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Bond Prices and Yields10Bodie, Kane, and MarcusEssentials of Investments, 10th EditionMcGraw-Hill/Irwin Copyright 2013 by The McGraw-Hill Companies, Inc. All rights reserved.1Homework: Problem sets: 3-10, 14, 15, 19, 21, 26, CFA problems: 2, 6(b), 6(c), and 6 (d)10-#10.1 Bond CharacteristicsBondSecurity that obligates issuer to make payments to holder over timeFace Value, Par ValuePayment to bondholder at maturity of bondCoupon RateBonds annual interest payment per dollar of par valueZero-Coupon BondPays no coupons, sells at discount, provides only payment of par value at maturity10-#3Figure 10.1 Prices/Yields of U.S. Treasury BondsMaturityCouponBidAskedChangeAsked Yield8/15/20121.750101.570101.594-0.0160.1518/15/20144.250111.547111.594-0.0940.35812/31/20152.125105.789105.820-0.1640.7698/15/20174.750120.219120.266-0.2341.2342/15/20208.500152.063152.094-0.3441.8478/15/20236.250137.406137.438-0.6882.5982/15/20276.625145.547145.594-0.7192.9412/15/20315.375130.266130.297-0.9533.26311/15/20394.375111.766111.813-0.8133.6975/15/20414.375111.719111.750-0.9383.718U.S. Treasury Quotes: Treasury note and bond data are representative over-the-counter quotations as of 3pm Eastern time.10-#410.1 Bond Characteristics10-#5Example of Accrued InterestSuppose that the coupon rate is 8%. Then the annual coupon is_____? And the semi-annual coupon payment is_____.

Because 30days have passed since the last coupon payment, the accrued interest on the bond is: ______x(30/182)=_____.

If the quoted price of the bond is $990, the invoice price of the bond is:_____10-#6Figure 10.2 Listing of Corporate Bonds

10-#710.1 Bond CharacteristicsCorporate BondsCall provisions on corporate bondsCallable bonds: May be repurchased by issuer at specified call price during call periodConvertible bondsAllow bondholder to exchange bond for specified number of common stock shares10-#810.1 Bond CharacteristicsCorporate BondsPuttable bondsHolder may choose to exchange for par value or to extend for given number of yearsFloating-rate bondsCoupon rates periodically reset according to specified market date10-#910.1 Bond CharacteristicsPreferred StockCommonly pays fixed dividendDividends not normally tax-deductibleCorporations that purchase other corporations preferred stock are taxed on only 30% of dividends received10-#1010.1 Bond CharacteristicsOther Domestic IssuersState, local governments (municipal bonds)Federal Home Loan Bank BoardFarm Credit agenciesGinnie Mae, Fannie Mae, Freddie Mac10-#1110.1 Bond CharacteristicsInternational BondsForeign bondsIssued by borrower in different country than where bond sold, denominated in currency of market countryEurobondsDenominated in currency (usually that of issuing country) different than that of market10-#1210.2 Bond Pricing10-#1310.2 Bond PricingPrices fall as market interest rate risesInterest rate fluctuations are primary source of bond market riskBonds with longer maturities more sensitive to fluctuations in interest rate10-#14Figure 10.3 Inverse Relationship between Bond Prices and Yields

10-#15Table 10.2 Bond Prices at Different Interest Rates

10-#1610.2 Bond PricingBond Pricing between Coupon DatesInvoice price = Flat price + Accrued interestBond Pricing in Excel=PRICE (settlement date, maturity date, annual coupon rate, yield to maturity, redemption value as percent of par value, number of coupon payments per year)10-#17Spreadsheet 10.1 Valuing Bonds6.25% coupon bond,4.375% coupon bond,8% coupon bond,maturing August 15, 2023Formula in column Bmaturing Nov 15, 203930-year maturitySettlement date8/15/2011=DATE(2011,8,15)8/15/20111/1/2000Maturity date8/15/2023=DATE(2023,8,15)11/15/20391/1/2030Annual coupon rate0.06250.043750.08Yield to maturity0.025980.036970.1Redemption value (% of face value)100100100Coupon payments per year222Flat price (% of par)137.444=PRICE(B4,B5,B6,B7,B8,B9)111.81981.071Days since last coupon0=COUPDAYBS(B4,B5,2,1)920Days in coupon period184=COUPDAYS(B4,B5,2,1)184182Accrued interest0=(B13/B14)*B6*100/21.0940Invoice price137.444=B12+B15112.91381.07110-#1810.3 Bond YieldsYield to MaturityDiscount rate that makes present value of bonds payments equal to price.Current YieldAnnual coupon divided by bond pricePremium BondsBonds selling above par valueDiscount BondsBonds selling below par value10-#19Spreadsheet 10.2 Finding Yield to MaturitySemiannual couponsAnnual couponsSettlement date1/1/20001/2/2000Maturity date1/1/20301/2/2030Annual coupon rate0.080.08Bond price (flat)127.676127.676Redemption value (% of face value)100100Coupon payments per year21Yield to maturity (decimal) 0.06000.0599The formula entered here is =YIELD(B3,B4,B5,B6,B7,B8)10-#20YTM ExampleSuppose an 8% coupon, 30-year bond is selling at $1,276.76. What average rate of return would be earned if an investor purchasing the bond at this price (assuming semi-annual payment)?

