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Chapter 14

Chapter 14. Bond Prices and Yields. Bond Characteristics. Face or par value Coupon rate Zero coupon bond Compounding and payments Accrued Interest Indenture. Different Issuers of Bonds. U.S. Treasury Notes and Bonds Corporations Municipalities

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Chapter 14

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  1. Chapter 14 Bond PricesandYields 14-1

  2. Bond Characteristics • Face or par value • Coupon rate • Zero coupon bond • Compounding and payments • Accrued Interest • Indenture 14-2

  3. Different Issuers of Bonds • U.S. Treasury • Notes and Bonds • Corporations • Municipalities • International Governments and Corporations • Innovative Bonds • Indexed Bonds • Floaters and Reverse Floaters 14-3

  4. Provisions of Bonds • Secured or unsecured • Call provision • Convertible provision • Put provision (putable bonds) • Floating rate bonds • Sinking funds 14-4

  5. Default Risk and Ratings • Rating companies • Moody’s Investor Service • Standard & Poor’s • Duff and Phelps • Fitch • Rating Categories • Investment grade • Speculative grade 14-5

  6. Factors Used by Rating Companies • Coverage ratios • Leverage ratios • Liquidity ratios • Profitability ratios • Cash flow to debt 14-6

  7. Protection Against Default • Sinking funds • Subordination of future debt • Dividend restrictions • Collateral 14-7

  8. Bond Pricing 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 14-8

  9. 20  1 1 = + P 40 1000 B t 20 (1+.03) (1+.03) t =1 Solving for Price: 10-yr, 8% Coupon Bond, Face = $1,000 PB = $1,148.77 Ct = 40 (SA) P = 1000 T = 20 periods r = 3% (SA) 14-9

  10. Bond Prices and Yields 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 14-10

  11. Price Yield Prices and Coupon Rates 14-11

  12. 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 14-12

  13. Yield to Maturity Example 10 yr Maturity Coupon Rate = 7% Price = $950 Solve for r = semiannual rate r = 3.8635% 14-13

  14. 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 % 14-14

  15. Realized Yield versus YTM • Reinvestment Assumptions • Holding Period Return • Changes in rates affects returns • Reinvestment of coupon payments • Change in price of the bond 14-15

  16. Holding-Period Return: Single Period HPR = [ I + ( P0 - P1 )]/P0 where I = interest payment P1 = price in one period P0 = purchase price 14-16

  17. 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) 14-17

  18. Holding-Period Return: Multiperiod • Requires actual calculation of reinvestment income • Solve for the Internal Rate of Return using the following: • Future Value: sales price + future value of coupons • Investment: purchase price 14-18

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