Bond market Tutorial 6

What is a bond? Long-term contract in which the bond holder lends money to a company, government or some other organisation The company or government, etc. promises to make predetermined payments (usually regular) in the future which may consist of interest and a capital sum at the end of the bond’s life The time to maturity for bonds is generally between 5 and 30 years. With a bond you are promised a return Less risky Bondholders do not (usually) share in the increase in value created by an extraordinarily successful business Absence of any voting power over the management of the company Referred to collectively as fixed-interest securities.

Cum-dividend and ex-dividend Gilts usually pay coupons twice a year Between payments the interest accrues on a daily basis You buy the gilt cum-dividend Gilts (and other bonds) are quoted at clean prices Buyer will pay the clean price plus the accrued interest value (called the dirty price or full price or invoice price) é ë ù û Annual coupon 2 Number of days since last coupon Number of days separating coupon payments Dirty price = Clean price + ___________________ x ____________________________________________________ So, if the bond pays an annual coupon of 7 per cent and is currently quoted at a clean price of £101, the dirty price is: é ë ù û £7 60 Dirty price = £101 + ____ x = £102.15385 ____ 2 182

Does Governance of Firms Affect the Prices of Their Bonds? No. Bond prices are primarily determined by interest rate movements and therefore are not affected by the governance of the firms that issued bonds. Yes. Bond prices reflect the risk of default. Firms that impose more effective governance may be able to reduce their default risk and therefore increase the price of the bond.

Does Governance of Firms Affect the Prices of Their Bonds? ANSWER: A bond’s price is based on the investor’s required rate of return, and investors may accept a lower return on bonds issued by firms that are subject to a higher degree of governance. Thus, governance can affect the price of the firm’s bonds

Impact of Economic Conditions. Assume that breaking news causes bond portfolio managers to suddenly expect much higher economic growth. How might bond prices be affected by this expectation? Explain. Now assume that breaking news causes bond portfolio managers to suddenly anticipate a recession. How might bond prices be affected? Explain.

Higher economic growth places upward pressure on interest rates and downward pressure on bond prices. As bond portfolio managers sell their bonds based on this expectation, there is immediate downward pressure on bond prices. A recession tends to imply a reduced demand for loanable funds and therefore lower interest rates and higher prices of existing bonds. As bond portfolio managers purchase bonds to capitalize on this expectation, there is immediate upward pressure on bond prices.

Is the price of a long-term bond more or less sensitive to a change in interest rates than the price of a short-term security? Why? The price of a long-term bond is more sensitive to a given change in interest rates than the price of a short-term security. The long-term bond provides fixed payments for a longer period of time. Consequently, it will provide these fixed payments, whether interest rates decline or rise. The benefit of fixed payments during a period of falling interest rates is more pronounced for longer maturities. The same is true for the disadvantage of fixed payments during a period of rising rates.

Explain. Assume that oil-producing countries have agreed to reduce their oil production by 30 percent. How would bond prices be affected by this announcement? ANSWER: Reduced oil production implies higher oil prices, higher interest rates, and lower bond prices. Thus bond portfolio managers would sell bonds immediately causing immediate downward pressure on the bond prices.

Bond Price Sensitivity Bond Price Sensitivity. Explain how bond prices may be affected by money supply growth, oil prices, and economic growth. ANSWER: Any factors that affect inflationary expectations may affect interest rate expectations and therefore affect the demand for bonds. Higher oil prices, excessive money supply growth, and strong economic growth contribute to higher inflationary expectations.

the demand for bonds would decline, and bond prices would decline. Bond Price Sensitivity. Explain how bond prices may be affected by money supply growth, oil prices, and economic growth. Thus, interest rates would be expected to increase under these conditions (holding other factors constant); the demand for bonds would decline, and bond prices would decline. Lower oil prices or a weak economy could reduce inflationary expectations and result in an increased demand for bonds, causing bond prices to rise.

Explain. If a bond’s coupon rate is above its required rate of return, would its price be above or below its par value? ANSWER: When a bond’s coupon rate is above the required rate of return, the price of the bond would be above its par value because the coupons provide more than the return required.

How would a financial institution with a large bond portfolio be affected by falling interest rates? Would it be affected more than a financial institution with a greater concentration of bonds (and fewer short-term securities)? Explain.

ANSWER: The market value of the financial institution’s bond portfolio will increase. A financial institution that has a greater concentration of bonds would be even more favorably affected because the market value of its portfolio would be more sensitive to interest rates.

Explain. Assume that inflation is expected to decline in the near future. How could this affect future bond prices? Would you recommend that financial institutions increase or decrease their concentration in long-term bonds based on this expectation?

ANSWER: Since lower inflation normally causes a decline in interest rates (other things being equal), financial institutions would benefit if they increase their concentration of long-term bonds before this occurs.

Bond Valuation You are interested in buying a $1,000 par value bond with 10 years to maturity and an 8 percent coupon rate that is paid semiannually. How much should you be willing to pay for the bond if the investor’s required rate of return is 10 percent?

ANSWER PV = C(PVIFA k = 5%, n = 20) + FV(PVIFk = 5%, n = 20)

Required rate of return by investors = 12% Valuing a Zero-Coupon Bond. Assume the following information for existing zero-coupon bonds: Par value = $100,000 Maturity = 3 years Required rate of return by investors = 12% How much should investors be willing to pay for these bonds?

PV of Bond = PV of Coupon Payments + PV of Principal = $0 + 100,000(PVIFi = 12%,n = 3) = $100,000(.7118) = $71,180

Bond Valuation. Assume the following information for an existing bond that provides annual coupon payments: Par value = $1,000 Coupon rate = 11% Maturity = 4 years Required rate of return by investors = 11% a. What is the present value of the bond?

PV of Bond = PV of Coupon Payments + PV of Principal = $110(PVIFAi = 11%,n = 4) + $1,000(PVIFi = 11%,n = 4) = $110(3.1024) + $1,000(.6587) = $341 + $659 = $1,000

If the required rate of return by investors were 14 percent instead of 11 percent, what would be the present value of the bond?

PV of Bond = PV of Coupon Payments + PV of Principal = $110(PVIFAi = 14%,n = 4) + $1,000(PVIFi = 14%,n = 4) = $110(2.9137) + $1,000(.5921) = $321 + $592 = $913

If the required rate of return by investors were 9 percent, what would be the present value of the bond? PV of Bond = PV of Coupon Payments + PV of Principal = $110(PVIFAi = 9%,n = 4) + $1,000(PVIFi = 9%,n = 4) = $110(3.2397) + $1,000(.7084) = $356 + $708 = $1,064

The valuation of bonds is generally perceived to be ______________ the valuation of equity securities. A) harder than B) easier than C) just as difficult as D) none of the above  ANSWER: B

If the coupon rate equals the required rate of return, the price of the bond A) should be above its par value. B) should be below its par value. C) should be equal to its par value. D) is negligible.  ANSWER: C

When financial institutions expect interest rates to ______, they may ______. A) increase; sell bonds and buy short‑term securities B) increase; sell short‑term securities and buy bonds C) decrease; sell bonds and buy short‑term securities D) B and C  ANSWER: A

If the United States announces that it will borrow an additional $10 billion, this announcement will normally cause the bond traders to expect A)higher interest rates in the future, and will buy bonds now. B)higher interest rates in the future, and will sell bonds now. C)stable interest rates in the future, and will buy bonds now. D)lower interest rates in the future, and will buy bonds now. E)lower interest rates in the future, and will sell bonds now.   ANSWER: B