PV=_____, FV=______, N=________, PMT=_______, YTM=________10-#2110.3 Bond YieldsYield to CallCalculated like yield to maturityTime until call replaces time until maturity; call price replaces par valuePremium bonds more likely to be called than discount bondsCurrent yield: a bonds annual coupon payment divided by the bond price.10-#22Comparison of YTM, Coupon Rate, and Current YieldFor an 8%m 30-year bond currently selling at $1,276.76. Current yield=_________.Effective Annual Yield to Maturity is: 6.09%Coupon rate__Current yield___YTM.

10-#23Figure 10.4 Bond Prices: Callable and Straight Debt

10-#2410.3 Bond YieldsRealized Compound Returns versus Yield to MaturityRealized compound returnCompound rate of return on bond with all coupons reinvested until maturityHorizon analysisAnalysis of bond returns over multiyear horizon, based on forecasts of bonds yield to maturity and investment optionsReinvestment rate riskUncertainty surrounding cumulative future value of reinvested coupon payments10-#25Figure 10.5 Growth of Invested Funds

10-#26Example of Horizon AnalysisSuppose you buy a 30-year, 7.5% (annual payment) coupon bond for $980, and plan to hold it for 20 years. Your forecast is that the bonds yield to maturity will be 8% when its sold and that the reinvestment rate on the coupons will be 6%. At the end of your investment horizon, the bond will have 10 years remaining until expiration. What is the forecasted sale price and what is the realized compound return?10-#2710.4 Bond Prices Over TimeYield to Maturity versus Holding Period Return (HPR)Yield to maturity measures average RoR if investment held until bond maturesHPR is RoR over particular investment period; depends on market price at end of period10-#28Figure 10.6 Price Paths of Coupon Bonds in Case of Constant Market Interest Rates

10-#2910.4 Bond Prices Over TimeZero-Coupon Bonds and Treasury STRIPSZero-coupon bond: Carries no coupons, provides all return in form of price appreciationSeparate Trading of Registered Interest and Principal of Securities (STRIPS): Oversees creation of zero-coupon bonds from coupon-bearing notes and bonds10-#30Figure 10.7 Price of 30-Year Zero-Coupon Bond over Time at Yield to Maturity of 10%

10-#3110.4 Bond Prices Over TimeAfter-Tax ReturnsBuilt-in price appreciation on original-issue discount bonds constitutes implicit interest payment to holderIRS calculates price appreciation schedule to determine taxable interest income for built-in appreciation10-#3210.5 Default Risk and Bond PricingInvestment grade bondRated BBB and above by S&P or Baa and above by MoodysSpeculative grade or junk bondRated BB or lower by S&P, Ba or lower by Moodys, or unrated10-#33Figure 10.8 Bond Rating Classes

10-#3410.5 Default Risk and Bond PricingDeterminants of Bond SafetyCoverage ratios: Company earnings to fixed costsLeverage ratio: Debt to equityLiquidity ratiosCurrent: Current assets to current liabilitiesQuick: Assets excluding inventories to liabilitiesProfitability ratios: Measures of RoR on assets or equityCash flow-to-debt ratio: Total cash flow to outstanding debt10-#35Table 10.3 Financial Ratios and Default Risk

10-#3610.5 Default Risk and Bond PricingYield to Maturity and Default RiskStated yield is maximum possible yield to maturity of bondDefault premiumIncrement to promised yield that compensates investor for default risk10-#37Figure 10.10 Yield Spreads between Corporate and 10-Year Treasury Bonds10-#3810.5 Default Risk and Bond PricingCredit Default Swaps (CDS)Insurance policy on default risk of corporate bond or loanDesigned to allow lenders to buy protection against losses on large loansLater used to speculate on financial health of companies10-#39Figure 10.11A Prices of CDSs, U.S. Banks

10-#40Figure 10.11B Prices of CDSs, German Sovereign Debt

10-#4110.6 The Yield CurveYield CurveGraph of yield to maturity as function of term to maturityTerm Structure of Interest RatesRelationship between yields to maturity and terms to maturity across bondsExpectations HypothesisYields to maturity determined solely by expectations of future short-term interest rates10-#42Figure 10.13 Returns to Two 2-Year Investment Strategies

10-#4310.6 The Yield Curve10-#4410.6 The Yield Curve10-#45Figure 10.14 Illustrative Yield Curves

10-#46Figure 10.15 Term Spread: Yields on 10-Year versus 90-day Treasury Securities10-#47