Each Bond Rating Class
Definitions of Each Bond Rating Class Factors Used by Rating Companies
Factors Used by Rating Companies Coverage ratios
Leverage ratios
Liquidity ratios
Profitability ratios
Cash flow to debt Protection Against Default
Protection Against Default Sinking funds
Subordination of future debt
Dividend restrictions
Collateral Credit Default Swaps
Credit Default Swaps Credit default swap (CDS): insurance policy on the default risk of a bond or loan
Seller collects an annual premium (and sometimes an upfront fee) from swap buyer
If bond issuer or borrower defaults, seller pays drop in value from par Credit Default Swaps
Credit Default Swaps Credit Default Swaps
Credit Default Swaps New regulations on CDS
◊ CDS contracts will be traded on exchanges with collateral requirements to limit risk.
◊ Exchange trading will increase transparency Measuring Bond Yields
Measuring Bond Yields Current yield » Ratio of coupon interest to current market price Yield to maturity » Compound rate of return » Equates PV of expected future CFs to initialinvestment Yield to call » Assumes bond is called at end of deferred call period Yield to Maturity
Yield to Maturity
T P B= ∑
t= 1 C t T + Par Value T
T
(1+ y )
(1+ y ) Yield to Maturity
Yield to Maturity Investors earn the YTM if the bond is held to maturity and all coupons are reinvested at YTM YTM Example Problem
YTM Example Problem Suppose you invest in a bond that has a $1000 par value and pays 10% coupon rate (paid annually). If you paid face value for the bond and the bond has a maturity of five years, what is your yield to maturity?
What is your yield if you paid $900?
What is your yield if you paid $1200? Yield to Call
Yield to Call Yield to a specified call date and call price
Substitute number of periods until first call date for T and call price for par value
C Coupon t
Call Price
P=∑
+
t
(1 + YTC) C
t =1 (1 + YTC) YTC Example Problem
YTC Example Problem Suppose you invest in a bond that pays a 6% coupon rate (paid semiannually) and has a 30year maturity. The bond is currently selling for $1200 and is callable in 10 years at a call price of $1150. What is the yield to call? Reinvestment Risk
Reinvestment Risk Reinvestment rate risk means that coupons may be reinvested at various rates
Interest on interest is the income earned on the reinvestment of intermediate cash flows
Interest on interest significantly affects the total dollar return from a bond
A zero coupon bond eliminates reinvestment rate risk Realized Compound Yield
Realized Compound Yield Rate of return actually earned on a bond given the reinvestment of the coupons at varying rates
Can only be calculated after investment period is over RCY Example Problem
RCY Example Problem Assume we paid $900 for a 10% bond (semiannual coupons), with a 20year maturity. If we were able to reinvest our payments at 12%, what was our realized compound yield? Bond Quotes
Bond Quotes Example: IBM 9s26 par value = $1000 coupon = 9% of par value per year = $90 per year ($45 every 6 months (due to s)) maturity = in 2026 so 15 years Issued by IBM Treasury Quotes
Treasury Quotes
8 Nov 27 125:05 125:11 46 5.86 What is the coupon rate on the bond? When does the bond mature?
What is the bid price?
What is the ask price?
How much did the price change from the previous day? What is the yield based on the ask price? ...
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This note was uploaded on 12/10/2011 for the course FIN 401 taught by Professor Staff during the Spring '08 term at Miami University.
 Spring '08
 STAFF
 Compounding

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