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Chapter 7 Interest Rate and Bond Valuation Homework: 15, 16 17 & 26.

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Presentation on theme: "Chapter 7 Interest Rate and Bond Valuation Homework: 15, 16 17 & 26."— Presentation transcript:

1 Chapter 7 Interest Rate and Bond Valuation Homework: 15, & 26

2 Lecture Organization Bonds and Bond Features Bond Valuation and Bond Return Bond Ratings Interest Rate Risk Real and Nominal Interest Rates

3 Bond Features Bond - evidence of debt issued by a corporation or a governmental body. A bond represents a loan made by investors to the issuer. The issuer promises to: Make regular coupon payments every period until the bond matures, and Pay the face/par/maturity value of the bond when it matures. Default - since the above-mentioned promises are contractual obligations, an issuer who fails to keep them is subject to legal action on behalf of the lenders (bondholders).

4 If a bond has five years to maturity, an $80 annual coupon, and a $1000 face value, its cash flows would look like this: Time Coupons$80$80$80$80$80 Face Value$ 1000 $______ How much is this bond worth? It depends on the level of current market interest rates. If the going rate on bonds like this one is 10%, then this bond is worth $ Why? Bond Features (continued)

5 Features of a May Department Stores Bond Term Explanation Amount of issue$200 millionThe company issued $200 million worth of bonds. Date of issue 8/4/94The bonds were sold on 8/4/94. Maturity 8/1/24The principal will be paid 30 years after the issue date. Face Value$1,000The denomination of the bonds is $1,000. Annual coupon 8.375Each bondholder will receive $83.75 per bond per year (8.375% of the face value). Offer price 100The offer price will be 100% of the $1,000 face value per bond.

6 Features of a May Department Stores Bond (concluded) Term Explanation Coupon payment dates2/1, 8/1Coupons of $83.75/2 = $ will be paid on these dates. SecurityNoneThe bonds are debentures. Sinking fundAnnual The firm will make annual payments beginning 8/1/05toward the sinking fund. Call provisionNot callable The bonds have a deferred call feature. before 8/1/04 Call price initially,After 8/1/04, the company can buy back declining to 100the bonds for $1, per bond, declining to $1,000 on 8/1/14. RatingMoody’s A2This is one of Moody’s higher ratings. The bonds have a low probability of default.

7 The Bond Indenture The bond indenture is a three-party contract between the bond issuer, the bondholders, and the trustee. The trustee is hired by the issuer to protect the bondholders’ interests. The indenture includes  The basic terms of the bond issue  The total amount of bonds issued  A description of the security (if any)  Repayment arrangements  Call provisions  Details of the protective covenants

8 Bond Prices and Yields The price of a bond (B) is determined by its face value (F), the coupon payment per period (C), the number of periods until maturity times the number of interest rate periods in a year (T), and the underlying yield to maturity (y):

9 Bond Price Sensitivity to YTM 4%6%8%10% 12% 14%16% $1,800 $1,600 $1,400 $1,200 $1,000 $ 800 $ 600 Bond price Yields to maturity, YTM Coupon = $ years to maturity $1,000 face value

10 Bond Rates and Yields Suppose a bond currently sells for $ It pays an annual coupon of $70, and it matures in 10 years. It has a face value of $1000. What are its coupon rate, current yield, and yield to maturity (YTM)?  1.The coupon rate (or just “coupon”) is the annual dollar coupon expressed as a percentage of the face value: Coupon rate =  2.The current yield is the annual coupon divided by the current market price of the bond: Current yield = Under what conditions will the coupon rate and current yield be the same?

11 Bond Rates and Yields (concluded) 3.The yield to maturity (or “YTM”) is the rate that makes the price of the bond just equal to the present value of its future cash flows. It is the unknown r in: $ = $_______ [1 - 1/(1 + r) 10 ]/r + $_______ /(1 + r) 10 To find the YTM is trial and error: a.Try 10%: b.Try 9%: c.Try 8%: ( ) The yield to maturity is

12 Valuing a Bond Assume you have the following information. Barnhart, Inc. bonds have a $1,000 face value The promised annual coupon is $100 The bonds mature in 20 years The market’s required return on similar bonds is 10%  1. Calculate the present value of the face value  2. Calculate the present value of the coupon payments  3. The value of each bond =

13 Example: A Discount Bond Assume you have the following information. Barnhart, Inc. bonds have a $1,000 face value The promised annual coupon is $100 The bonds mature in 20 years The market’s required return on similar bonds is 12%  1. Calculate the present value of the face value  2. Calculate the present value of the coupon payments  3. The value of each bond =

14 Example: A Premium Bond Assume you have the following information. Barnhart, Inc. bonds have a $1,000 face value The promised annual coupon is $100 The bonds mature in 20 years The market’s required return on similar bonds is 8%  1. Calculate the present value of the face value  2. Calculate the present value of the coupon payments  3. The value of each bond = Why do the bonds in this and the preceding example have prices that are different from par?

