14 Cont’d • Second, for a given maturity and a given YTM , the higher the coupon rate, the more dependent the bond’s total dollar return will be on the reinvestment of the coupon payments in order to produce the YTM expected at the time of purchase. • This means that holding maturity and YTM constant, premium bonds will be more dependent on interest-on-interest than bonds selling at par. • Discount bonds will be less dependent on interest-on-interest than bonds selling at par. • For zero coupon bonds, none of the bond’s total dollar return is dependent on interest-on-interest. So a zero coupon bond has no reinvestment risk if held to maturity.
8 15 Term Structure of Interest Rates (Yield Curve) • The relationship between a security yield-to-maturity and its term to maturity is known to as the maturity structure or term structure of interest rates. It is also referred to as the yield curve. 16 Rising Yield Curve Maturity Yield • The rising yield curve is the most common. • It is formed when the yields on the short term issues are low and rise consistently with longer maturities. • A rising yield curve is a signal that interest rates are expected to rise in the futures
9 17 Decline Yield Curve Maturity Yield • The declined yield curve is formed when the yields on short-term issues are high while yields on longer maturities are falling. • This pattern generally indicates lower interest rates in the future. 18 Humped Yield Curve Maturity Yield • The humped yield is formed when yields on intermediate-term issues are higher than yields on short-term issues, and rates of longer-term issues decline to levels below those for the short-term and then level out.
10 19 Flat Yield Curve Maturity Yield • When the yields on short-term and long-term issues are the same, this will result in a flat yield curve 20 Bond Ratings • Bonds are rated by the issuer’s default risk • Large bond investors, traders and managers evaluate default risk by analyzing the issuer’s financial ratios and security prices • Two major bond rating agencies are Moody’s and Standard & Poor’s (S&P) • Bonds assigned a letter grade based on perceived probability of issuer default
11 21 Bond Ratings Investment grade Speculative 22 #1 Bond X is a premium bond making annual payments. The bond pays a 9 percent coupon, has a YTM of 6 percent, and has 16 years to maturity. Bond Y is a discount bond making annual payments. This bond pays a 6 percent coupon, has a YTM of 9 percent, and also has 16 years to maturity. If interest rates remain unchanged, how much do you would expect the price of Bonds X and Y to be: (a) 3 years from now (b) 10 years from now.
12 23 Bond X P 0 Enter 16 6% $90 $1,000 N I/Y PV PMT FV Solve for $1,303.18 P 3 Enter 13 6% $90 $1,000 N I/Y PV PMT FV Solve for $1,265.58 P 10 Enter 6 6% $90 $1,000 N I/Y PV PMT FV Solve for $1,147.52 24 Cont’d Bond Y P 0 Enter 16 9% $60 $1,000 N I/Y PV PMT FV Solve for $750.62 P 3 Enter 13 9% $60 $1,000 N I/Y PV PMT FV Solve for $775.39 P 10 Enter 6 8% $60 $1,000 N I/Y PV PMT FV Solve for $865.42
13 25 #2 Bond J is a 4 percent coupon bond. Bond K is a 9 percent coupon bond. Both bonds have 7
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