BOND FUNDAMENTALS
CHAPTER FOUR
Practical Investment Management
Robert A. Strong
A1 3
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Bond Principles Identification of Bonds Classification of Bonds
• Issuer• Security• Term
Terms of Repayment• Interest Only• Sinking Fund• Balloon Loan• Income Bond
Outline
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Bond Principles … continued Bond Cash Flows
• Annuities• Zero Coupon• Variable Rate• Consols• Inflation-Indexed Treasury Bonds
Convertible and Exchangeable Bonds Registration
• Bearer Bonds• Registered Bonds• Book Entry Bonds
Outline
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The Financial Page Listing Basic Information Footnotes Government Bonds
Bond Pricing and Returns Valuation Equations
• Annuities• Zero Coupon Bonds• Variable Rate Bonds• Consols
Outline
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Bond Pricing and Returns … continued Yield to Maturity
• Calculating the Yield to Maturity• Misreading the Yield to Maturity• The Yield Curve
Spot Rates Realized Compound Yield Current Yield Accrued Interest
Outline
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Bond Risks Price Risks
• Default Risk• Interest Rate Risk
Convenience Risks• Call Risk• Reinvestment Rate Risk• Marketability Risk
Outline
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Bond Principles: Identification of Bonds
Bonds are identified by issuer, coupon rate, and maturity.
The face value of a bond is called its par value.
e.g. 5 of “Hertz sevens of 03” (Hertz 7s03)
A legal document called the indenture contains the details of the bond issue.
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a. government e.g. US Treasury, federal agency, state, local
b. corporation e.g. industrial, utility, financial, transportation
c. others e.g. foreign government, foreign corporation, World Bank
Bond Principles: Classification of Bonds
Method 1: By issuer
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Bond Principles: Classification of Bonds
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a. unsecured debt - backed by faith in the taxingpower of the government, or the good name ofthe company (debenture)
b. secured debt e.g. revenue bond, assessmentbond, mortgage, collateral trust bond, equipment trust certificate
Bond security sometimes comes from non-traditional sources. Recently, some rock stars floated bonds using their future earnings as backing.
Method 2: By security
Bond Principles: Classification of Bonds
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Method 3: By term
a. short-term - a year e.g. US Treasury bills
b. intermediate-term e.g. US Treasury notes (2 to 10 years )
c. long-term e.g. US Treasury bonds ( 10 years)
d. open-ended e.g. corporate line of credit
e. serial bond - a portfolio of bonds with staggered terms
Bond Principles: Classification of Bonds
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Bond Principles: Classification of Bonds
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interest only - the periodic payments are entirely interest
sinking fund - periodically, a portion of the debt principal is set aside or a certain number of the bonds is retired
balloon loan - the debt may be partially amortized with each payment
income bond- interest is payable only if it is earned
Bond Principles: Terms of Repayment
annuities - most bonds are annuities plus an ultimate repayment of principal
zero coupon - only the par value is returned at maturity
variable (adjustable) rate - the rate fluctuates in accordance with some market index or predetermined schedule
consols - a level rate of interest is paid perpetually
inflation-indexed Treasury bonds - the principal value is adjusted based on the consumer price index
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Bond Principles: Bond Cash Flows
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convertible bond - may be exchanged for common stock in the company that issued the bond
exchangeable bond - may be exchanged for shares in another firm
Bond Principles: Options
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bearer (coupon) bonds - belong to whomever legally hold them; no longer issued in the United States because of tax considerations
registered bonds - the bonds show the bondholder’s name
book entry bonds - bond ownership is reflected only in the accounting records
Bond Principles: Registration
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Bond Principles: Registration
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Basic Information
Cur Net Bonds Yld Vol Close Chg.AMR 9s16 8.4 23 107 + ¾
Footnotescv - convertible zr - zero couponvj - bankruptcy dc - deep discountf - trading flat
GovernmentBonds
Maturity AskRate Mo/Yr Bid Asked Chg. Yld. 6 Feb 26 86:09 86:11 - 9 7.11
The Financial Page Listing
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The Financial Page Listing
Insert Figure 4-2 here.
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present the from periods semiannual in time ratediscount
periods semiannual in bond the of term where
1
value par
1
interest
al)PV(princip t)PV(interes price bondcurrent
1
trn
rr n
n
tt
22
1. AnnuitiesThe bond pricing relationship is customarily expressed in terms of semiannual periods.
Bond Pricing & Returns: Valuation Equations
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2. Zero Coupon Bonds
nr 1
value par al)PV(princip price bondcurrent
3. Variable Rate Bonds
n
tttr
t
1 21
timeat flow cash price bondcurrent
Bond Pricing & Returns: Valuation Equations
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4. Consols
r
t
r
t
tt
timeat flow cash
timeat flow cash price bondcurrent
1 1
Bond Pricing & Returns: Valuation Equations
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The yield to maturity is the single interest rate that, when applied to the stream of cash flows associated with a bond, causes the present value of those cash flows to equal the bond’s market price.