15 Bond Prices Over Time

16 Semiannual Coupons In practice, bonds issued in Canada usually make coupon payments twice a year. Bond yields are quoted like APRs. The quoted rate is equal to the actual rate per period multiplied by the number of periods. Suppose the coupon rate is 8%. With a 10% quoted yield and semiannual coupon payments, the true yield is ________________. The bond matures in 7 years. What is the bond’s price?

17 Sample Bond Quotations Bonds Supplied by RBC Dominion Securities Inc./ International from Reuters CouponMat. DateBid SYld% Government Canada6.500Aug 01/ Canada7.750Sep 01/ Canada10.500Jul 01/ Canada7.250Jun 01/ OMHC8.200Jun 30/ OMHC5.100Jun 02/ Corporate Bank of Mont6.900Oct 16/ Cdn Imp Bank4.500Dec 06/ Imperial Oil9.875Dec 15/ Loblaws Co.6.650Nov 08/ Royal Bank11.000Jan 11/ Union Gas8.650Nov 10/ Source: The Financial Post, June 17, 1998, p.45. Used with permission. 1

18 Bond Returns Holding period return on a bond stems from Yield to maturity is internal return on bond but only relevant if coupons reinvested at same rate up to maturity date

19 Bond Return Example Assume you have a 1-year investment horizon and are choosing among three investment grade bonds with 10-years to maturity: a zero-coupon bond, an 8% coupon bond, a 10% coupon bond. Assume yield to maturity of 8%. If the yields on the three bonds are expected to be 8% next year, what is their holding period return?

20 Default Risk Although all bonds are promises to repay the amount borrowed, at times firms find themselves unable to pay. The risk that the firm may not repay the issue is default risk. Several agencies quantitatively measure default risk through a bond rating.  What determines ratings?  Why do firms get rated?

21 Bond Ratings Low Quality, speculative, Investment-Quality Bond Ratings and/or “Junk” High GradeMedium GradeLow GradeVery Low Grade Moody’sAaaAaABaaBaBCaaCaCD DBRS (S&P)AAAAAABBBBBBCCCCCCD Moody’sDBRS AaaAAADebt rated Aaa and AAA has the highest rating. Capacity to pay interest and principal is extremely strong. AaAADebt rated Aa and AA has a very strong capacity to pay interest and repay principal. Together with the highest rating, this group comprises the high-grade bond class. AADebt rated A has a strong capacity to pay interest and repay principal, although it is somewhat more susceptible to the adverse effects of changes in circumstances and economic conditions than debt in high rated categories.

22 Bond Ratings (concluded) BaaBBBDebt rated Baa and BBB is regarded as having an adequate capacity to pay interest and repay principal. Whereas it normally exhibits adequate protection parameters, adverse economic conditions or changing circumstances are more likely to lead to a weakened capacity to pay interest and repay principal for debt in this category than in higher rated categories. These bonds are medium-grade obligations. Ba, BBB, BDebt rated in these categories is regarded, on balance, as Ca, CCC, Cpredominantly speculative with respect to capacity to pay interest and repay principal in accordance with the terms of the obligation. BB and Ba indicate the lowest degree of speculation, and CC and Ca the highest degree of speculation. Although such debt will likely have some quality and protective characteristics, these are out- weighed by large uncertainties or major risk exposures to adverse conditions. Some issues may be in default. DDDebt rated D is in default, and payment of interest and/or repayment of principal is in arrears

23 Interest Rate Risk of Bonds Risk that the bond you own will change in value because interest rates (e.g. YTM) have changed Review:  As interest rates rise, PV _________ all else equal  As interest rates fall, PV _________ all else equal

24 Determinants of the Interest Rate Risk of Bonds Time to Maturity:  The longer the time to maturity, the greater the interest rate risk, all else equal Reason:  10% 1-year and 30-year bonds. Which bond’s price will change more with a change in YTM?

