1. Definition of a Bond n A bond is a security that obligates the issuer to make specified interest and principal payments to the holder on specified dates.  Coupon rate  Face value (or par)  Maturity (or term) n Bonds are sometimes called fixed income securities.

2. Types of Bonds n Pure Discount or Zero-Coupon Bonds  Pay no coupons prior to maturity.  Pay the bond’s face value at maturity. n Coupon Bonds  Pay a stated coupon at periodic intervals prior to maturity.  Pay the bond’s face value at maturity. n Perpetual Bonds (Consols)  No maturity date.  Pay a stated coupon at periodic intervals.

3. Bond Issuers n Government n Financial Institutions n Countries n Corporations

4. Government Bonds n Treasury Bills (Gilts)  No coupons (zero coupon security)  Face value paid at maturity  Maturities up to one year n Treasury Notes  Coupons paid semiannually  Face value paid at maturity  Maturities from 2-10 years

5. Government Bonds n Treasury Bonds  Coupons paid semiannually  Face value paid at maturity  Maturities over 10 years  The 30-year bond is called the long bond.

6. Government Bonds n No default risk. Considered to be riskfree. n Exempt from state and local taxes. n Sold regularly through a network of primary dealers. n Traded regularly in the over-the-counter market.

7. Corporate Bonds n Secured Bonds (Asset-Backed)  Secured by real property  Ownership of the property reverts to the bondholders upon default. n Debentures  General creditors  Have priority over stockholders, but are subordinate to secured debt.

8. Common Features of Corporate Bonds n Senior versus subordinated bonds n Convertible bonds n Callable bonds n Putable bonds n Sinking funds

9. Bond Ratings

10. Valuing Zero Coupon Bonds l What is the current market price of a U.S. Treasury strip that matures in exactly 5 years and has a face value of £1,000. The yield to maturity is r d =7.5%. l What is the yield to maturity on a U.S. Treasury strip that pays £1,000 in exactly 7 years and is currently selling for £591.11? 1000 1075 56 5. £696.  59111 1000 1 7.   r d

11. Bond Yields and Prices The case of zero coupon bonds l Consider three zero-coupon bonds, all with »face value of F=100 »yield to maturity of r=10%, compounded annually. We obtain the following table:

12. l Suppose the yield would drop suddenly to 9%, or increase to 10%. How would prices respond? l Bond prices move up if the yield drops, decrease if yield rises l Prices respond more strongly for higher maturities The Impact of Price Responses

13. l What is the market price of a U.S. Treasury bond that has a coupon rate of 9%, a face value of £1,000 and matures exactly 10 years from today if the required yield to maturity is 10% compounded semiannually? 0 6 12 18 24... 120Months 45 45 45 45 1045 Bond Valuation: An Example

14. Relationship Between Bond Prices and Yields n Bond prices are inversely related to interest rates (or yields). n A bond sells at par only if its coupon rate equals the coupon rate n A bond sells at a premium if its coupon is above the coupon rate. n A bond sells a a discount if its coupon is below the coupon rate.

15. Volatility of Coupon Bonds l Consider two bonds with 10% annual coupons with maturities of 5 years and 10 years. l The yield is 8% l What are the responses to a 1% price change? l The sensitivity of a coupon bond increases with the maturity?

16. Bond Prices and Yields Bond Price F c Yield Longer term bonds are more sensitive to changes in interest rates than shorter term bonds.