Download - BOND BASICS
Interest Rates and Bond Valuation 1
BOND BASICS
IBM
$1,000 LOAN
Interest each year at coupon rate$1,000 at maturity
Interest Rates and Bond Valuation 2
Bond Valuation
Discount bond cash flows at required rate of return (yield to maturity)Don’t use coupon rate If you do, you’ll find value is $1,000
Interest rates increase, bond values decrease
Interest rates decrease, bond values increase
Interest Rates and Bond Valuation 3
Bond Valuation
Maturity 4% 6% 8% 10% 12% 14%
1 $1,038.46 $1,018.87 $1,000.00 $981.82 $964.29 $947.37As bonds approach maturity, value converges to $1,000
5 $1,178.07 $1,084.25 $1,000.00 $924.18 $855.81 $794.0210 $1,324.44 $1,147.20 $1,000.00 $877.11 $773.99 $687.0315 $1,444.74 $1,194.24 $1,000.00 $847.88 $727.57 $631.4720 $1,543.61 $1,229.40 $1,000.00 $829.73 $701.22 $602.6125 $1,624.88 $1,255.67 $1,000.00 $818.46 $686.27 $587.6230 $1,691.68 $1,275.30 $1,000.00 $811.46 $677.79 $579.84 Longer term, more volatile
Maturity 2% 4% 6% 8% 10% 12%5 $1,188.54 $1,089.04 $1,000.00 $920.15 $848.37 $783.71
10 $1,359.30 $1,162.22 $1,000.00 $865.80 $754.22 $660.9915 $1,513.97 $1,222.37 $1,000.00 $828.81 $695.76 $591.3520 $1,654.06 $1,271.81 $1,000.00 $803.64 $659.46 $551.8325 $1,780.94 $1,312.44 $1,000.00 $786.50 $636.92 $529.4130 $1,895.86 $1,345.84 $1,000.00 $774.84 $622.92 $516.69 Lower coupon rate, more volatile
Required Rate of Return
8% Coupon Rate BondRequired Rate of Return
6% Coupon Rate Bond
Interest Rates and Bond Valuation 4
Interest Rate Risk
Longer time to maturity, more interest rate risk (bond price more volatile)
Lower coupon rate, more interest rate risk (bond price more volatile)
CT: Why 100-year bonds?
Interest Rates and Bond Valuation 5
Bond Valuation
Discount bond cash flows at required rate of return (yield to maturity)Don’t use coupon rate If you do, you’ll find value is $1,000
Interest rates increase, bond values decrease
Interest rates decrease, bond values increase
Interest Rates and Bond Valuation 6
Calculating YTM (Required Return) and Bond Price Bond has 7% coupon rate, 5 years to maturity
and is priced at $1,257. What is yield to maturity?
Bond has 3% coupon rate, 30 years to maturity and is priced at $985. What is yield to maturity?
Bond has 6% coupon rate, a YTM of 10% and 20 years to maturity. What is the price?
Bond has 5% coupon rate, a YTM of 4% and 3 years to maturity. What is the price?
Interest Rates and Bond Valuation 7
Bond Features
Terms Call provision Protective covenants
Interest Rates and Bond Valuation 8
Bond Terms
Most bonds…$1,000 face value at maturity Interest is paid semi-annually
We’ll ignore this in our calculationsDebentures: unsecured
Remember bonds are loans
Interest Rates and Bond Valuation 9
Call Provision
Allows company to repay loan earlyCall price is generally above face valueCall price declines over time
Often can’t call bond for a period of years after bond issued
Most corporate bonds are callable Most Treasury bonds are not
Interest Rates and Bond Valuation 10
Call Provision
Why would a bond with a coupon rate of 6% be called?
Will interest rates on callable bonds generally be higher or lower than rates on bonds that can’t be called?
CT 5: Costs and benefits of call provision.
Interest Rates and Bond Valuation 11
Protective Covenants
Protect lender (purchaser of bond) Negative covenants
Limit dividendsLimit issuing additional debt
Positive covenantsMaintain times interest earned ratioMaintain debt ratio
What happens if covenants violated?
Interest Rates and Bond Valuation 12
Bond Ratings
S&P and Moodys paid to rate creditworthiness of bond issuerCorporate and government bondsLess biased evaluation than stock analysts
Junk bonds: not investment gradePension funds and some mutual funds only
buy investment grade bondHigh-yield, high risk bonds
CT 8 and 9: Why gave bonds
rated? Why are junk bonds and U.S. bonds not
rated?
Interest Rates and Bond Valuation 13
Government Bonds
U.S. TreasuryTwo year notes to 30-year bondsGenerally not callableNo default risk???
Biggest borrower in the world… Interest is not subject to state income
tax Illinois tax rate is 3%
Interest Rates and Bond Valuation 14
Municipal Bonds
Issued by state and municipal governmentsSome default risk???
Orange County, Bridgeport, CN
After-tax yield6% IBM coupon vs. 5% Illinois couponTaxpayer with 30% marginal tax rate
Interest Rates and Bond Valuation 15
Zero Coupon Bonds
Just receive $1,000 at maturity Issuer deducts imputed interest each year even
though pays no cash Generally increase in value of bond is imputed
interest Owner of bond pays tax on interest each year
even though none received Very volatile (risky) bonds Sinking fund
Interest Rates and Bond Valuation 16
Bond Prices
Price quoted is percent of face value97 ½ is $975; 103 is $1,030
Current yield = required rate of return Remember bond prices converge
towards $1,000 at maturityDiscount bonds increase; premium bonds
decrease
Interest Rates and Bond Valuation 17
Investing In Bonds
$1,000 per bond How many bonds to diversify? Market not transparent Difficulty in assessing default risk
CT 13: Implications for investors since
bond market not transparent?
Interest Rates and Bond Valuation 18
Bond Mutual Funds
Pool investors funds Professional management Specialize in certain types of bonds
GovernmentHigh Yield (Junk)Municipal
Don’t blindly chase higher yields unless…
Interest Rates and Bond Valuation 19
What Determines Interest Rates? Real rate of return Inflation risk premium Default risk premium Maturity risk premium Liquidity risk premium
Interest Rates and Bond Valuation 20
Real Rate of Return
Inflation-adjusted Treasury bills No inflation risk No default risk No maturity risk No liquidity risk
Rates: 1.20% as of 01/09 Over 4% , in 10/01
Interest Rates and Bond Valuation 21
Inflation Risk Premium
Inflation reduces value of future dollars Add premium for anticipated inflation
Interest Rates and Bond Valuation 22
Inflation Risk Premium
Steep yield curve Inverted yield
curve Figure 6.7, Page
175 Future economic
activity?
Interest Rates and Bond Valuation 23
Default Risk Premium
Higher risk, higher required return GM and Ford
Interest Rates and Bond Valuation 24
Maturity Risk Premium
Long-term bonds more volatileMore risk, demand higher return
CT 1: Are Treasury
securities risk-free?
Interest Rates and Bond Valuation 25
Liquidity Premium
Corporate bonds don’t trade on an exchange like stocksTreasury bonds very liquidMany corporate bonds not very liquid
Interest Rates and Bond Valuation 26
What Determines Interest Rates? Real rate of return + Inflation risk premium + Default risk premium + Maturity risk premium + Liquidity risk premium + = Required Rate of Return