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CHAPTER 10

Explore bond characteristics, pricing formulas, yield calculations, and risk considerations in the bond market. Learn about various bond types, including Treasury issues, corporate bonds, and innovative instruments like TIPS and catastrophe bonds. Understand the relationship between bond prices and yields, different yield measures, premium vs. discount bonds, default risk factors, and the term structure of interest rates. Delve into theories of term structure, yield curves, and forward rates to enhance your understanding of bond market dynamics.

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CHAPTER 10

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  1. CHAPTER 10 Bond Prices and Yields

  2. 10.1 BOND CHARACTERISTICS

  3. Bond Characteristics • Face or par value • Coupon rate • Zero coupon bond • Compounding and payments • Accrued Interest • Indenture

  4. Treasury Notes and Bonds • T Note maturities range up to 10 years • T bond maturities range from 10 – 30 years • Bid and ask price • Quoted in points and as a percent of par • Accrued interest • Quoted price does not include interest accrued

  5. Figure 10.1 Listing of Treasury Issues

  6. Corporate Bonds • Most bonds are traded over the counter • Registered • Bearer bonds • Call provisions • Convertible provision • Put provision (putable bonds) • Floating rate bonds • Preferred Stock

  7. Figure 10.2 Investment Grade Bonds

  8. Other Domestic Issuers • Federal Home Loan Bank Board • Farm Credit Agencies • Ginnie Mae • Fannie Mae • Freddie Mac

  9. Innovations in the Bond Market • Reverse floaters • Asset-backed bonds • Pay-in-kind bonds • Catastrophe bonds • Indexed bonds • TIPS (Treasury Inflation Protected Securities)

  10. 10.2 BOND PRICING

  11. Bond Pricing T å Par Value C P T t = + B + T + ( 1 r ) T ( 1 r ) = t 1 PB = Price of the bond Ct = interest or coupon payments T = number of periods to maturity r = semi-annual discount rate or the semi-annual yield to maturity

  12. Price of 8%, 10-yr. with yield at 6% 20 1 1 å P = ´ + ´ 40 1000 t 20 B ( 1 . 03 ) ( 1 . 03 ) = t 1 P = 1 , 148 . 77 B Coupon = 4%*1,000 = 40 (Semiannual) Discount Rate = 3% (Semiannual) Maturity = 10 years or 20 periods Par Value = 1,000

  13. 10.3 BOND YIELDS

  14. Bond Prices and Yields • Prices and Yields (required rates of return) have an inverse relationship • When yields get very high the value of the bond will be very low • When yields approach zero, the value of the bond approaches the sum of the cash flows

  15. Yield to Maturity • YTM is the discount rate that makes the present value of a bond’s payments equal to its price • 8% coupon, 30-year bond selling at $1,276.76:

  16. Figure 10.3 The Inverse Relationship Between Bond Prices and Yields

  17. Alternative Measures of Yield • Current Yield • Yield to Call • Call price replaces par • Call date replaces maturity • Holding Period Yield • Considers actual reinvestment of coupons • Considers any change in price if the bond is held less than its maturity

  18. Figure 10.4 Bond Prices: Callable and Straight Debt

  19. Figure 10.5 Growth of Invested Funds

  20. 10.4 BOND PRICES OVER TIME

  21. Premium and Discount Bonds • Premium Bond • Coupon rate exceeds yield to maturity • Bond price will decline to par over its maturity • Discount Bond • Yield to maturity exceeds coupon rate • Bond price will increase to par over its maturity

  22. Figure 10.6 Premium and Discount Bonds over Time

  23. Figure 10.7 The Price of a Zero-Coupon Bond over Time

  24. 10.5 DEFAULT RISK AND BOND PRICING

  25. Default Risk and Ratings • Rating companies • Moody’s Investor Service • Standard & Poor’s • Fitch • Rating Categories • Investment grade • Speculative grade

  26. Figure 10.8 Definitions of Each Bond Rating Class

  27. Factors Used by Rating Companies • Coverage ratios • Leverage ratios • Liquidity ratios • Profitability ratios • Cash flow to debt

  28. Protection Against Default • Sinking funds • Subordination of future debt • Dividend restrictions • Collateral

  29. Figure 10.9 Callable Bond Issued by Mobil

  30. 10.6 THE YIELD CURVE

  31. Term Structure of Interest Rates • Relationship between yields to maturity and maturity • Yield curve - a graph of the yields on bonds relative to the number of years to maturity • Usually Treasury Bonds • Have to be similar risk or other factors would be influencing yields

  32. Figure 10.10 Yields on Long-Term Bonds

  33. Figure 10.11 Treasury Yield Curves

  34. Theories of Term Structure • Expectations • Long term rates are a function of expected future short term rates • Upward slope means that the market is expecting higher future short term rates • Downward slope means that the market is expecting lower future short term rates • Liquidity Preference • Upward bias over expectations • The observed long-term rate includes a risk premium

  35. Figure 10.12 Returns to Two 2-year Investment Strategies

  36. Forward Rates Implied in the Yield Curve + + + - n n 1 ( 1 ) ( 1 ) ( 1 ) y y f = - n n 1 n 2 1 ( 1 . 12 ) ( 1 . 11 ) ( 1 . 1301 ) = For example, using a 1-yr and 2-yr rates Longer term rate, y(n) = 12% Shorter term rate, y(n-1) = 11% Forward rate, a one-year rate in one year = 13.01%

  37. Figure 10.13 Illustrative Yield Curves

  38. Figure 10.14 Term Spread

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