25 Interest Rate Risk and Time to Maturity (Figure 7.2) Bond values ($) Interest rates (%) 1-year bond 30-year bond $1, $ $1, $ ,000 1,500 1, Value of a Bond with a 10% Coupon Rate for Different Interest Rates and Maturities Interest rate 1 year 30 years 5%$1,047.62$1, , , Time to Maturity

26 Determinants of the Interest Rate Risk of Bonds (Continued) Coupon Rate:  The lower the coupon rate, the greater the interest rate risk, all else equal Reason:  0% 8-year and 10% 8-year bonds. Which one has higher interest rate sensitivity?

27 Bond Pricing Theorems The following statements about bond pricing are always true.  1.Bond prices and market interest rates move in _______ directions.  2.When a bond’s coupon rate is (greater than / equal to / less than) the market’s required return, the bond’s market value will be (greater than / equal to / less than) its par value.  3.Given two bonds identical but for maturity, the price of the longer-term bond will change _____ than that of the shorter-term bond, for a given change in market interest rates.  4.Given two bonds identical but for coupon, the price of the lower-coupon bond will change _____ than that of the higher-coupon bond, for a given change in market interest rates.

28 Solution to Problem 7.17 Bond J has a 4% coupon and Bond K a 10% coupon. Both have 10 years to maturity, make semiannual payments, and have 9% YTMs. If market rates rise by 2%, what is the percentage price change of these bonds? If rates fall by 2%? What does this say about the risk of lower-coupon bonds? Current Prices: Bond J: Bond K:

29 Solution to Problem 7.17 (continued) Prices if market rates rise by 2%: Bond J: Bond K:

30 Solution to Problem 7.17 (continued) Prices if market rates fall by 2%: Bond J: Bond K:

31 Percentage Changes in Bond Prices Bond Prices and Market Rates 7%9%11% _________________________________ Bond J % chg.( % )( %) Bond K % chg.( %)( %) _________________________________ The results above demonstrate that, all else equal, the price of the ________________ changes more (in percentage terms) than the price of the _____________ when market rates change. Solution to Problem 7.17 (concluded)

32 Floaters and Inverse Floaters If interest rates rise: - value of principal falls (normal). - current coupon payment increases (floaters). - current coupon payment falls (inverse floaters!!). If interest rates fall: - value of principal rises (normal). - current coupon payment falls (floaters). - current coupon payment rises (inverse floaters!!).

33 Inverse Floaters Constant coupon bonds have ______ interest rate risk Floating coupon bonds have _________ interest rate risk. Inverse floaters have _________ interest rate risk.

34 Callable bonds and convertible bonds Callable bonds: - When will issuers call? - Yield-to-maturity compared with non-callables Convertible bonds: - Why convertible?

35 What Do They Do on Bay Street and Wall Street Often Use Contingent claims pricing Important as bonds are risky. Two types of bond price risk: Basic Idea:  Take into account changes in interest rate and probability of default

36 Inflation and Returns Key issues:  What is the difference between a real and a nominal return?  How can we convert from one to the other? Example: Suppose we have $1,000, and Diet Coke costs $2.00 per six pack. We can buy 500 six packs. Now suppose the rate of inflation is 5%, so that the price rises to $2.10 in one year. We invest the $1,000 and it grows to $1,100 in one year. What’s our return in dollars? In six packs?

37 Inflation and Returns (continued) A.Dollars. Our return is B.Six packs.

38 Inflation and Returns (continued) Real versus nominal returns: Your nominal return is the percentage change in ______________________. Your real return is the percentage change in __________________________.

39 Inflation and Returns (concluded) The relationship between real and nominal returns is described by the Fisher Effect. Let: R=the nominal return r=the real return h=the inflation rate According to the Fisher Effect: 1 + R = (1 + r) x (1 + h) For example, the nominal return is 10%, the inflation rate is 5%, then the real return is _______.

40 U.S. Interest Rates:

41 The Term Structure of Interest Rates (Fig. 7.4)

42

43 Solution to Problem 7.8 Joe Kernan Corporation has bonds on the market with 10.5 years to maturity, a yield-to-maturity of 8 percent, and a current price of $850. The bonds make semiannual payments. What must the coupon rate be on the bonds? Total number of coupon payments = Yield to maturity per period = Maturity value = F = $1000

44 Solution to Problem 7.8 (concluded) Substituting the values into the bond pricing equation: Bond Value = C/2  [1 - 1/(1 + r ) t ] / r + F / (1 + r ) t


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