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Key Concepts and Skills

• Know the important bond features and bond types • Understand: – Bond values and why they fluctuate – Bond ratings and what they mean – The impact of inflation on interest rates – The term structure of interest rates and the determinants of bond yields 6-2

Chapter Outline

6.1 6.2 6.3 6.4 6.5 6.6 6.7 Bonds and Bond Valuation More on Bond Features Bond Ratings Some Different Types of Bonds Bond Markets Inflation and Interest Rates Determinants of Bond Yields 6-3

6-1

Bond Definitions

• Bond

– Debt contract – Interest-only loan

• • • • •

Par value (face value) ~ $1,000 Coupon rate Coupon payment Maturity date Yield to maturity 6-4

Key Features of a Bond

• Par value:

– Face amount – Re-paid at maturity – Assume $1,000 for corporate bonds

• Coupon interest rate:

– Stated interest rate – Usually = YTM at issue – Multiply by par value to get coupon payment 6-5

Key Features of a Bond

• Maturity:

– Years until bond must be repaid

• Yield to maturity (YTM):

– The market required rate of return for bonds of similar risk and maturity – The discount rate used to value a bond – Return if bond held to maturity – Usually = coupon rate at issue – Quoted as an APR 6-6

6-2

Bond Value

• Bond Value = PV(coupons) + PV(par) • Bond Value = PV(annuity) + PV(lump sum) • Remember: – As interest rates increase present values decrease ( r → PV ) – As interest rates increase, bond prices decrease and vice versa

6-7

The Bond-Pricing Equation

1 1- (1 YTM) t Bond Value C YTM PV(Annuity)

F t (1 YTM)

PV(lump sum)

C = Coupon payment; F = Face value

Return to Quiz 6-8

Pricing Specific Bonds in Excel

=PRICE(Settlement,Maturity,Rate,Yld,Redemption, Frequency,Basis) =YIELD(Settlement,Maturity,Rate,Pr,Redemption, Frequency,Basis) – Settlement = actual date as a serial number – Maturity = actual date as a serial number – Redemption and Pr(ice) = % of par value – Rate (coupon) and Yld = annual rates as decimals – Frequency = # of coupons per year – Basis = day count convention

6-9

6-3

Valuing a Discount Bond with Annual Coupons

• • • • • Coupon rate = 10% Annual coupons Par = $1,000 Maturity = 5 years YTM = 11%

Note: When YTM > Coupon rate Price < Par = “Discount Bond”

6-10

Valuing a Premium Bond with Annual Coupons

• • • • • Coupon rate = 10% Annual coupons Par = $1,000 Maturity = 20 years YTM = 8%

Note: When YTM < Coupon rate Price > Par = “Premium Bond”

6-11

Graphical Relationship Between Price and Yield-to-maturity

1500 1400 1300

Bond Price

1200 1100 1000 900 800 700 600 0% 2% 4% 6% 8% 10% 12% 14%

Yield-to-maturity

6-12

6-4

Bond Prices:

Relationship Between Coupon and Yield • Coupon rate = YTM Price = Par • Coupon rate < YTM Price < Par –“Discount bond” … Why? • Coupon rate > YTM Price > Par –“Premium bond” … Why?

6-13

Bond Value ($) vs Years remaining to Maturity

Premium

CR>YTM

1,000

YTM = CR

M

CR S/T – Inverted = downward-sloping L/T < S/T

Return to Quiz

6-45

6-15

Figure 6.5 A – Upward-Sloping Yield Curve

REPLACE with FIGURE 6.5 A

6-46

Figure 6.5 B – DownwardSloping Yield Curve

6-47

Figure 6.6 – Treasury Yield Curve

6-48

6-16

Factors Affecting Required Return

• Default risk premium – bond ratings • Taxability premium – municipal versus taxable • Liquidity premium – bonds that have more frequent trading will generally have lower required returns • Maturity premium – longer term bonds will tend to have higher required returns. Anything else that affects the risk of the cash flows to the bondholders will affect the required returns Return to Quiz 6-49

Quick Quiz

• How do you find the value of a bond and why do bond prices change? (Slide 6.8) • What is a bond indenture and what are some of the important features? (Slide 6.30) •...