Chapter 10 investments bond prices and yields

- Face or par value - Coupon rate: Determine interest payment Zero coupon bond: Issued at prices considerably below par value... EX If coupon rate > current market yield, extend the bond

Chapter 10 Bond Prices and Yields

10.1 Bond Characteristics

U.S Credit Market Instruments O/S 2008 Q3

U.S Equity Market (Common) $19,648 Billion

U.S Credit Market Debt $51,796 Billion

Debt by Selected Major Borrowers:

U.S Government Securities $13,850 Billion (27%)

(Includes Agency & GSE)

%s are percent of Total U.S Credit Market Debt, source is Federal Reserve Flow of Funds

U.S Credit Market Instruments O/S 2008 Q3

By Selected Major Borrowers

Corporate & Foreign Bonds $11,262 Billion (22%)

Municipal Bonds $2,669 Billion (5%)

Mortgages $14,720 Billion (28%)

Bond Characteristics

Bond: A security that obligates the issuer to make specified payments to the holder over a period of time.

- Face or par value

- Coupon rate: Determine interest payment

Zero coupon bond: Issued at prices considerably below par value.

- Maturity

Treasury Notes and Bonds

T Note maturities range up to 10 years

T bond maturities range from 10 to 30 years

Make semiannual coupon payment

Bid and ask price

- Quoted in dollars and 32nds as a percent of par

EX) 100:10 = 100 10/32 = 100.313% of par value = $1,003.13

- Typical par = $1,000

Yield to Maturity

: Interpreted as a measure of the average rate of return to an investor

Figure 10.1 Prices and Yields of U.S Treasuries

Corporate Bonds & Debt

Most bonds are traded over the counter

Par = $1,000

As a general rule, safer bonds with the higher ratings promise lower yields to maturity.

Corporate Bonds & Debt

Call provisions

- Allow the issuer to repurchase the band at a specified call price before maturity date

- Callable bonds typically come with a period of call protection,

deferred callable bonds

Corporate Bonds & Debt

Puttable bonds

- Allows the bondholder to extend or retire the bond at the put date

EX) If coupon rate > current market yield, extend the bond’s life

If coupon rate < current market yield, not extend the bond and instead reclaims principal, which can be invested at current yields

Preferred Stock

Like bonds, Preferred stock promises to pay a specified stream of dividends

Unlike bonds, the failure to pay the promised dividend does not result in corporate bankruptcy

Instead, the dividends owed simply cumulate, and the common stockholders ma

y not receive any dividends until the preferred stockholders have been paid in fu

ll

In the event of bankruptcy, the priority for the claim is as follows:

Bondholders > preferred stockholders > common stockholdersRarely gives its holders full voting privileges in the firm However, if the preferre

d dividend is skipped, the preferred stockholders will then be provided some voting power

Other Domestic Issuers

Federal Home Loan Bank Board Farm Credit Agencies

Ginnie Mae Fannie Mae Freddie Mac Municipal bonds: interest payments are tax-free

Innovations in the Bond Market

Innovations in the Bond Market

Catastrophe bonds

- In the event of a specified ‘disaster’, the bond issuer’s required

payments are reduced or eliminated

: Receive compensation in the form of higher coupon rates for taking

on the risk

Indexed bonds

- Payments are tied to a price index or the price of a commodity

: TIPS (Treasury Inflation Protected Securities) With TIPS the par value

of the bond increases with the Consumer Price Index

 A risk-free real rate

10.2 BOND PRICING

BOND PRICING

• The price depends on the value of dollars to be received in the future compared to dollars in hand today  Present Value

• Bond Value = Present value of coupons + Present value of par value

• If we call the maturity date T and call the discount rate r, the bond value can be

written as

• The first term is the PV of an annuity and the second term is PV of the final payment

of the bond’s par value.

• Price = Coupon + Par Value

T

t r t (1 r)

Par value )

1 (

Bond Pricing

EX) Bond Price for a corporate bond:

C = Coupon = 10%, Interest rate = YTM = r = 12%, Maturity = N

or T = 10 years, P = price, Par = $1,000What is the bond’s price using semiannual compounding?

2 / ( 1

(C/2) P

06 (1

$50 P

Bond Pricing

d by the bondholder is lower Therefore, the bond price will fall as market interest rates rise  the main source of risk in t

he bond market

10.3 BOND YIELDS

The current yield of a bond measures only the cash income provided b

y the bond as a percentage of bond price and ignores any capital gains

or losses

We may want to measure the rate of return that accounts for both curre

nt income as well as price increase or decrease over the bond life

YTM is the standard measure of the total rate of return

Bond Prices and Yields

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.

