1 Bond Price, Yields, and Returns Different Bond Types Bond Price Bond Yield Bond Returns Bond Risk Structure

2 Face or par value Coupon rate Zero coupon bond Compounding and payments Accrued Interest Indenture Bond Characteristics

3 Accrued Interest Example on page 447

4 Different Issuers of Bonds U.S. Treasury Notes and Bonds Corporations Municipalities International Governments and Corporations Innovative Bonds Floaters and Inverse Floaters Asset-Backed Catastrophe

5 Figure 14.2 Corporate Bond Listings

6 Secured or unsecured Call provision Convertible provision Put provision (putable bonds) Floating rate bonds Sinking funds Provisions of Bonds

7 Principal and Interest Payments for TIPS The above is index bond. See pages Compute real returns in year 1, 2, 3

8 P B =Price of the bond C t = interest or coupon payments T = number of periods to maturity y = semi-annual discount rate or the semi-annual yield to maturity Bond Pricing Accrued interest: page 459

9 C t = 40 (SA) P= 1000 T= 20 periods r= 3% (SA) Price: 10-yr, 8% Coupon, Face = $1,000

10 Prices and Yields (required rates of return) have an inverse relationship When yields get very high the value of the bond will be very low. When yields approach zero, the value of the bond approaches the sum of the cash flows. Bond Prices and Yields

11 Inverse Relation Between Prices and Yields

12 Yield to Maturity Interest rate that makes the present value of the bond’s payments equal to its price. Solve the bond formula for r

13 Yield Measures Bond Equivalent Yield 7.72% = 3.86% x 2 Effective Annual Yield (1.0386) = 7.88%

14 Current Yield Annual Interest / Market Price $70 / $950 = 7.37 %

15 Yield to Call For callable bonds See example on page 454

16 Holding Period Return versus YTM Reinvestment Assumptions Holding Period Return Changes in rates affects returns Reinvestment of coupon payments Change in price of the bond

17 Figure 14.6 Prices over Time of 30-Year Maturity, 6.5% Coupon Bonds

18 Holding-Period Return: Single Period HPR = [ I + ( P 0 - P 1 )] / P 0 where I = interest payment P 1 = price in one period P 0 = purchase price

19 Example (Single period analysis) CR = 8% YTM = 10% N=10 years Semiannual Compounding What is HPR when the rate falls to 7% in six months?

20 Horizon Analysis (multiple period) Example 14.6 – page 456

21 Mortgage Example Say you are interested in buying a 2-bedroom condo in Boston. The price is $300,000. You have a 30-year 3.5% APR mortgage with 20% down payment. (1) What would be the monthly mortgage payment? (2) What if you have 15-year mortgage with the same APR? (3) Suppose you could rent the place out and the rent you collect will cover your mortgage payment. What would be the annual return of your investment if the condo value stays constant.

22 Zero-coupon Bonds and Treasury Strips Zero coupon bonds – page 459 Short term treasuries Long term zero coupons Treasury may strip payments from treasury coupon bonds -- STRIPS

23 The Price of a 30-Year Zero-Coupon Bond over Time at a Yield to Maturity of 10% After-tax return – see page 478.

24 Rating companies (P 461) Moody’s Investor Service Standard & Poor’s Fitch Rating Categories Investment grade Speculative grade Page 462 Default Risk and Ratings

25 Coverage ratios Leverage ratios Liquidity ratios Profitability ratios Cash flow to debt Factors Used by Rating Companies

26 Sinking funds Subordination of future debt Dividend restrictions Collateral Protection Against Default

27 Yields on Long-Term Bonds, 1954 – 2006 Understand default premium – page

28 Chapter 1: Overview Credit Default Swaps A credit default swap (CDS) acts like an insurance policy on the default risk of a corporate bond or loan. CDS buyer pays annual premiums. CDS issuer agrees to buy the bond in a default or pay the difference between par and market values to the CDS buyer.

29 Chapter 1: Overview Credit Default Swaps Institutional bondholders, e.g. banks, used CDS to enhance creditworthiness of their loan portfolios, to manufacture AAA debt. CDS can also be used to speculate that bond prices will fall. This means there can be more CDS outstanding than there are bonds to insure!

30 Chapter 1: Overview Figure Prices of Credit Default Swaps

Credit Risk and Collateralized Debt Obligations (CDOs) Major mechanism to reallocate credit risk in the fixed-income markets Structured Investment Vehicle (SIV) often used to create the CDO Loans are pooled together and split into tranches with different levels of default risk. Mortgage-backed CDOs were an investment disaster in 2007

Figure Collateralized Debt Obligations