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7/26/2019 9-Bond Prices and Yields
1/28
Comm 324 W. suoSlide 1Slide 1
Bond Prices and
Yields
7/26/2019 9-Bond Prices and Yields
2/28
Comm 324 W. suoSlide 2Slide 2
Objective
To review the principles of bond pricing and to
examine the determinants of credit risk. Bond Characteristics Bond ricing and !T" Taxation #ss$es %efa$lt &isk and &atings
7/26/2019 9-Bond Prices and Yields
3/28
Comm 324 W. suoSlide 'Slide '
Characteristics (ace or par val$e Co$pon rate
)ero co$pon bond Compo$nding and pa*ments #ndent$re #ss$ers
rovisions of Bonds Sec$red or $nsec$red Call provision
Convertible provision &etractable and extendible +p$ttable, bonds (loating rate bond
-now *o$r bond
7/26/2019 9-Bond Prices and Yields
4/28
Comm 324 W. suoSlide /Slide /
0 price of the bond0 interest or co$pon pa*ments
0 n$mber of periods to mat$rit*
0 the appropriate semiann$al compo$nding disco$nt rate
Bond ricing
7/26/2019 9-Bond Prices and Yields
5/28
Comm 324 W. suoSlide Slide
0 /3 +S4,
0 1333
0 53 periods
0 136 +S4,
0
7813.91
Solving for rice: '3*r; 86
Co$pon Bond; ar 0 71;333
7/26/2019 9-Bond Prices and Yields
6/28
Comm 324 W. suoSlide 5Slide 5
Bond rices at %ifferent #nterest &ates +86 Co$ponBond; Co$pons aid Semiann$all*
7/26/2019 9-Bond Prices and Yields
7/28Comm 324 W. suoSlide 9Slide 9
The #nverse &elationship Between
rices and %isco$nt rate
rices and disco$nt rates +reero; the val$e of the bond approaches
the s$m of the cash flows
7/26/2019 9-Bond Prices and Yields
8/28Comm 324 W. suoSlide 8Slide 8
!ields
!ield to mat$rit* bond equivalent yield
!ield to first call
?ffective 4nn$al !ield
C$rrent !ield +4nn$al #nterest@"arket rice,
7/26/2019 9-Bond Prices and Yields
9/28Comm 324 W. suoSlide ASlide A
!ield to "at$rit*
#nterest rate that makes the present val$e of the
bonds pa*ments e
7/26/2019 9-Bond Prices and Yields
10/28Comm 324 W. suoSlide 13Slide 13
!ield to "at$rit* ?xample
'3 *r "at$rit* Co$pon &ate 0 86;
C$rrent price 0 71;295.95
Solve for 0 5.36
7/26/2019 9-Bond Prices and Yields
11/28Comm 324 W. suoSlide 11Slide 11
!ield "eas$res
?ffective ann$al *ield
+1.3',2 1 0 5.3A6
C$rrent *ield +ann$al interest@market price,
783 @ 71;295.95 0 5.29 6
Note: contrary to what is used in industry, out
textbook refers to as the yield to maturity
7/26/2019 9-Bond Prices and Yields
12/28Comm 324 W. suoSlide 12Slide 12
!ield to Call
?xample: S$ppose a 86 co$pon; '3*ear mat$rit* bond isselling for 7113; and is callable in 13 *ears at a call priceof 71133. !ield to mat$rit* and *ield to call will be
calc$lated $sing:
7/26/2019 9-Bond Prices and Yields
13/28Comm 324 W. suoSlide 1'Slide 1'
Bond rices and !ields for a Callable Bond
7/26/2019 9-Bond Prices and Yields
14/28Comm 324 W. suoSlide 1/Slide 1/
oldingeriod &et$rn: Single eriod
olding period ret$rn:
?xample: D D *ears; semiann$al compo$nding 30 71333
#n 5" the rate falls to 96; 1071358.
olding period ret$rn
013.86 +semiann$al,
7/26/2019 9-Bond Prices and Yields
15/28Comm 324 W. suoSlide 1Slide 1
oldingeriod &et$rn: "$ltiple eriod
Compo$nd *ield vs. !T"
&e
7/26/2019 9-Bond Prices and Yields
16/28Comm 324 W. suoSlide 15Slide 15
?xample
Two*ear bond selling at par; 136 co$pon paid once a
*ear. (irst co$pon is reinvested at 86; then
(
0A.316
Similarl*; if first co$pon is reinvested at 136; the
reali>ed holding period ret$rn is 136
7/26/2019 9-Bond Prices and Yields
17/28Comm 324 W. suoSlide 19Slide 19
Growth of #nvested ($nds
7/26/2019 9-Bond Prices and Yields
18/28Comm 324 W. suoSlide 18Slide 18
rice aths of Co$pon Bonds
7/26/2019 9-Bond Prices and Yields
19/28Comm 324 W. suoSlide 1ASlide 1A
)eroCo$pon Bonds and Taxation #ss$es
(or constant *ields; disco$nt bond prices rise over time andpremi$m bond prices decline over time
Original iss$e disco$nt +O#%, bonds price appreciation+based on constant *ield, is taxed as ordinar* income
rice changes stemming from *ield changes are taxed ascapital gains if the bond is sold
7/26/2019 9-Bond Prices and Yields
20/28Comm 324 W. suoSlide 23Slide 23
?xample: Tax
'3*ear bond with /6 co$pon rate; iss$ed at an 86 !T"D if sold one *ear later; when
!T"096; for a '56 income tax and a 236 capital gains tax:
30/A.5AD
1+86,0'.55D1+96,05'1.59
#ncome tax +22'.55 2/A.5A, 3.'5
/3 3.'5 12.8'
= +
+ =
+5'1.59 '.55, 3.23 1.5
1.8' 1.5 '1./'/3
+5'1.59 /A.5A, '1./' A3.
A3. @ /A.5A 15.6
CG tax
Total taxAfter tax income
Rate of return
= =
= + =
= +
+ =
= =
7/26/2019 9-Bond Prices and Yields
21/28Comm 324 W. suoSlide 21Slide 21
=hat #s a Credit &atingH
#ndependent; thirdpart* opinion of an entit* or sec$rit* credit
7/26/2019 9-Bond Prices and Yields
22/28Comm 324 W. suoSlide 22Slide 22
=h* %o &atings "atterH
The credit market is act$all* larger +both in si>e and
vol$me, than the e
7/26/2019 9-Bond Prices and Yields
23/28
7/26/2019 9-Bond Prices and Yields
24/28
Comm 324 W. suoSlide 2/Slide 2/
The &ating #nd$str*
Mohn "ood* started assessing railwa* bonds in 1A38 Lo reg$lation; no oversight; no independent research =hen it existed; financial information was not timel* and of d$bio$s
7/26/2019 9-Bond Prices and Yields
25/28
Comm 324 W. suoSlide 2Slide 2
Bond &ating Classes
7/26/2019 9-Bond Prices and Yields
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Comm 324 W. suoSlide 25Slide 25
CREDIT RATINGS & THE CANADIAN FIXED INCOME MARKET 26
&atings N %efa$lt &ates
Best
Credits
Average
Credits
Worst
Credits
Hardly ever
default
Sometimes
default
Frequentlydefault
AAA AA A BBB BB B CCC CC C D
0.3% 0.6% % 3 % !% 30% " #0%
+?stimated c$m$lative defa$lt rates over 9 *ears b* rating categor*,
$nvestment rade S&e'ulative rade
7/26/2019 9-Bond Prices and Yields
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Comm 324 W. suoSlide 29Slide 29
"ethods are proprietar*
4cco$nting ratios
Coverage ratios Jeverage ratio Ji
7/26/2019 9-Bond Prices and Yields
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Sinking f$nds S$bordination of f$t$re debt
%ividend restrictions
Collateral
rotection 4gainst %efa$lt
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