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7-2 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

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7-3 Key Features of a Bond Debt instrument issued by a corp. or government.

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7-4 Key Features of a Bond Par value = face amount of the bond, which is paid at maturity (assume $1,000). =

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7-5 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.

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7-6 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.

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7-7 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.

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7-8 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.

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7-9 Suppose you just inherited $500,000. You intend to invest the money and live off the interest. Reinvestment rate risk example

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7-10 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%.

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7-11 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.

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7-12 Long-term bonds: High interest rate risk, low reinvestment rate risk. Short-term bonds: Low interest rate risk, high reinvestment rate risk.

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7-13 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.

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7-14 0 1 2 3 4 5 2009 2010 2011 2012 2013 63.75 1,000.00 IBM Bond Timeline:

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7-15 $63.75 Annuity for 5 years $1000 Lump Sum in 5 years 0 1 2 3 4 5 2009 2010 2011 2012 2013 63.75 1000.00 IBM Bond Timeline:

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7-16 = 63.75 PMT 1000 FV 8% I 5 N = PV = 935.12 $63.75 Annuity for 5 years $1000 Lump Sum in 5 years 0 1 2 3 4 5 2009 2010 2011 2012 2013 63.75 1000.00 IBM Bond Timeline:

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7-17 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?

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7-18 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 bondholder receives 10 semiannual payments of $45. 0 1 2 3 4 5 2009 2010 2011 2012 2013 45 45.00 1000.00 45

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7-19 Compute the value of the bond given that you require a 10% s-a. return on your investment. 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 V B = 45 PMT 1000 FV 5% I ?N Most Bonds Pay Interest Semi-Annually: 0 1 2 3 4 5 2009 2010 2011 2012 2013 45 45.00 1000.00 45

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7-20 Most Bonds Pay Interest Semi-Annually: = PV = 961.39 Compute the value of the bond given that you require a 10% s-a. return on your investment. 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 0 1 2 3 4 5 2009 2010 2011 2012 2013 45 1,000 45

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7-21 If YTM > Coupon Rate bond Sells at a DISCOUNT If YTM < Coupon Rate bond Sells at a PREMIUM Yield to Maturity -1,000 0 1 2 3 4 5 2009 2010 2011 2012 2013 80 1,000

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7-22 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 ? -966.25 ?? 0 1 2 3 4 5 2009 2010 2011 2012 2013 63.75 1000.00 + ?? 966.25

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7-23 Yield to Maturity YTM B = 63.75 PMT 1000 FV 5 N -966.25 PV I = ? 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 2013 63.75 1000.00 + ?? 966.25

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7-24 What’s the YTM on a 10-year, 9% annual coupon, $1,000 par value bond that sells for $887? 90 01910 r d =? 1,000 PV 1. PV 10 PV M 887 Find r d that “works”!...

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7-25 10 -887 90 1000 NI/YR PV PMTFV 10.91 INPUTS OUTPUT

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7-26 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

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7-27 Types of Bonds Junk Bonds – below investment grade

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7-28 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) AAABest Quality AAHigh Quality AUpper Medium Grade BBBMedium Grade BBSpeculative BVery Speculative CCCVery Very Speculative CC CNo Interest Being Paid DCurrently in Default

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7-29 What affects Bond prices? Risk Interest rates

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7-30 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.

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7-31 Draw a normal yield curve

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7-32 Hypothetical Treasury Yield Curve 0 5 10 15 1 10 20 Years to Maturity Interest Rate (%) 1 yr 8.0% 10 yr 11.4% 20 yr 12.65% Real risk-free rate Inflation premium Maturity risk premium

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7-33 Current Rates Bloomberg

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7-34 What factors can explain the shape of this yield curve?

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7-35 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.

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7-36 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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