Intro to Financial Management Bonds

Review Homework Expected rate of return Required rate of return Risk-free rate of return Market rate of return Systemic and idiosyncratic risk Beta? CAPM

Review What is “the time value of money?” How do you calculate and what do these mean? Compounding interest PV, FV (incl. solving for n) Different flows Non-annual periods Simple annuity (PV?) Amortized loans APR Perpetuity

Bonds A bond is basically an IOU Characteristics Coupon rate Predetermined, fixed amount of interest Paid semi-annually Maturity date Par Value Amount owed at maturity (normally $1000) Prices are given as a % of par (face) value E.g. bond at 125 can be bought at 125% of its par value May be callable (redeemable) Claim on assets

Types of Bonds Corporate Government Eurobonds Sovereign debt Debenture – unsecured Subordinated debentures – comes after debentures if insolvent Secured Government U.S Treasury Bonds Municipal Bonds (munis) General obligation Revenue Eurobonds Sovereign debt Convertible Mortgage bonds

Bond Ratings Companies rate the creditworthiness of bonds Standard & Poor’s (S&P) Moody’s Fitch Typical ratings scale AAA AA A BBB BB BB and below are “junk” bonds (also called “high yield”) B CCC … D in default

Value Book value – shown in the financial statements Liquidation value – value if assets were sold Market value Intrinsic / economic value PV of future expected cash flows PV of future cash flows affected by Amount and timing of payments Riskiness of payments Required rate of return

Ci is cash flow in period i n = time to maturity PV of Future Cash Flows Ci is cash flow in period i n = time to maturity r = required rate of return Exercise - Compute value of example bonds.

Bond Yields Yield to maturity Current yield Expected rate of return Use market price for PV Use par value for FV Use coupon interest rate for payments Current yield Interest payment / price Use to compare to alternative investments

Bond Risk Default risk Interest rate risk Inflation risk Maturity Will affect your required rate of return to take on the risk Interest rate risk If goes up, then required rate of return goes up If retired rate of return goes up, price goes down Inflation risk Maturity The longer the maturity, the higher the risk Why?

Bond Prices Price will be below par if required rate of return is above coupon interest rate And vice versa Inverse relationships between bond prices and Market interest rates Inflation

Yield Curve