Bond Pricing & Returns: Yield to Maturity
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value) 0.4(par price) 0.6(market
maturity until yearsvalue par - pricemarket
-interest annual YTMapprox
A heuristic:
Bond Pricing & Returns: Yield to Maturity
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Bond Pricing & Returns: Yield to Maturity
The yield to maturity calculation carries an assumption that coupon proceeds are reinvested at the yield to maturity.
If a bond pays periodic interest, it is not possible to lock in a prescribed yield to maturity.
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Bond Pricing & Returns: Yield to Maturity
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A plot of interest rates against time tomaturity is known as a yield curve.
yield
time
Bond Pricing & Returns: Yield to Maturity
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Bond Pricing & Returns: Yield to Maturity
Insert Figure 4-4 here.
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A spot rate is the yield to maturity ofa zero coupon security of the chosen maturity.
A treasury strip is a government bond or notethat has been decomposed into two parts, one for the stream of interest payments and one for the return of principal at maturity.
The yield to maturity is a derived statistic afterthe bond price is known.
Bond Pricing & Returns: Spot Rates
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The yield to maturity can be thought of as an “average” of the spot rates, or as a flat yield curve at some constant interest rate.
This single interest rate makes the presentvalue of the future cash flows equal to the bond’s market price.
%
Term
Yield to Maturity
Spot Rate Curve
Bond Pricing & Returns: Spot Rates
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Bond Pricing & Returns: Spot Rates
Insert Figure 4-5 here.
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Realized Compound Yield:
yearper payments of number maturity to yield where
1 rate annual effective
xr
x
rx
1
How can two investments paying interest on two different time schedules be compared?
Bond Pricing & Returns
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The current yield only measures the return associated with the bond’s interest payments.
A bond whose market price is less than its par value is selling at a discount. The price of such bonds rise as maturity approaches.
If the market price is more than the parvalue, the bond is selling at a premium.
Bond Pricing & Returns: Current Yield
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Bond Pricing & Returns: Current Yield
Insert Figure 4-6 here.
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Interest is earned for each day that a bond is held, although interest payments are generally made twice a year only.
A bond buyer must pay the accrued interest to the seller of the bond.
dirty price = bond price + accrued interestclean price = bond price
By convention, accrued interest iscalculated using a 360-day year.
Bond Pricing & Returns: Accrued Interest
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Bond Pricing & Returns: Accrued Interest
Insert Figure 4-7 here.
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default risk - the possibility that the issuer of the bond is unable to pay - rated by agencies like Moody’s and Standard & Poor’s
Bond Risks: Price Risks
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Bond Risks: Price Risks
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interest rate risk - the chance of loss due to changing interest rates
Bond Risks: Price Risks
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call risk - the possibility that the company will exercise a bond’s call feature
Bond Risks: Convenience Risks
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Bond Risks: Convenience Risks
Insert Figure 4-8 here.
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reinvestment rate risk - the chance that the interest received cannot be reinvested to earn as much as the bond’s original yield to maturity - the higher the coupon on a bond, the higher its reinvestment rate risk
marketability risk - the difficulty of selling a bond in the secondary market
Bond Risks: Convenience Risks
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Bond Principles Identification of Bonds Classification of Bonds
• Issuer• Security• Term
Terms of Repayment• Interest Only• Sinking Fund• Balloon Loan• Income Bond
Review
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Bond Principles … continued Bond Cash Flows
• Annuities• Zero Coupon• Variable Rate• Consols• Inflation-Indexed Treasury Bonds
Convertible and Exchangeable Bonds Registration
• Bearer Bonds• Registered Bonds• Book Entry Bonds
Review
South-Western / Thomson Learning © 2004 4 - 45
The Financial Page Listing Basic Information Footnotes Government Bonds
Bond Pricing and Returns Valuation Equations
• Annuities• Zero Coupon Bonds• Variable Rate Bonds• Consols
Review
South-Western / Thomson Learning © 2004 4 - 46
Bond Pricing and Returns … continued Yield to Maturity
• Calculating the Yield to Maturity• Misreading the Yield to Maturity• The Yield Curve
Spot Rates Realized Compound Yield Current Yield Accrued Interest
Review
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Bond Risks Price Risks
• Default Risk• Interest Rate Risk
Convenience Risks• Call Risk• Reinvestment Rate Risk• Marketability Risk
Review