CHAPTER 8 Bonds and Their Valuation

CHAPTER 8 Bonds and Their Valuation

CHAPTER 8Bonds and Their Valuation

7-#7-#1A 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 Basics7-#2Key Features of a BondDebt instrument issued by a corp. or government.

7-#3Key Features of a BondPar value = face amount of the bond, which is paid at maturity (assume $1,000).

=7-#4Key Features of a BondCoupon rate stated interest rate (generally fixed) paid by the issuer. Multiply by par to get dollar payment of interest.

7-#5Key Features of a BondMaturity date when the bond must be repaid.Yield to maturity - rate of return earned on a bond held until maturity.

7-#6What 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.

7-#7What 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.

7-#8Suppose you just inherited $500,000. You intend to invest the money and live off the interest.

Reinvestment rate risk example7-#9Reinvestment rate risk exampleYou may invest in either a 10-year bond or a series of ten 1-year bonds. Both bonds currently yield 5%.7-#10If 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.

7-#11Long-term bonds: High interest rate risk, low reinvestment rate risk.Short-term bonds: Low interest rate risk, high reinvestment rate risk.7-#12Bond 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.7-#7-#130 1 2 3 4 5 2009 2010 2011 2012 201363.7563.7563.7563.7563.751,000.00IBM Bond Timeline:7-#7-#14$63.75 Annuity for 5 years$1000 Lump Sum in 5 years0 1 2 3 4 5 2009 2010 2011 2012 201363.7563.7563.7563.7563.751000.00IBM Bond Timeline:7-#7-#15= 63.75 PMT 1000 FV 8% I 5 N = PV = 935.12$63.75 Annuity for 5 years$1000 Lump Sum in 5 years0 1 2 3 4 5 2009 2010 2011 2012 201363.7563.7563.7563.7563.751000.00IBM Bond Timeline:7-#7-#16Most 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?

7-#7-#17Most 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 $45.0 1 2 3 4 5 2009 2010 2011 2012 20134545.001000.0045454545454545457-#7-#18Compute 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 usesemiannual compoundingVB = 45 PMT 1000 FV 5% I ?N Most Bonds Pay Interest Semi-Annually:0 1 2 3 4 5 2009 2010 2011 2012 20134545.001000.0045454545454545457-#7-#19Most Bonds Pay Interest Semi-Annually:= PV = 961.39Compute 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 usesemiannual compounding0 1 2 3 4 5 2009 2010 2011 2012 201345451,00045454545454545457-#7-#20If YTM > Coupon Rate bond Sells at a DISCOUNTIf YTM < Coupon Rate bond Sells at a PREMIUMYield to Maturity-1,0000 1 2 3 4 5 2009 2010 2011 2012 201380808080801,0007-#21Yield to MaturityIf 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 ? -966.25??0 1 2 3 4 5 2009 2010 2011 2012 201363.7563.7563.7563.7563.751000.00 + ??966.257-#22Yield to MaturityYTMB = 63.75 PMT 1000 FV 5 N -966.25 PVI = ?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%?-966.25??0 1 2 3 4 5 2009 2010 2011 2012 201363.7563.7563.7563.7563.751000.00 + ??966.257-#23Whats the YTM on a 10-year, 9% annual coupon, $1,000 par value bond that sells for $887? 9090 9001910rd=?1,000PV1 . . .PV10PVM887Find rd that works!...7-#2410 -887 90 1000NI/YR PV PMTFV10.91INPUTSOUTPUT7-#25Types of BondsVanilla fixed coupons, repaid at maturityConvertible can be converted into to stockZero Coupon pay no explicit interest but instead, sell at a deep discount

7-#26Types of BondsJunk Bonds below investment grade

7-#27Bond RatingsMoodys and Standard & Poors regularly monitor issuers financial condition and assign a rating to the debtInvestment GradeBelow Investment Grade (Junk)AAABest QualityAAHigh QualityAUpper Medium GradeBBBMedium GradeBBSpeculativeBVery SpeculativeCCCVery Very SpeculativeCCCNo Interest Being PaidDCurrently in Default7-#28What affects Bond prices?RiskInterest rates

7-#29What 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.7-#30Draw a normal yield curve7-#Hypothetical Treasury Yield Curve05101511020Years to MaturityInterestRate (%) 1 yr 8.0%10 yr 11.4%20 yr 12.65%Real risk-free rateInflation premiumMaturity risk premium7-#32Current RatesBloomberg 7-#What factors can explain the shape of this yield curve?7-#34What 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.7-#35Default riskIf an issuer defaults, investors receive less than the promised return. Influenced by the issuers financial strength and the terms of the bond contract.7-#36