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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- Spring '11
- tohmunheng
- Interest Rates, Interest, Valuation, Yield Curve, YTM, Convertible bond