Chapter #

Report
Chapter 07
McGraw-Hill/Irwin
Valuing Bonds
Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.
Bond Market Overview
• Debt obligations
– Repayment of principal
– Interest payments
• Known as fixed-income securities
7-2
Bond Market Overview
• Indenture agreement contains bond terms
–
–
–
–
–
Maturity date
Par value
Time to maturity
Call feature
Coupon Rate
7-3
Bond Issuers
• US Treasury
• Corporations
• Municipalities
7-4
Other Bonds and Securities
• Treasury Inflation-Protected Securities (TIPS)
– Indexed to inflation
• U.S. government agency securities
– Fannie Mae, Freddie Mac, student loans
• Mortgage-backed securities
7-5
Reading Bond Quotes
• Premium bond sells for higher price than par
• Discount bond sells for lower price than par
• Coupon rate set at time of issue
7-6
Bond Valuation
• Uses time value of money concepts
• Price of bond
– Present value of future cash flows discounted at
prevailing market interest rate
7-7
Bond Valuation
• Zero-coupon bond
– No interest payments
– Pays par value at maturity
7-8
Bond Valuation
• Timeline for zero-coupon bond
7-9
Present Value of Bond
– Present value of interest payments + Present value of
par value
7-10
Bond Yields
•
•
•
•
Current Yield
Yield to Maturity
Yield to Call
Municipal Bond Equivalent Taxable Yield
7-11
Bond Yields
• Yield to Maturity (YTM)
– Discount rate that equates the present value of future
cash flows with current bond price
7-12
Bond Yields
• Yield to Call
– Price of callable bond = Present value of interest
payments to call data + Present value of call price
7-13
Bond Yields
• Municipal Bond Equivalent Taxable Yield
– Compares tax-exempt municipal bonds to taxable
bonds
7-14
Credit Risk
• Bond ratings
• Credit risk and yield
7-15
Credit Risk
• Bond ratings
– Credit risk is the chance the issuer will not be able to
repay on a timely basis
– Credit rating agencies
• Investment-grade bonds are AAA to BBB rated
• Junk bond (high-yield) are rated below BB
7-16
Credit Risk and Yield
• Yield is affected by credit risk
– Lower quality bonds offer higher yields
– Higher quality bonds offer lower yields
7-17
Yield to Maturity
Long-Term Bonds of Different Credit Risk from 1980-2010
7-18
Bond Markets
• Decentralized, over-the-counter trading
• Most trades occur between bond dealers and
large institutions
• Bond prices have inverse relationship to interest
rates
7-19

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