Practice investment management pim3 ch04 bond fundamentals

 Bond Pricing and Returns … continued Yield to Maturity • Calculating the Yield to Maturity • Misreading the Yield to Maturity • The Yield Curve...  annuities - most bonds are annuiti

 Bond Principles … continued

 Bond Cash Flows

• Annuities

• Zero Coupon

• Variable Rate

• Consols

• Inflation-Indexed Treasury Bonds

 Convertible and Exchangeable Bonds

 The Financial Page Listing

• Zero Coupon Bonds

• Variable Rate Bonds

• Consols

Outline

 Bond Pricing and Returns … continued

 Yield to Maturity

• Calculating the Yield to Maturity

• Misreading the Yield to Maturity

• The Yield Curve

Bond Principles: Identification of Bonds

 Bonds are identified by issuer, coupon

rate, and maturity

 The face value of a bond is called its par value

 e.g 5 of “Hertz sevens of 03” (Hertz 7s03)

 A legal document called the indenture

contains the details of the bond issue.

a government e.g US Treasury, federal agency,

state, local

b corporation e.g industrial, utility, financial,

transportation

c others e.g foreign government, foreign

corporation, World Bank

Bond Principles: Classification of Bonds

Method 1: By issuer

Bond Principles: Classification of Bonds

Insert Table 4-1 here.

a unsecured debt - backed by faith in the taxing

power of the government, or the good name of the company (debenture)

b secured debt e.g revenue bond, assessment

bond, mortgage, collateral trust bond,

equipment trust certificate

Bond security sometimes comes from non-traditional

sources Recently, some rock stars floated bonds

using their future earnings as backing.

Method 2: By security Bond Principles: Classification of Bonds

Method 3: By term

a short-term -  a year e.g US Treasury bills

b intermediate-term e.g US Treasury notes

(2 to 10 years )

c long-term e.g US Treasury bonds ( 10 years)

d open-ended e.g corporate line of credit

e serial bond - a portfolio of bonds with

staggered terms

Bond Principles: Classification of Bonds

Bond Principles: Classification of Bonds

Insert Table 4-2 here.

 interest only - the periodic payments are

entirely interest

 sinking fund - periodically, a portion of the

debt principal is set aside or a certain number of the bonds is retired

 balloon loan - the debt may be partially

amortized with each payment

 income bond- interest is payable only if it is

earned

Bond Principles: Terms of Repayment

 annuities - most bonds are annuities plus an

ultimate repayment of principal

 zero coupon - only the par value is returned

at maturity

 variable (adjustable) rate - the rate fluctuates

in accordance with some market index or predetermined schedule

 consols - a level rate of interest is paid

perpetually

 inflation-indexed Treasury bonds - the

principal value is adjusted based

on the consumer price index

Bond Principles: Bond Cash Flows

 convertible bond - may be exchanged for

common stock in the

company that issued the bond

 exchangeable bond - may be exchanged for

shares in another firm

Bond Principles: Options

 bearer (coupon) bonds - belong to whomever

legally hold them; no longer

issued in the United States

because of tax considerations

 registered bonds - the bonds show the

bondholder’s name

 book entry bonds - bond ownership is

reflected only in the

accounting records

Bond Principles: Registration

Bond Principles: Registration

Insert Figure 4-1 here.

Basic

Information

Cur Net Bonds Yld Vol Close

Yld.

6 Feb 26 86:09 86:11 - 9 7.11

The Financial Page Listing

The Financial Page Listing

Insert Figure 4-2 here.

   

present the

from periods

semiannual in

time

rate discount

periods semiannual

in bond the

of term where

1

value

par 1

interest

al) PV(princip t)

PV(interes price

bond current

2 Zero Coupon Bonds

1 r  n

value

par al)

PV(princip price

time

at flow

cash price

bond current

Bond Pricing & Returns: Valuation Equations

4 Consols

r

t r

t

time

at flow

cash

time

at flow

cash price

bond current

The yield to maturity is the single interest rate that, when applied to the stream of cash flows associated with a bond, causes the present

value of those cash flows to equal the bond’s market price.

Bond Pricing & Returns: Yield to Maturity

 

value) 0.4(par

price) 0.6(market

maturity until

years

value par

price

-market -

interest

annual

Bond Pricing & Returns: Yield to Maturity

 The yield to maturity calculation carries an

assumption that coupon proceeds are

reinvested at the yield to maturity.

 If a bond pays periodic interest, it is not

possible to lock in a prescribed yield to

maturity.

Bond Pricing & Returns: Yield to Maturity

Insert Table 4-3 here.

 A plot of interest rates against time to

maturity is known as a yield curve.

yield

time

Bond Pricing & Returns: Yield to Maturity

Bond Pricing & Returns: Yield to Maturity

Insert Figure 4-4 here.

 A spot rate is the yield to maturity of

a zero coupon security of the chosen maturity.

 A treasury strip is a government bond or note

that has been decomposed into two parts, one for the stream of interest payments and one for the return of principal at maturity.

 The yield to maturity is a derived statistic after

the bond price is known.

Bond Pricing & Returns: Spot Rates

 The yield to maturity can be thought of as an

“average” of the spot rates, or as a flat yield curve at some constant interest rate.

 This single interest rate makes the present

value of the future cash flows equal to the bond’s market price.

%

Term Yield to Maturity Spot Rate Curve

Bond Pricing & Returns: Spot Rates

Bond Pricing & Returns: Spot Rates

Insert Figure 4-5 here.

Realized Compound Yield:

year per

payments of

number

maturity to

yield where

1 rate

annual effective

 The current yield only measures the return

associated with the bond’s interest

payments.

 A bond whose market price is less than its

par value is selling at a discount The price

of such bonds rise as maturity approaches.

 If the market price is more than the par

value, the bond is selling at a premium

Bond Pricing & Returns: Current Yield

Bond Pricing & Returns: Current Yield

Insert Figure 4-6 here.

 Interest is earned for each day that a bond

is held, although interest payments are

generally made twice a year only.

 A bond buyer must pay the accrued interest

to the seller of the bond.

 dirty price = bond price + accrued interest

clean price = bond price

 By convention, accrued interest is

calculated using a 360-day year

Bond Pricing & Returns: Accrued Interest

Bond Pricing & Returns: Accrued Interest

Insert Figure 4-7 here.

 default risk - the possibility that the issuer

of the bond is unable to pay

- rated by agencies like Moody’s and Standard & Poor’s

Bond Risks: Price Risks

Bond Risks: Price Risks

Insert Table 4-5 here.

 interest rate risk - the chance of loss due to

changing interest rates

Bond Risks: Price Risks

 call risk - the possibility that the company

will exercise a bond’s call feature

Bond Risks: Convenience Risks

Bond Risks: Convenience Risks

Insert Figure 4-8 here.

 reinvestment rate risk - the chance that the

interest received cannot be

reinvested to earn as much as the bond’s original yield to maturity

- the higher the coupon on a bond, the higher its reinvestment rate risk

 marketability risk - the difficulty of selling a

bond in the secondary

market

Bond Risks: Convenience Risks

 Bond Principles … continued

 Bond Cash Flows

• Annuities

• Zero Coupon

• Variable Rate

• Consols

• Inflation-Indexed Treasury Bonds

 Convertible and Exchangeable Bonds

 The Financial Page Listing

• Zero Coupon Bonds

• Variable Rate Bonds

• Consols

Review

 Bond Pricing and Returns … continued

 Yield to Maturity

• Calculating the Yield to Maturity

• Misreading the Yield to Maturity

• The Yield Curve