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7-1 Bond Basics A bond is simply a negotiable IOU, or a loan. Investors who buy bonds are lending a specific sum of money to a corporation, government, or some other borrowing institution. Bonds are often referred to as fixed-income investments. 7-2 Key Features of a Bond Debt instrument issued by a corp. or government. 7-3 Key Features of a Bond Par value = face amount of the bond, which is paid at maturity (assume $1,000). = 7-4 Key Features of a Bond Coupon rate – stated interest rate (generally fixed) paid by the issuer. Multiply by par to get dollar payment of interest. 7-5 Key Features of a Bond Maturity date – when the bond must be repaid. Yield to maturity - rate of return earned on a bond held until maturity. 7-6 What is reinvestment rate risk? Reinvestment rate risk is the concern that interest rates will fall, and future money will have to be reinvested at lower rates, hence reducing income. 7-7 What is interest rate risk? Interest rate risk is the concern that interest rates will rise, and therefore, a reduction in the value of a security. 7-8 Reinvestment rate risk example Suppose you just inherited $500,000. You intend to invest the money and live off the interest. 7-9 Reinvestment rate risk example You may invest in either a 10-year bond or a series of ten 1-year bonds. Both bonds currently yield 5%. 7-10 If you choose the 1-year bond strategy: After Year 1, you receive $25,000 in income and have $500,000 to reinvest. But, if 1-year rates fall to 3%, your annual income would fall to $15,000. If you choose the 10-year bond strategy: You can lock in a 5% interest rate, and $25,000 annual income. 7-11 Long-term bonds: High interest rate risk, low reinvestment rate risk. Short-term bonds: Low interest rate risk, high reinvestment rate risk. 7-12 Bond Valuation Compute the value for an IBM Bond with a 6.375% coupon that will mature in 5 years given that you require an 8% return on your investment. 7-13 IBM Bond Timeline: 2009 0 2010 2011 1 2 63.75 63.75 2012 3 63.75 2013 4 63.75 5 63.75 1,000.00 7-14 IBM Bond Timeline: 2009 0 2010 2011 1 2 63.75 63.75 $63.75 Annuity for 5 years 2012 3 2013 4 63.75 63.75 5 63.75 1000.00 $1000 Lump Sum in 5 years 7-15 IBM Bond Timeline: 2009 0 2010 2011 1 2 63.75 63.75 $63.75 Annuity for 5 years 2012 3 2013 4 63.75 5 63.75 63.75 1000.00 $1000 Lump Sum in 5 years = 63.75 PMT 1000 FV 8% I 5N = PV = 935.12 7-16 Most Bonds Pay Interest Semi-Annually: What is the value of a bond with a semi-annual coupon with 5 years to maturity, 9% (nominal) coupon rate if an investor desires a 10% (nominal) return? 7-17 Most Bonds Pay Interest Semi-Annually: e.g. semiannual coupon bond with 5 years to maturity, 9% annual coupon rate. Instead of 5 annual payments of $90, the bondholder receives 10 semiannual payments of $45. 2009 0 2010 1 45 45 2011 2 45 45 2012 3 45 45 2013 4 45 45 5 45 45.00 1000.00 7-18 Most Bonds Pay Interest Semi-Annually: 2009 0 2010 1 45 45 2011 2 45 45 2012 3 45 45 2013 4 45 45 5 45 45.00 1000.00 Compute the value of the bond given that you require a 10% s-a. return on your investment. Since interest is received every 6 months, we need to use semiannual compounding VB = 45 PMT 1000 FV 5% I ?N 7-19 Most Bonds Pay Interest Semi-Annually: 2009 0 2010 1 45 45 2011 2 45 45 2012 3 45 45 2013 4 45 45 5 45 45 1,000 Compute the value of the bond given that you require a 10% s-a. return on your investment. Since interest is received every 6 months, we need to use semiannual compounding = PV = 961.39 7-20 Yield to Maturity 2009 0 -1,000 2010 1 80 2011 2 80 2012 2013 3 4 80 80 5 80 1,000 If YTM > Coupon Rate bond Sells at a DISCOUNT If YTM < Coupon Rate bond Sells at a PREMIUM 7-21 Yield to Maturity If an investor purchases a 6.375% annual coupon bond today for $966.25 and holds it until maturity (5 years), what is the expected annual rate of return ? 2009 0 -966.25 ?? + ?? 2010 2011 1 2 63.75 63.75 2012 3 63.75 2013 4 63.75 5 63.75 1000.00 966.25 7-22 Yield to Maturity • If an investor purchases a 6.375% annual coupon bond today for $966.25 and holds it until maturity (5 years), what is the expected annual rate of return ? Will it be >< than 6.375%? 2009 0 -966.25 ?? + ?? 966.25 2010 2011 1 2 63.75 63.75 2012 3 63.75 2013 4 5 63.75 63.75 1000.00 YTMB = 63.75 PMT 1000 FV 5N -966.25 PV I=? 7-23 What’s the YTM on a 10-year, 9% annual coupon, $1,000 par value bond that sells for $887? 0 rd=? 1 887 10 ... 90 PV1 . . . PV10 PVM 9 90 90 1,000 Find rd that “works”! 7-24 INPUTS OUTPUT 10 N I/YR 10.91 -887 PV 90 PMT 1000 FV 7-25 Types of Bonds Vanilla – fixed coupons, repaid at maturity Convertible – can be converted into to stock Zero Coupon – pay no explicit interest but instead, sell at a deep discount 7-26 Types of Bonds Junk Bonds – below investment grade 7-27 Bond Ratings Moody’s and Standard & Poor’s regularly monitor issuer’s financial condition and assign a rating to the debt Investment Grade Below Investment Grade (Junk) AAA AA A BBB BB B CCC CC C D Best Quality High Quality Upper Medium Grade Medium Grade Speculative Very Speculative Very Very Speculative No Interest Being Paid Currently in Default 7-28 What affects Bond prices? Risk Interest rates 7-29 What is the “term structure of interest rates”? What is a “yield curve”? Term structure: the relationship between interest rates (or yields) and maturities. A graph of the term structure is called the yield curve. 7-30 Draw a normal yield curve 7-31 Hypothetical Treasury Yield Curve Interest Rate (%) 15 Maturity risk premium 10 Inflation premium 1 yr 10 yr 20 yr 8.0% 11.4% 12.65% 5 Real risk-free rate Years to Maturity 0 1 10 20 7-32 Current Rates Bloomberg 7-33 What factors can explain the shape of this yield curve? 7-34 What factors can explain the shape of this yield curve? This constructed yield curve is upward sloping. This is due to increasing expected inflation and an increasing maturity risk premium. 7-35 Default risk If an issuer defaults, investors receive less than the promised return. Influenced by the issuer’s financial strength and the terms of the bond contract. 7-36