1. McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 14-1 Bond Prices and Yields Chapter 14

2. McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 14-2 Face or par value Coupon rate -Zero coupon bond Compounding and payments -Accrued Interest Indenture Bond Characteristics

3. McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 14-3 Different Issuers of Bonds U.S. Treasury -Notes and Bonds Corporations Municipalities International Governments and Corporations Innovative Bonds -Indexed Bonds -Floaters and Reverse Floaters

4. McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 14-4 Secured or unsecured Call provision Convertible provision Put provision (putable bonds) Floating rate bonds Sinking funds Provisions of Bonds

5. McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 14-5 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

6. McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 14-6 C t = 40 (SA) P= 1000 T= 20 periods r= 3% (SA) Solving for Price: 10-yr, 8% Coupon Bond, Face = $1,000

7. McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 14-7 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

8. McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 14-8 Price Yield Prices and Coupon Rates

9. McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 14-9 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

10. McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 14-10 Yield to Maturity Example 10 yr MaturityCoupon Rate = 7% Price = $950 Solve for r = semiannual rate r = 3.8635%

11. McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 14-11 Yield Measures Bond Equivalent Yield 7.72% = 3.86% x 2 Effective Annual Yield (1.0386) 2 - 1 = 7.88% Current Yield Annual Interest / Market Price $70 / $950 = 7.37 %

12. McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 14-12 Realized Yield versus YTM Reinvestment Assumptions Holding Period Return -Changes in rates affects returns -Reinvestment of coupon payments -Change in price of the bond

13. McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 14-13 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

14. McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 14-14 Holding-Period Example CR = 8% YTM = 8%N=10 years Semiannual CompoundingP 0 = $1000 In six months the rate falls to 7% P 1 = $1068.55 HPR = [40 + ( 1068.55 - 1000)] / 1000 HPR = 10.85% (semiannual)

15. McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 14-15 Holding-Period Return: Multiperiod Requires actual calculation of reinvestment income Solve for the Internal Rate of Return using the following: -Future Value: sales price + future value of coupons -Investment: purchase price

16. McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 14-16 Rating companies -Moody’s Investor Service -Standard & Poor’s -Duff and Phelps -Fitch Rating Categories -Investment grade -Speculative grade Default Risk and Ratings

17. McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 14-17 Coverage ratios Leverage ratios Liquidity ratios Profitability ratios Cash flow to debt Factors Used by Rating Companies

18. McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 14-18 Sinking funds Subordination of future debt Dividend restrictions Collateral Protection Against Default

19. McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 14-19 Default Risk and Yield Risk structure of interest rates Default premiums -Yields compared to ratings -Yield spreads over business cycles