Chapter 12 Bond Prices and the Importance of Duration

1. Chapter 12Bond Prices and the Importance of Duration

2. Outline • Introduction • Review of bond principles • Bond pricing and returns • Bond risk • The meaning of bond diversification • Choosing bonds • Example: monthly retirement income

3. Introduction • The investment characteristics of bonds range completely across the risk/return spectrum • As part of a portfolio, bonds provide both stability and income • Capital appreciation is not usually a motive for acquiring bonds

4. Review of Bond Principles • Identification of bonds • Classification of bonds • Terms of repayment • Bond cash flows • Convertible bonds • Registration

5. Identification of Bonds • A bond is identified by: • The issuer • The coupon • The maturity • For example, five IBM “eights of 10” means $5,000 par IBM bonds with an 8% coupon rate and maturing in 2010

6. Classification of Bonds • Introduction • Issuer • Security • Term

7. Introduction • The bond indenture describes the details of a bond issue: • Description of the loan • Terms of repayment • Collateral • Protective covenants • Default provisions

8. Issuer • Bonds can be classified by the nature of the organizations initially selling them: • Corporation • Federal, state, and local governments • Government agencies • Foreign corporations or governments

9. Definition • The security of a bond refers to what backs the bond (what collateral reduces the risk of the loan)

10. Unsecured Debt • Governments: • Full faith and credit issues (general obligation issues) is government debt without specific assets pledged against it • E.g., U.S. Treasury bills, notes, and bonds

11. Unsecured Debt (cont’d) • Corporations: • Debentures are signature loans backed by the good name of the company • Subordinated debentures are paid off after original debentures

12. Secured Debt • Municipalities issue: • Revenue bonds • Interest and principal are repaid from revenue generated by the project financed by the bond • Assessment bonds • Benefit a specific group of people, who pay an assessment to help pay principal and interest

13. Secured Debt (cont’d) • Corporations issue: • Mortgages • Well-known securities that use land and buildings as collateral • Collateral trust bonds • Backed by other securities • Equipment trust certificates • Backed by physical assets

14. Term • The term is the original life of the debt security • Short-term securities have a term of one year or less • Intermediate-term securities have terms ranging from one year to ten years • Long-term securities have terms longer than ten years

15. Terms of Repayment • Interest only • Sinking fund • Balloon • Income bonds

16. Interest Only • Periodic payments are entirely interest • The principal amount of the loan is repaid at maturity

17. Sinking Fund • A sinking fund requires the establishment of a cash reserve for the ultimate repayment of the bond principal • The borrower can: • Set aside a potion of the principal amount of the debt each year • Call a certain number of bonds each year

18. Balloon • Balloon loans partially amortize the debt with each payment but repay the bulk of the principal at the end of the life of the debt • Most balloon loans are not marketable

19. Income Bonds • Income bonds pay interest only if the firm earns it • For example, an income bond may be issued to finance an income-producing project

20. Bond Cash Flows • Annuities • Zero coupon bonds • Variable rate bonds • Consols

21. Annuities • An annuity promises a fixed amount on a regular periodic schedule for a finite length of time • Most bonds are annuities plus an ultimate repayment of principal

22. Zero Coupon Bonds • A zero coupon bond has a specific maturity date when it returns the bond principal • A zero coupon bond pays no periodic income • The only cash inflow is the par value at maturity

23. Variable Rate Bonds • Variable rate bonds allow the rate to fluctuate in accordance with a market index • For example, U.S. Series EE savings bonds

24. Consols • Consols pay a level rate of interest perpetually: • The bond never matures • The income stream lasts forever • Consols are not very prevalent in the U.S.

25. Definition • A convertible bond gives the bondholder the right to exchange them for another security or for some physical asset • Once conversion occurs, the holder cannot elect to reconvert and regain the original debt security

26. Security-Backed Bonds • Security-backed convertible bonds are convertible into other securities • Typically common stock of the company that issued the bonds • Occasionally preferred stock of the issuing firm, common stock of another firm, or shares in a subsidiary company

27. Commodity-Backed Bonds • Commodity-backed bonds are convertible into a tangible asset • For example, silver or gold

28. Bearer Bonds • Bearer bonds: • Do not have the name of the bondholder printed on them • Belong to whoever legally holds them • Are also called coupon bonds • The bond contains coupons that must be clipped • Are no longer issued in the U.S.

29. Registered Bonds • Registered bonds show the bondholder’s name • Registered bondholders receive interest checks in the mail from the issuer

30. Book Entry Bonds • The U.S. Treasury and some corporation issue bonds in book entry form only • Holders do not take actual delivery of the bond • Potential holders can: • Open an account through the Treasury Direct System at a Federal Reserve Bank • Purchase a bond through a broker

31. Bond Pricing and Returns • Introduction • Valuation equations • Yield to maturity • Realized compound yield • Current yield • Term structure of interest rates • Spot rates

32. Bond Pricing and Returns (cont’d) • The conversion feature • The matter of accrued interest

33. Introduction • The current price of a bond is the market’s estimation of what the expected cash flows are worth in today’s dollars • There is a relationship between: • The current bond price • The bond’s promised future cash flows • The riskiness of the cash flows

34. Valuation equations • Annuities • Zero coupon bonds • Variable rate bonds • Consols

35. Annuities • For a semiannual bond:

36. Annuities (cont’d) • Separating interest and principal components:

37. Annuities (cont’d) Example A bond currently sells for $870, pays $70 per year (Paid semiannually), and has a par value of $1,000. The bond has a term to maturity of ten years. What is the yield to maturity?

38. Annuities (cont’d) Example (cont’d) Solution: Using a financial calculator and the following input provides the solution: N = 20 PV = $870 PMT = $35 FV = $1,000 CPT I = 4.50 This bond’s yield to maturity is 4.50% x 2 = 9.00%.

39. Zero Coupon Bonds • For a zero-coupon bond (annual and semiannual compounding):

40. Zero Coupon Bonds (cont’d) Example A zero coupon bond has a par value of $1,000 and currently sells for $400. The term to maturity is twenty years. What is the yield to maturity (assume semiannual compounding)?

41. Zero Coupon Bonds (cont’d) Example (cont’d) Solution:

43. Variable Rate Bonds • The valuation equation must allow for variable cash flows • You cannot determine the precise present value of the cash flows because they are unknown:

44. Consols • Consols are perpetuities:

45. Consols (cont’d) Example A consol is selling for $900 and pays $60 annually in perpetuity. What is this consol’s rate of return?

46. Consols (cont’d) Example (cont’d) Solution:

47. Yield to Maturity • Yield to maturity captures the total return from an investment • Includes income • Includes capital gains/losses • The yield to maturity is equivalent to the internal rate of return in corporate finance

50. Realized Compound Yield • The effective annual yield is useful to compare bonds to investments generating income on a different time schedule