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CHAPTER 8 Bonds and Their Valuation

CHAPTER 8 Bonds and Their Valuation. A bond is simply a negotiable IOU , or a loan. Investors who buy bonds are lending a specific sum of money to a corporation, government, or some other borrowing institution. Bonds are often referred to as fixed-income investments. Bond Basics.

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CHAPTER 8 Bonds and Their Valuation

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  1. CHAPTER 8Bonds and Their Valuation

  2. A bond is simply a negotiable IOU, or a loan. Investors who buy bonds are lending a specific sum of money to a corporation, government, or some other borrowing institution. Bonds are often referred to as fixed-income investments. Bond Basics

  3. Key Features of a Bond • Debt instrument issued by a corp. or government.

  4. Key Features of a Bond • Par value = face amount of the bond, which is paid at maturity (assume $1,000). =

  5. Key Features of a Bond • Coupon rate – stated interest rate (generally fixed) paid by the issuer. Multiply by par to get dollar payment of interest.

  6. Key Features of a Bond • Maturity date – when the bond must be repaid. • Yield to maturity - rate of return earned on a bond held until maturity.

  7. What is reinvestment rate risk? • Reinvestment rate risk is the concern that interest rates will fall, and future money will have to be reinvested at lower rates, hence reducing income.

  8. What is interest rate risk? • Interest rate risk is the concern that interest rates will rise, and therefore, a reduction in the value of a security.

  9. Reinvestment rate risk example Suppose you just inherited $500,000. You intend to invest the money and live off the interest.

  10. Reinvestment rate risk example • You may invest in either a 10-year bond or a series of ten 1-year bonds. • Both bonds currently yield 5%.

  11. If you choose the 1-year bond strategy: • After Year 1, you receive $25,000 in income and have $500,000 to reinvest. But, if 1-year rates fall to 3%, your annual income would fall to $15,000. • If you choose the 10-year bond strategy: • You can lock in a 5% interest rate, and $25,000 annual income.

  12. Long-term bonds: High interest rate risk, low reinvestment rate risk. • Short-term bonds: Low interest rate risk, high reinvestment rate risk.

  13. Bond Valuation Compute the value for an IBM Bond with a 6.375% coupon that will mature in 5 years given that you require an 8% return on your investment.

  14. 2009 2010 2011 2012 2013 0 1 2 3 4 5 63.75 63.75 63.75 63.75 63.75 1,000.00 IBM Bond Timeline:

  15. 2009 2010 2011 2012 2013 0 1 2 3 4 5 63.75 63.75 63.75 63.75 63.75 1000.00 IBM Bond Timeline: $1000 Lump Sum in 5 years $63.75 Annuity for 5 years

  16. IBM Bond Timeline: $1000 Lump Sum in 5 years $63.75 Annuity for 5 years 2009 2010 2011 2012 2013 0 1 2 3 4 5 63.75 63.75 63.75 63.75 63.75 1000.00 = 63.75 PMT 1000 FV 8% I 5 N = PV = 935.12

  17. Most Bonds Pay Interest Semi-Annually: What is the value of a bond with a semi-annual coupon with 5 years to maturity, 9% (nominal) coupon rate if an investor desires a 10% (nominal) return?

  18. 2009 2010 2011 2012 2013 0 1 2 3 4 5 45.00 1000.00 45 45 45 45 45 45 45 45 45 Most Bonds Pay Interest Semi-Annually: e.g. semiannual coupon bond with 5 years to maturity, 9% annual coupon rate. Instead of 5 annual payments of $90, the bondholderreceives 10 semiannual payments of $45.

  19. 2009 2010 2011 2012 2013 0 1 2 3 4 5 45.00 1000.00 45 45 45 45 45 45 45 45 45 Most Bonds Pay Interest Semi-Annually: Compute the value of the bond given that you require a 10% s-a. return on your investment. Since interest is received every 6 months, we need to use semiannual compounding VB = 45 PMT 1000 FV 5% I ?N

  20. Compute the value of the bond given that you require a 10% s-a. return on your investment. 2009 2010 2011 2012 2013 Since interest is received every 6 months, we need to use semiannual compounding 0 1 2 3 4 5 45 1,000 45 45 45 45 45 45 45 45 45 Most Bonds Pay Interest Semi-Annually: = PV = 961.39

  21. -1,000 2009 2010 2011 2012 2013 0 1 2 3 4 5 80 80 80 80 80 1,000 Yield to Maturity • If YTM > Coupon Rate bond Sells at a DISCOUNT • If YTM < Coupon Rate bond Sells at a PREMIUM

  22. 2009 2010 2011 2012 2013 0 1 2 3 4 5 Yield to Maturity • If an investor purchases a 6.375% annual coupon bond today for $966.25 and holds it until maturity (5 years), what is the expected annual rate of return ? 63.75 63.75 63.75 63.75 63.75 -966.25 1000.00 ?? + ?? 966.25

  23. If an investor purchases a 6.375% annual coupon bond today for $966.25 and holds it until maturity (5 years), what is the expected annual rate of return ? Will it be >< than 6.375%? 2009 2010 2011 2012 2013 0 1 2 3 4 5 63.75 63.75 63.75 63.75 63.75 -966.25 1000.00 ?? + ?? 966.25 Yield to Maturity YTMB = 63.75 PMT 1000 FV 5 N -966.25 PV I = ?

  24. What’s the YTM on a 10-year, 9% annual coupon, $1,000 par value bond that sells for $887? 0 1 9 10 rd=? ... 90 90 90 1,000 PV1 . . . PV10 PVM Find rd that “works”! 887

  25. 10 -887 90 1000 N I/YR PV PMT FV 10.91 INPUTS OUTPUT

  26. Types of Bonds • Vanilla – fixed coupons, repaid at maturity • Convertible – can be converted into to stock • Zero Coupon – pay no explicit interest but instead, sell at a deep discount

  27. Types of Bonds • Junk Bonds – below investment grade

  28. AAA Best Quality AA High Quality A Upper Medium Grade BBB Medium Grade BB Speculative B Very Speculative CCC Very Very Speculative CC C No Interest Being Paid D Currently in Default Bond Ratings • Moody’s and Standard & Poor’s regularly monitor issuer’s financial condition and assign a rating to the debt Investment Grade Below Investment Grade (Junk)

  29. What affects Bond prices? • Risk • Interest rates

  30. What is the “term structure of interest rates”? What is a “yield curve”? • Term structure: the relationship between interest rates (or yields) and maturities. • A graph of the term structure is called the yield curve.

  31. Draw a normal yield curve

  32. Hypothetical Treasury Yield Curve Interest Rate (%) 1 yr 8.0% 10 yr 11.4% 20 yr 12.65% 15 Maturity risk premium 10 Inflation premium 5 Real risk-free rate Years to Maturity 0 1 20 10

  33. Current Rates • Bloomberg

  34. What factors can explain the shape of this yield curve?

  35. What factors can explain the shape of this yield curve? • This constructed yield curve is upward sloping. • This is due to increasing expected inflation and an increasing maturity risk premium.

  36. Default risk • If an issuer defaults, investors receive less than the promised return. • Influenced by the issuer’s financial strength and the terms of the bond contract.

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