Floating Rate bonds

* Floating rate bonds make interest payments that are tied to a measure of current market rates Example: Rate may be adjusted annually to the current T bill rate plus 2% * Major risk involved for floaters is due to the changes in the firm’s financial strength * Yield spread is fixed over life of security however if the firm’s strength deteriorates then investors would demand a greater yield premium * This makes the price of bonds to fall

* Floaters do not adjust to changes in financial condition of the firm

* For bonds, the price an investor would be willing to pay for a claim to the interest and principal repayments depends on the value of dollars received in the future compared to dollars in hand today Bond Value=Present Value of coupons+Present value of par value * At higher interest rates, the present value of payments to be received by the bond holder is lower Bond prices fall as market interest rates rise * Convexity in bond graphs demonstrates that progressive increases in interest rate results in progressive smaller reductions in the bond price Curve is flatter when reaching higher interest rates * Corporate bonds are issued at par value Underwriters must choose coupon rates which matches the market yields * Bondholders may buy or sell bonds in secondary markets In this market, bond prices fluctuate inversely with market interest rates * The maturity of the bond will generally affect the sensitivity of bond prices to market yields * Longer the maturity of bond Greater the sensitivity of price to fluctuations * For example, when you buy a bond at par with an 8% coupon rate and market rates subsequently rise then you suffer a loss There are better alternatives but you’re locked into the 8% * This is called capital loss on the bond Fall in market price * The longer the bond is tied up the greater the loss The greater the drop in bond price

Bond pricing between coupon Dates

* To price bonds between coupon dates Compute the present value of each remaining payment and sum up * Bond prices are typically quoted net of accrued interest Prices are called flat prices * Actual invoice price includes accrued interest:

Invoice Price=Flat Price+Accrued Interest

Bond Yields

Yield to Maturity

* Yield to maturity is a standard measure of the total rate of return * It is the rate that makes the present value of a bond’s payments equal to its price * The interest rate is interpreted as the average rate of return that is earned on a bond if it is bought now and held to maturity * It is the compound rate of return over the life of the bond under the assumption that all coupons are reinvested * Current Yield = The bond’s annual coupon payment divided by the bond price * For example, a bond with 8% coupon selling at 1276.76 will have a current yield of 80/1276.76 = 0.0627 6.27% * Premium Bonds = Bonds that are selling above the par value When coupon rate > Current Yield > YTM * Discount Bonds = Bonds selling below par value YTM > Current Yield > Coupon rate

Realized compound return Vs. Yield to maturity

* The yield to maturity will equal the rate of return realised over the life of the bond if all coupons are reinvested at an interest rate equal to the bond’s yield * The compound rate of return is calculated by:

V0 (1+r)2 = V2

* To calculated the total cash received:

Future value of first coupon payment with interest earnings + cash payment in second year = Total value of investment of reinvested coupons * Realized compound returns are only compounded after the investment period ends because of future interest rate uncertainty * It cannot be computed without a forecast of future reinvestment rates * As interest rate changes, bond investors are subject to two sources of offsetting risk * When rates rise, bond prices...