Chapter 5 – Bonds and Bond Pricing  Learning Objectives  Apply the TVM Equations in bond pricing  Understand the difference between annual bonds and semi-annual bonds  Differentiate between different types of bonds  Calculate yields on bonds Bond Features  Understand basic features of bonds  Delineate Bond Ratings

Real vs. Financial Assets  Real Assets have physical characteristics that determine the value of the asset  Size, Shape, Material, Color, etc.  Price based on the benefits of the physical characteristics  Financial Assets physical characteristics are inconsequential  Value based on claim to promised or anticipated cash flows  TVM concepts used to price financial assets

Application of TVM – Bond Pricing  Bond instrument is a long-term debt instrument (long-term liability) of a company  Bond issuer promises a specific set of cash payments in the future  Coupon (interest) payments  Principal repayment  Timing and amount of future cash payments stated on the bond…see Figure 5.2 for time line of cash flow promises

Application of TVM – Bond Pricing  Timeline for promised cash flows  Example, Patel Corporation Bond  $1,000 par value (principal)  8% annual coupon payments (interest)  Twenty year bond  Principal $1,000 due 12/31/23 is lump sum  Coupons of $80 annually are annuity  What is the current value (present value) of these promised future cash payments?

Application of TVM – Bond Pricing  Steps to price a bond  Determine annuity stream  Coupon Rate times Par Value  8% x $1,000 = $80  Find PV of annuity stream  Find PV of principal repayment  Add PVs together for bond price  Patel Corporation Bond  PV of coupons is $  PV of principal is $  Price of Patel Corporation bond is $1,229.39

Application of TVM – Bond Pricing

Key Components of a Bond  Par Value or Face Value or Principal  Coupon Rate (annual interest rate percent)  Coupon (regular interest payment)  Maturity Date or Expiration Date (bond is totally repaid)  Yield or Yield to Maturity or Discount Rate

Semi-Annual Bonds  Corporations and governments elect how often they will make coupon payments  Most common choice is every six months  Consistent with interest rates from chapter 4  Coupon rate is stated annually  Coupon payment = (Coupon Rate x Par Value) / 2  Discount rate for TVM is the yield to maturity / 2  Number of periods (n) is years x 2  Timeline of promised cash flows, Figure 5.5 page 117

Semi-Annual Bond

Three Methods to Bond Pricing  Equations or Formula  Solve the two pieces separately and add them up (coupons and principal present values)  TVM Keys on a Calculator  Note with TI BAII Plus…use of P/Y variable  Compute price directly  Spreadsheet  Function is PV and variables require time preference  Compute price directly

Types of Bonds  By Issuer  Corporate Bonds – Companies  Treasury Bonds – U.S. Government  Municipal Bonds – State and Local Governments  By Features – Table 5.1, page 120  Standard, Semi-Annual, Floating Rate (coupon rate changes), Zero, Consol,  Callable, Putable, Convertible

Pricing a Zero-Coupon Bond  Special Pricing Feature of Zero-Coupon Bond  No coupon payments  Priced as Semi-Annual Bond for Principal repayment  Also know as deep discount bond  Price of bond is the initial principal  Difference between price and final payment is interest on bond  Interest is implied each year as bond price changes using the original yield to maturity  Amortization schedule (Table 5.2) shows implied interest payments each six months

Finding Yield to Maturity  Yield to maturity – return on the bond if held to maturity  Discount rate for pricing the bond  If price and cash flows are known you can find YTM  Iterative Process – can not isolate r in TVM formula  Calculator or Spreadsheet fast and accurate  Relationship of Coupon Rate and YTM (see Table 5.3)

Bond Features  Variables  Price, Principal, YTM, Coupon Rate, Maturity Date, Frequency of Coupon Payments  Need all but one variable to determine missing variable  Indenture or Deed of Trust (Bond Contract)  Collateral or Security of Bond  Real Property is Collateral – Mortgage Bond  No Collateral - Debenture

Bond Features  Senior Debt versus Junior Debt  Older Issue is Senior  Junior Debt paid off after Senior Debt  Protective Covenants  Prohibits actions of bond issuer  Designed to protect bondholder  Added Features to Bond (Options)  Call, Put, Conversion  Provides issuer or holder future choices

Bond Ratings  Agencies Rate Bonds  Ratings based on potential default  Best rating AAA  Categories based on ratings (Table 5.4)  Investment Grade (AAA to BBB- or Baa3)  Speculative Grade (BB+ or Ba1 to B- or B3)  Also known as Junk Bonds  Extremely Speculative (C rating group)  Default (D rating by Standard and Poor’s)

Quoting Conventions and Markets  Bonds usually trade in a dealer market  Dealers state buying and selling prices  Dealers usually in money center banks  Some bonds listed on NYSE  Bonds listed by issuing company  Bond’s coupon rate and maturity date part of the bond name  Current yield  Volume, Closing Price, and Net Change

Homework  Problem 1 – Pricing with Annual Coupons  Problem 2 – Pricing with Semi-Annual Coupons  Problem 6 – Yield on Semi-Annual Bonds  Problem 10 – Coupon Rates  Problem 12– Pricing Semi-Annual Bond  Problem 14 – Zero Coupon Bond

Appendix – Government Bonds  Names of federal government bonds based on maturity dates at issue:  U.S. Treasury Bill, maturity less than one year  U.S. Treasury Note, maturity between two and ten years  U.S. Treasury Bonds, maturity over ten years  Pricing for Notes and Bonds…  Semi-annual coupon bonds  Another application of TVM equations

U.S. Treasury Bills  Treasury Bills are short term pure discount bills (pay no interest)  Pricing formula discounts but ignores compounding and conventional return calculation methods  Formula: