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CHAPTER 14 CHAPTER 14 Investments Investments Bond Prices and Bond Prices and Yields Yields Slides by Slides by Richard D. Johnson Richard D. Johnson Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin McGraw-Hill/Irwin Cover image

CHAPTER 14 Investments Bond Prices and Yields Slides by Richard D. Johnson Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin

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Page 1: CHAPTER 14 Investments Bond Prices and Yields Slides by Richard D. Johnson Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin

CHAPTER 14CHAPTER 14

InvestmentsInvestments

Bond Prices and Bond Prices and YieldsYields

Slides bySlides by

Richard D. JohnsonRichard D. Johnson

Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reservedCopyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/IrwinMcGraw-Hill/Irwin

Cover image

Page 2: CHAPTER 14 Investments Bond Prices and Yields Slides by Richard D. Johnson Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin

14- 14- 22

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Face or par valueCoupon rate

– Zero coupon bond

Compounding and payments– Accrued Interest

Indenture

Bond Characteristics

Page 3: CHAPTER 14 Investments Bond Prices and Yields Slides by Richard D. Johnson Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin

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Different Issuers of Bonds

U.S. Treasury

– Notes and Bonds Corporations Municipalities International Governments and Corporations Innovative Bonds

– Floaters and Inverse Floaters

– Asset-Backed

– Catastrophe

Page 4: CHAPTER 14 Investments Bond Prices and Yields Slides by Richard D. Johnson Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin

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Figure 14.1 Listing of Treasury Issues

Page 5: CHAPTER 14 Investments Bond Prices and Yields Slides by Richard D. Johnson Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin

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Figure 14.2 Corporate Bond Listings

Page 6: CHAPTER 14 Investments Bond Prices and Yields Slides by Richard D. Johnson Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin

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Secured or unsecuredCall provisionConvertible provisionPut provision (putable bonds)Floating rate bondsSinking funds

Provisions of Bonds

Page 7: CHAPTER 14 Investments Bond Prices and Yields Slides by Richard D. Johnson Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin

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Table 14.1 Principal and Interest Payments for Treasury Inflation Protected Security

Page 8: CHAPTER 14 Investments Bond Prices and Yields Slides by Richard D. Johnson Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin

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)1()1(1 rParValue

rCP T

T

T

tt

tB

PB = Price of the bond

Ct = interest or coupon payments

T = number of periods to maturity

y = semi-annual discount rate or the semi-annual yield to maturity

Bond Pricing

Page 9: CHAPTER 14 Investments Bond Prices and Yields Slides by Richard D. Johnson Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin

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Ct = 40 (SA)P = 1000T = 20 periodsr = 3% (SA)

Price: 10-yr, 8% Coupon, Face = $1,000

77.148,1$

)03.1(

1000

03.1

140

20

20

1

P

Pt

t

Page 10: CHAPTER 14 Investments Bond Prices and Yields Slides by Richard D. Johnson Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin

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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.

Bond Prices and Yields

Page 11: CHAPTER 14 Investments Bond Prices and Yields Slides by Richard D. Johnson Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin

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Figure 14.3 The Inverse Relationship Between Bond Prices and Yields

Page 12: CHAPTER 14 Investments Bond Prices and Yields Slides by Richard D. Johnson Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin

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Table 14.2 Bond Prices at Different Interest Rates (8% Coupon Bond, Coupons Paid Semiannually

Page 13: CHAPTER 14 Investments Bond Prices and Yields Slides by Richard D. Johnson Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin

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Yield to Maturity

Interest rate that makes the present value of the bond’s payments equal to its price.

Solve the bond formula for r

)1()1(1 rParValue

rCP T

T

T

tt

tB

Page 14: CHAPTER 14 Investments Bond Prices and Yields Slides by Richard D. Johnson Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin

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Yield to Maturity Example

)1(1000

)1(35950

20

1 rrT

tt

10 yr Maturity Coupon Rate = 7%

Price = $950

Solve for r = semiannual rate r = 3.8635%

Page 15: CHAPTER 14 Investments Bond Prices and Yields Slides by Richard D. Johnson Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin

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Yield Measures

Bond Equivalent Yield

7.72% = 3.86% x 2

Effective Annual Yield

(1.0386)2 - 1 = 7.88%

Current Yield

Annual Interest / Market Price

$70 / $950 = 7.37 %

Yield to Call

Page 16: CHAPTER 14 Investments Bond Prices and Yields Slides by Richard D. Johnson Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin

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Figure 14.4 Bond Prices: Callable and Straight Debt

Page 17: CHAPTER 14 Investments Bond Prices and Yields Slides by Richard D. Johnson Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin

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Example 14.4 Yield to Call

Page 18: CHAPTER 14 Investments Bond Prices and Yields Slides by Richard D. Johnson Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin

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Realized Yield versus YTM

Reinvestment AssumptionsHolding Period Return

– Changes in rates affects returns

– Reinvestment of coupon payments

– Change in price of the bond

Page 19: CHAPTER 14 Investments Bond Prices and Yields Slides by Richard D. Johnson Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin

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Figure 14.5 Growth of Invested Funds

Page 20: CHAPTER 14 Investments Bond Prices and Yields Slides by Richard D. Johnson Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin

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Figure 14.6 Prices over Time of 30-Year Maturity, 6.5% Coupon Bonds

Page 21: CHAPTER 14 Investments Bond Prices and Yields Slides by Richard D. Johnson Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin

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Holding-Period Return: Single Period

HPR = [ I + ( P0 - P1 )] / P0

where

I = interest payment

P1 = price in one period

P0 = purchase price

Page 22: CHAPTER 14 Investments Bond Prices and Yields Slides by Richard D. Johnson Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin

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Holding-Period Example

CR = 8% YTM = 8% N=10 years

Semiannual Compounding P0 = $1000

In six months the rate falls to 7%

P1 = $1068.55

HPR = [40 + ( 1068.55 - 1000)] / 1000

HPR = 10.85% (semiannual)

Page 23: CHAPTER 14 Investments Bond Prices and Yields Slides by Richard D. Johnson Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin

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Figure 14.7 The Price of a 30-Year Zero-Coupon Bond over Time at a Yield to Maturity of 10%

Page 24: CHAPTER 14 Investments Bond Prices and Yields Slides by Richard D. Johnson Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin

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Rating companies– Moody’s Investor Service

– Standard & Poor’s

– Fitch

Rating Categories– Investment grade

– Speculative grade

Default Risk and Ratings

Page 25: CHAPTER 14 Investments Bond Prices and Yields Slides by Richard D. Johnson Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin

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Figure 14.8 Definitions of Each Bond Rating Class

Page 26: CHAPTER 14 Investments Bond Prices and Yields Slides by Richard D. Johnson Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin

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Coverage ratiosLeverage ratiosLiquidity ratiosProfitability ratiosCash flow to debt

Factors Used by Rating Companies

Page 27: CHAPTER 14 Investments Bond Prices and Yields Slides by Richard D. Johnson Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin

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Table 14.3 Financial Ratios and Default Risk by Rating Class, Long-Term Debt

Page 28: CHAPTER 14 Investments Bond Prices and Yields Slides by Richard D. Johnson Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin

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Figure 14.9 Discriminant Analysis

Page 29: CHAPTER 14 Investments Bond Prices and Yields Slides by Richard D. Johnson Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin

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Sinking fundsSubordination of future debtDividend restrictionsCollateral

Protection Against Default

Page 30: CHAPTER 14 Investments Bond Prices and Yields Slides by Richard D. Johnson Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin

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Figure 14.10 Callable Bond Issue by Mobil

Page 31: CHAPTER 14 Investments Bond Prices and Yields Slides by Richard D. Johnson Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin

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Default Risk and Yield

Risk structure of interest ratesDefault premiums

– Yields compared to ratings

– Yield spreads over business cycles

Page 32: CHAPTER 14 Investments Bond Prices and Yields Slides by Richard D. Johnson Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin

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Figure 14.11 Yields on Long-Term Bonds,1954 – 2006


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