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Chapter 5 - Topics Covered

Chapter 5 - Topics Covered. Bond Characteristics reading the financial pages Interest Rates and Bond Prices Current Yield and Yield to Maturity Bond Rates and Returns Corporate Bonds and the Risk of Default The Yield Curve. Bonds. Terminology

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Chapter 5 - Topics Covered

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  1. Chapter 5 - Topics Covered • Bond Characteristics • reading the financial pages • Interest Rates and Bond Prices • Current Yield and Yield to Maturity • Bond Rates and Returns • Corporate Bonds and the Risk of Default • The Yield Curve

  2. Bonds Terminology • Bond – Legal Agreement that obligates the issuer to make specified payments to the bondholder. • Coupon - The interest payments made to the bondholder (usually due every six months). • Face Value(Par Value or Principal Value) - Payment at the maturity of the bond (usually $1,000). • Coupon Rate - Annual interest payment, as a percentage of face value.

  3. Bonds WARNING The coupon rate IS NOT the discount rate used in the Present Value calculations. The coupon rate merely tells us what cash flow the bond will produce. Since the coupon rate is listed as a %, this misconception is quite common.

  4. Bond Pricing The price of a bond is the Present Value of all cash flows generated by the bond (i.e. coupons and face value) discounted at the required rate of return.

  5. Bond Pricing Example What is the price of a 5.5 % annual coupon bond, with a $1,000 face value, which matures in 3 years? Assume a required return of 3.5%.

  6. Bond Cash Flows

  7. Bond Pricing Example (continued) What is the price of the bond if the required rate of return is 5.5 %?

  8. Bond Pricing Example (continued) What is the price of the bond if the required rate of return is 15 %?

  9. Bond Pricing Example (continued) What is the price of the bond if the required rate of return is 3.5% AND the coupons are paid semi-annually?

  10. Bond Pricing Example (continued) Q: How did the calculation change, given semi-annual coupons versus annual coupon payments?

  11. Bond Pricing Example (continued) Q: How did the calculation change, given semi-annual coupons versus annual coupon payments? Time Periods Paying coupons twice a year, instead of once doubles the total number of cash flows to be discounted in the PV formula. Discount Rate Since the time periods are now half years, the discount rate is also changed from the annual rate to the half year rate.

  12. Bond Yields • Current Yield - Coupon payments for next year divided by bond price. • Yield To Maturity - Interest rate for which the present value of the bond’s payments equal today’s price.

  13. Bond Yields Calculating Yield to Maturity (YTM=r) If you are given the price of a bond (PV) and the coupon rate, the yield to maturity can be found by solving for r.

  14. Bond Yields Example What is the YTM of a 5.5 % annual coupon bond, with a $1,000 face value, which matures in 3 years? The market price of the bond is $1,056.03.

  15. Bond Yields WARNING Calculating YTM by hand can be very tedious because it requires a trial and error approach. Solution: Use the “=Yield( )” function in Excel or solve for r using a financial calculator (make sure to include the face value as a FV at time t).

  16. Bond Yields Rate of Return – In general terms = Earnings per period per dollar invested.

  17. Bond Valuation Spreadsheet Esc and Double click on spreadsheet to access

  18. Bond Yield Spreadsheet Esc and Double click on spreadsheet to access

  19. Interest Rate Risk Price path for Premium Bond Price path for Discount Bond Maturity Today

  20. Interest Rate Risk When the interest rate equals the 5.5% coupon rate, both bonds sell at face value 30 yr bond 3 yr bond

  21. Nominal and Real rates Yield on UK nominal bonds Yield on UK bonds (real rate)

  22. Default Risk • Credit risk = risk of default on obligation • Default premium = higher interest rate applied to loans with higher credit risk • Rating Agencies: Moody’s, Standard & Poor’s • Assign ratings which reflect credit risk and associated default premium • Investment grade = Baa/BBB or better • “Junk bonds” = Ba/BB or lower

  23. Default Risk

  24. Corporate Bonds • Other types of bonds • Zero coupons: No coupons over life of bond • Note: this saves cash but increases risk • Sold at a deep discount to reflect missing interest • Floating rate bonds: Coupon rate fluctuates • Convertible bonds: Bond can be converted to stock if stock price rises to conversion price

  25. The Yield Curve Term Structure of Interest Rates - A listing of bond maturity dates and the interest rates that correspond with each date. Yield Curve - Graph of the term structure.

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