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McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

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6-2 Valuing Bonds A bond is a debt instrument issued by governments or corporations to raise money The successful investor must be able to: Understand bond structure Calculate bond rates of return Understand interest rate risk Differentiate between real and nominal returns

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6-3 Bond Basics When governments or companies issue bonds, they promise to make a series of interest payments and then repay the debt. Bond Security that obligates the issuer to make specified payments to the bondholder. Face Value Payment at the maturity of the bond. Coupon The interest payments paid to the bondholder. Coupon Rate Annual interest payment as a percentage of face value.

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6-4 Bond Pricing: Example Treasury bond prices are quoted in 32nds rather than in decimals. For a $1000 face value bond with a bid price of 103:05 and an asked price of 103:06, how much would an investor pay for the bond?

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6-5 Bond Pricing

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6-6 Bond Pricing: Example What is the price of a 9% annual coupon bond with a par value of $1,000 that matures in 3 years? Assume a required rate of return of 4%.

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6-7 Bond Pricing A bond is a package of two investments: an annuity and a final repayment.

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6-8 Bond Pricing: Example What is the value of a 3-year annuity that pays $90 each year and an additional $1,000 at the date of the final repayment? Assume a discount rate of 4%.

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6-9 Bond Prices & Interest Rates As interest rates change, so do bond prices. What is the present value of a 4% coupon bond with face value $1,000 that matures in 3 years? Assume a discount rate of 5%. What is the present value of this same bond at a discount rate of 2%?

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6-10 Bond Yields To calculate how much we earn on a bond investment, we can calculate two types of bond yields: Current Yield Yield to Maturity

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6-11 Current Yield: Example Suppose you spend $1,150 for a $1,000 face value bond that pays a $60 annual coupon payment for 3 years. What is the bond’s current yield?

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6-12 Yield to Maturity Yield to Maturity:

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6-13 Yield to Maturity: Example Suppose you spend $1,150 for a $1,000 face value bond that pays a $60 annual coupon payment for 3 years. What is the bond’s yield to maturity?

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6-14 Rate of Return

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6-15 Rate of Return: Example Suppose you purchase a 5% coupon bond, par value $1,000, with 5 years until maturity, for $975.00 today. After one year you sell the bond for $965.00. What was the rate of return during the period?

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6-16 The Yield Curve

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6-17 Interest Rates & Inflation In the presence of inflation, an investor’s real interest rate is always less than the nominal interest rate.

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6-18 Interest Rates & Inflation If you invest in a security that pays 10% interest annually and inflation is 6%, what is your real interest rate?

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6-19 Interest Rates & Inflation: Example Treasury Inflation Protected Securities (TIPS) Example: If you invest in 5% coupon, 3 year TIPS and inflation is 3% each year, what are your real annual cash flows? Year123 Real cash flows $50 $1,050

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6-20 The Risk of Default When investing in bonds, there is always the risk that the issuer may default. Default risk Default premium

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6-21 The Risk of Default Bonds come in many categories, with returns commensurate with risk. Credit agency Investment-grade bonds Junk bonds

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6-22 Types of Corporate Bonds Zero-Coupon Bonds Floating-Rate Bonds Convertible Bonds

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6-23 Appendix A: Treasury Bond Rates 10-year U.S. Treasury bond interest rates, 1900-2010

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6-24 Appendix B: Real vs. Nominal Yields Red line – Real yield on long-term UK indexed bonds Blue line – Nominal yield on long-term UK bonds

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6-25 Appendix C: Credit Ratings

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