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Understanding Bond Characteristics and Pricing

Explore bond features, issuers, provisions, default risk, ratings, pricing, and yields. Learn about yield measures and holding-period returns. Discover how to calculate yield to maturity and realized yield.

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Understanding Bond Characteristics and Pricing

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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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