BOND BASICS

1. BOND BASICS $1,000 at maturity Interest each year at coupon rate IBM $1,000 LOAN 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 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 calculations • Debentures: unsecured • Remember bonds are loans Interest Rates and Bond Valuation

9. Call Provision • Allows company to repay loan early • Call price is generally above face value • Call 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 dividends • Limit issuing additional debt • Positive covenants • Maintain times interest earned ratio • Maintain debt ratio • What happens if covenants violated? Interest Rates and Bond Valuation

12. CT 8 and 9: Why gave bonds rated? Why are junk bonds and U.S. bonds not rated? Bond Ratings • S&P and Moodys paid to rate creditworthiness of bond issuer • Corporate and government bonds • Less biased evaluation than stock analysts • Junk bonds: not investment grade • Pension funds and some mutual funds only buy investment grade bond • High-yield, high risk bonds Interest Rates and Bond Valuation

13. Government Bonds • U.S. Treasury • Two year notes to 30-year bonds • Generally not callable • No 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 governments • Some default risk??? • Orange County, Bridgeport, CN • After-tax yield • 6% IBM coupon vs. 5% Illinois coupon • Taxpayer 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 value • 97 ½ is $975; 103 is $1,030 • Current yield = required rate of return • Remember bond prices converge towards $1,000 at maturity • Discount bonds increase; premium bonds decrease Interest Rates and Bond Valuation

17. Investing In Bonds CT 13: Implications for investors since bond market not transparent? • $1,000 per bond • How many bonds to diversify? • Market not transparent • Difficulty in assessing default risk Interest Rates and Bond Valuation

18. Bond Mutual Funds • Pool investors funds • Professional management • Specialize in certain types of bonds • Government • High 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 volatile • More 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 stocks • Treasury bonds very liquid • Many 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 Interest Rates and Bond Valuation