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Chapters 10Bond Prices and YieldsCopyright 2010 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

110.1 Bond Characteristics (revise FM)Revise 2.1 and 2.2 of chapter 2 on your own.Fixed income/debt securities = a claim on a specified periodic stream of incomeFace or par value or principal valueMaturity dateCoupon rate Variable or fixedZeroReview with a video: http://www.youtube.com/watch?v=ftsNgtx2haY10.2 Bond Pricing & Yieldsa)Bond Price for a corporate bond:C = Coupon = 10%, interest rate r = YTM = 12%, Maturity = N or T = 10 years, P = price, Par = $1,000What is the bonds price using semiannual compounding?

64.8%35.2%

10-33Bond Pricing Between Coupon DatesThe flat price or quoted price assumes the bond is purchased on a coupon payment date.

If the bond buyer purchases a bond between payment dates the buyers invoice price = flat price + accrued interest.

10-44Bond Pricing Between Coupon DatesA bond has a flat price of $925.30 and an annual coupon of $42.50. 160 days have passed since the last coupon payment and there are 182 days separating the coupon payments. What is the bonds invoice price?

10-551. Yield to Maturity (YTM): The discount rate that makes the present value of a bonds payments equal to its pricee.g. Find the YTM for a 8% coupon, 30-year bond selling at $1,276.76

What are the assumptions of this calculation?10.3 Bond Yields

10-66Q1. A coupon bond which pays interest of 4% annually, has a par value of $1,000, matures in 5 years, and is selling today at $785. The actual yield to maturity on this bond is _________.7.2%8.8%9.1%9.6%0 of 40Q2. You purchased a 5-year annual interest coupon bond one year ago. Its coupon interest rate was 6% and its par value was $1,000. At the time you purchased the bond, the yield to maturity was 4%. If you sold the bond after receiving the first interest payment and the bond's yield to maturity had changed to 3%, your annual total rate of return on holding the bond for that year would have been approximately _________.5%5.5%7.6%8.9%0 of 40Alternative Measures of Yield2. Current YieldAnnual dollar coupon divided by the price; excludes capital gain or loss3. Yield to CallCall price replaces parCall date replaces maturity4. Holding Period Yield (HPY)use actual reinvestment rate on coupons; instead of YTMConsiders any change in price if the bond is sold prior to maturity10-99Bond Prices and YieldsPrices and Yields (required rates of return) have an inverse relationship (see fig. 10.3).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.Note the curvilinear relationship between bond prices and yields.10-1010Figure 10.3 The Inverse Relationship Between Bond Prices and Yields:

10-1111Fig 10.4 Yield to Call Illustrated10-12

12Figure 10.5 . The future value of the coupons depends on the rate of return when the coupons are reinvested. An investor will not earn the promised yield unless they reinvest the coupons at the promised YTM.

10-13Reinvestment Risk1310.4 Bond Prices Over TimePremium BondCoupon rate exceeds yield to maturityBond price will decline to par over its maturity

Discount BondYield to maturity exceeds coupon rateBond price will increase to par over its maturity

Can you explain why these price change will occur?Refer to figure 10.610-1414Figure 10.6 Premium and Discount Bonds over Time

10-15This illustrates the Pull to Par discussed on the prior slide.15Q3.Consider a 5-year bond with a 10% coupon rate selling at a YTM of 8%. If interest rates remain constant, the price of the bond at maturity will be __________.0 of 40HigherThe sameLowerFace valueZero-coupon bonds and Treasury StripsZero-coupon BondSell at discount (Interest type = discount).One cash-flow payment (= principal value) at maturity.e.g. U.S. Treasury bills.

Treasury STRIPS are longer-term zero-coupon bonds.eg. A 20-year bond with face value of $20,000 and 10% coupon rate is stripped into its principal and 40-semi-annual coupon payments. Each of the 41 securities have its own maturity date and trades separately with distinct ID until its maturity date at prices determined by the market.10-171710.5 Default Risk and Bond PricingDefault riskCredit rating: Investment grade versus speculative grade

Determinants of bond credit ratingCoverage ratio: times-interest-earned ratioLeverage ratio : Debt to equity ratioLiquidity ratios: current ratio and quick ratioProfitability ratios: ROA, ROECash flow-to-debt ratio10-1818Credit Default SwapSkip bond indentures and yield-to-maturity and default risk

Credit Default Swap (CDS)Insurance policy on the default risk of a corporate bond.Suppose a BB-rated bond bundled with CDS is effectively equivalent to a AAA-rated bond. Price of CDS approximates the yield differences between the BB-rated bond and the AAA-rated bond.10-1919Q4. Which of the following changes will increase the YTM on a bond?0 of 40Increase in times-interest-earned ratio.Decrease in debt-equity ratio.Decrease in quick ratio.Increase in current ratio.Q5. Which of the following will NOT improve the credit rating of a bond?0 of 40Add a CDS to the bond.Increase in equity value relative to debt value.Decrease in current ratio.Increase in ROA.10.6 Term structure of interest ratesasianbondsonline.adb.org/singapore.phpSingapore Treasury Bills and Bonds

10.6 Theories of the Term StructureExpectations Long term rates are a function of expected future short term ratesUpward slope means that the market is expecting higher future short term ratesDownward slope means that the market is expecting lower future short term rates

Liquidity PreferenceUpward bias over expectationsThe observed long-term rate includes a risk premium

10-2323Figure 10.13 Returns to Two 2-year Investment Strategies

10-2424Forward Rates Implied in the Yield Curve)1301.1()11.1()12.1()1()1()1(1211=-=+++-fyynnnnnFor example, using 1-yr and 2-yr ratesLonger term rate, yn = 12%Shorter term rate, yn-1 = 11%Forward rate, a one-year rate in one year from now = 13.01%10-2525Figure 10.14 Illustrative Yield Curves

10-2626Figure 10.15 Term Spread10-27

27Q6. The yield curve is upward-sloping. Which of the following statements could be valid? I. Investors expect short-term interest rates to be flat according to the expectations hypothesis.II. Investors expect a larger liquidity premium for longer-term investments.

0 of 40I onlyII only.I and II only.None of the aboveQ7. One, two and three year maturity, default-free, zero-coupon bonds have yields-to-maturity of 7%, 8% and 9% respectively. What is the implied one-year forward rate for the second year?2%8%9%11%0 of 40Q8. One, two and three year maturity, default-free, zero-coupon bonds have yields-to-maturity of 7%, 8% and 9% respectively. What is the implied one-year forward rate for the third year?0 of 409%10%11%12%Q9. One, two and three year maturity, default-free, zero-coupon bonds have yields-to-maturity of 7%, 8% and 9% respectively. What is the implied two-year forward rate for year 2?0 of 408%9%10%11%Q10. Based on your answers to Q7- Q9. Which of the following statements are true?I. The yield curve is rising due to falling future short-term rates.II. The yield curve is rising due to constant future short-term rates.III. The yield curve is rising due to rising future short-term rates.

0 of 40I onlyII onlyIII onlyNone of the above