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Definition of a Bond

Definition of a Bond. A bond is a security that obligates the issuer to make specified interest and principal payments to the holder on specified dates. Coupon rate Face value (or par) Maturity (or term) Bonds are sometimes called fixed income securities. Types of Bonds.

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Definition of a Bond

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  1. Definition of a Bond • A bond is a security that obligates the issuer to make specified interest and principal payments to the holder on specified dates. • Coupon rate • Face value (or par) • Maturity (or term) • Bonds are sometimes called fixedincome securities.

  2. Types of Bonds • Pure Discount or Zero-Coupon Bonds • Pay no coupons prior to maturity. • Pay the bond’s face value at maturity. • Coupon Bonds • Pay a stated coupon at periodic intervals prior to maturity. • Pay the bond’s face value at maturity. • Perpetual Bonds (Consols) • No maturity date. • Pay a stated coupon at periodic intervals.

  3. Bond Issuers • Government • Financial Institutions • Countries • Corporations

  4. Government Bonds • Treasury Bills (Gilts) • No coupons (zero coupon security) • Face value paid at maturity • Maturities up to one year • Treasury Notes • Coupons paid semiannually • Face value paid at maturity • Maturities from 2-10 years

  5. Government Bonds • Treasury Bonds • Coupons paid semiannually • Face value paid at maturity • Maturities over 10 years • The 30-year bond is called the long bond.

  6. Government Bonds • No default risk. Considered to be riskfree. • Exempt from state and local taxes. • Sold regularly through a network of primary dealers. • Traded regularly in the over-the-counter market.

  7. Corporate Bonds • Secured Bonds (Asset-Backed) • Secured by real property • Ownership of the property reverts to the bondholders upon default. • Debentures • General creditors • Have priority over stockholders, but are subordinate to secured debt.

  8. Common Features of Corporate Bonds • Senior versus subordinated bonds • Convertible bonds • Callable bonds • Putable bonds • Sinking funds

  9. Bond Ratings

  10. 1000  £696 . 56 5 1 . 075 1000 591 . 11  7 1  r d Valuing Zero Coupon Bonds • What is the current market price of a U.S. Treasury strip that matures in exactly 5 years and has a face value of £1,000. The yield to maturity is rd=7.5%. • What is the yield to maturity on a U.S. Treasury strip that pays £1,000 in exactly 7 years and is currently selling for £591.11?

  11. Bond Yields and PricesThe case of zero coupon bonds • Consider three zero-coupon bonds, all with • face value of F=100 • yield to maturity of r=10%, compounded annually. We obtain the following table:

  12. The Impact of Price Responses • Suppose the yield would drop suddenly to 9%, or increase to 10%. How would prices respond? • Bond prices move up if the yield drops, decrease if yield rises • Prices respond more strongly for higher maturities

  13. Bond Valuation:An Example What is the market price of a U.S. Treasury bond that has a coupon rate of 9%, a face value of £1,000 and matures exactly 10 years from today if the required yield to maturity is 10% compounded semiannually? 0 6 12 18 24 ... 120 Months 45 45 45 45 1045

  14. Relationship Between Bond Prices and Yields • Bond prices are inversely related to interest rates (or yields). • A bond sells at par only if its coupon rate equals the coupon rate • A bond sells at a premium if its coupon is above the coupon rate. • A bond sells a a discount if its coupon is below the coupon rate.

  15. Volatility of Coupon Bonds • Consider two bonds with 10% annual coupons with maturities of 5 years and 10 years. • The yield is 8% • What are the responses to a 1% price change? • The sensitivity of a coupon bond increases with the maturity?

  16. Bond Prices and Yields Longer term bonds are more sensitive to changes in interest rates than shorter term bonds. Bond Price F c Yield

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