1 1 Ch14 – MBA 566 Bond Price, Yields, and Returns Different Bond Types Bond Price Bond Yield Bond Returns Bond Risk Structure

2 2 Ch14 – MBA 566 Face or par value Coupon rate Zero coupon bond Compounding and payments Accrued Interest Indenture Bond Characteristics

3 3 Ch14 – MBA 566 Accrued Interest Example on page 447

4 4 Ch14 – MBA 566 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 5 Ch14 – MBA 566 Figure 14.2 Corporate Bond Listings

6 6 Ch14 – MBA 566 Secured or unsecured Call provision Convertible provision Put provision (putable bonds) Floating rate bonds Sinking funds Provisions of Bonds

7 7 Ch14 – MBA 566 Principal and Interest Payments for TIPS The above is index bond. See pages Compute real returns in year 1, 2, 3

8 8 Ch14 – MBA 566 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 9 Ch14 – MBA 566 C t = 40 (SA) P= 1000 T= 20 periods r= 3% (SA) Price: 10-yr, 8% Coupon, Face = $1,000

10 Ch14 – MBA 566 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 Ch14 – MBA 566 Inverse Relation Between Prices and Yields

12 Ch14 – MBA 566 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 Ch14 – MBA 566 Yield Measures Bond Equivalent Yield 7.72% = 3.86% x 2 Effective Annual Yield (1.0386) = 7.88%

14 Ch14 – MBA 566 Current Yield Annual Interest / Market Price $70 / $950 = 7.37 %

15 Ch14 – MBA 566 Yield to Call For callable bonds See example on page 460

16 Ch14 – MBA 566 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 Ch14 – MBA 566 Horizon Analysis Example 14.6 – page 462

18 Ch14 – MBA 566 Figure 14.6 Prices over Time of 30-Year Maturity, 6.5% Coupon Bonds

19 Ch14 – MBA 566 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

20 Ch14 – MBA 566 Example CR = 8% YTM = 10% N=10 years Semiannual Compounding What is HPR when the rate falls to 7% in six months?

21 Ch14 – MBA 566 Zero-coupon Bonds and Treasury Strips Zero coupon bonds – page 465 Short term treasuries Long term zero coupons Treasury may strip payments from treasury coupon bonds -- STRIPS

22 Ch14 – MBA 566 The Price of a 30-Year Zero-Coupon Bond over Time at a Yield to Maturity of 10% After-tax return – see page 478.

23 Ch14 – MBA 566 Rating companies (P 467) Moody’s Investor Service Standard & Poor’s Fitch Rating Categories Investment grade Speculative grade Page 468 Default Risk and Ratings

24 Ch14 – MBA 566 Coverage ratios Leverage ratios Liquidity ratios Profitability ratios Cash flow to debt Factors Used by Rating Companies

25 Ch14 – MBA 566 Sinking funds Subordination of future debt Dividend restrictions Collateral Protection Against Default

26 Ch14 – MBA 566 Yields on Long-Term Bonds, 1954 – 2006 Understand default premium – page

27 Ch14 – MBA 566 Credit Risk and CDO Collateralized debt obligations (CDOs): a mechanism to reallocate credit risk in the fixed income markets (figure 14.12) SIV Tranch subprime market crisis