YTM is the discount rate that makes the present value of a bond’s payments eq ual to its price.

YTM is often viewed as a measure of the average rate of return that will be earn

ed on a bond if it is bought now and held until maturity

Find the YTM for a 8% coupon, 30-year bond selling at $1,276.76.

Annual percentage rate or APR = 3% X 2 = 6%

Promised Yield to Maturity (YTM)

( 1

$40 76

276 , 1

half per

% 3 )

2 /

2 / ( 1

(C/2) P

Figure 10.3 The Inverse Relationship Between B ond Prices and Yields

Click to edit Master text styles

Second level

Third level

Fourth level

Fifth level

Current Yield

Annual dollar coupon divided by the price

Premium bonds (bonds selling above par value)

- Coupon rate > Current yield > Yield to maturity

Discount bonds (bonds selling below par value)

- Coupon rate < Current yield < Yield to maturity

10.4 BOND PRICES OVER TIME

Premium and Discount Bonds

Figure 10.6 Premium and Discount Bonds over Time

10.5 DEFAULT RISK AND BOND PRICING

Default Risk and Ratings

Main Ratings Companies

Moody’s Investor Service Standard & Poor’s

Fitch

Main Rating Categories

Investment grade Speculative grade (junk bonds)

Figure 10.8 Definitions of Bond Rating Classes

Click to edit Master text styles

Second level

Third level

Fourth level

Fifth level

Factors Used by Rating Companies

Coverage ratios

- Ratios of company earnings to fixed costs

- The times-interest-earned ratio (=EBIT / interest payments)

- Low or falling coverage ratios signal possible cash flow difficulties

Leverage ratios

- Debt to equity ratio

- Signal the possibility the firm will be unable to earn enough to satisfy obligations on its bond

Factors Used by Rating Companies

Liquidity ratios

- Current ratio (=current assets/current liabilities)

- Quick ratio (= current assets excluding inventories / current liabilities)

- Measure the firm’s ability to pay bills coming due with its most liquid assets

Profitability ratios

- Return on assets (=EBIT/total assets)

- Return on equity (=net income / equity)

- Indicators of a firm’s overall performance

Financial Ratios and Default Risk

Bond Indentures: Protection against Defaults

: Specify a set of restrictions that protect the rights of the bondholders

Sinking funds

- To help ensure that the commitment does not create a cash flow crisis, the fi

rm may agree to establish a sinking fund to spread the payment burden over several years

- Operate in one of two ways as follows

: Issuer may repurchase a given fraction of the outstanding bonds

each year, or

: Issuer may either repurchase at the lower of open market price or

Bond Indentures: Protection against Defaults

Subordination of future debt

- Subordination clauses restrict the amount of their additional borrowing.

- Additional debt might be required to be subordinated in priority to existing debt

- Senior debt holders must be paid in full before subordinated or junior debt holders.

Dividend restrictions

- Limit the dividends firms my pay

Collateral

- A specific asset pledged against possible default on a bond.

- Bondholders receive collateral if the firm defaults

Figure 10.9 Callable Bond Issued by Mobil

Click to edit Master text styles

Second level

Third level

Fourth level

Fifth level

Yield to Maturity and Default Risk

To compensate for the possibility of default, corporate bonds must offer a default premium

The default premium is the difference between the promised yield on a corporate bond and the yield of an otherwise identical riskyless government bond.The greater the default risk, the higher the default premium

Figure 10.10 Yield spreads between corporate an

d 10-year Treasury bonds

Credit Default Swaps

A credit default swap (CDS) is an insurance policy on the default risk of a bond or loan EX) The annual premium in Nov 2008 on a five-year Citigroup CDS: 2%

 The CDS buyer would pay the seller an annual premium of $2 for each

$100 of bond principal

The seller of the swap collects an annual premium (and sometimes an upfront fee) from the swap buyer, but must compensate the buyer for loss of bond value in the event of a default.

The buyer of the swap collects nothing unless the bond issuer or loan borrower default

s, in which case the seller of the swap essentially pays the drop in value from par to the s wap buyer

Credit Default Swaps

CDSs can be used to speculate on financial health of firms

- Swap buyer need not hold the underlying bond or loan.

- At their peak there were reportedly $63 trillion worth of CDS; US GDP is about $14 trillion

- What is the implication of the size of this market if the economy experiences greater than expected defaults?

- Did this contribute to the Financial Crisis of 2008?

Figure 10.11 Prices of CDS on several financial firms