Principles of Finance with Excel, 2 nd edition Instructor materials Chapter 15 Bond valuation

In this chapter  Basic definitions, example of bond value, and YTM  U.S. Treasury markets: discussion of the types of bonds and yield conventions  Discussion of T-bills  Treasury bonds  Strips  The U.S. Treasury yield curve  Corporate bond markets  Callable bonds  Preferred stock 2

Excel functions  IRR  XIRR  Rate  Yield 3

What’s a bond? 4

Bond terminology  Face value  Coupon rate  Maturity date  Payments: Annual? Semi-annual? Quarterly?  Covenants  Boilerplate 5

There’s a LOT of debt around! 6

U.S. government debt 7

Corporate bonds  Structurally—look like government bonds  Issue date  Maturity date  Interest payments—most often semi- annually 8

McDonald’s issues bonds 9

November 5, 2010: Looking up these bonds in Yahoo 10 Instructor: Make this the subject of a homework? See minicase on instructor website.

Back to XYZ bonds 11

Computing the yield to maturity (YTM) 12 YTM is essentially just the effective annual interest rate (EAIR) discussed in Chapter 3. Reminder: EAIR is the IRR properly calculated. When the XYZ bond was issued, it had a YTM = 7%

Complications in computing bond YTM  Uneven spacing of bond payments  Solution: Use Excel XIRR function  Semiannual payments of interest  Solution: XIRR again!  Accrued interest  Solution: Just understand what’s going on 13

Complication 1: Uneven bond payments  Example:  XYZ bond issued on 15 Dec 2009  What if you buy the XYZ bond on 15 May 2010 for $1050? 14

Use XIRR to solve this problem 15

Reminder: XIRR 16

Complication 2: What if XYZ bond has semiannual payments? 17 Semiannual payments: bond pays 7% annually, 3.5% every half year. Use IRR wisely or XIRR to compute the YTM of the bond.

Complication 3: Accrued interest  Problem: In U.S. the actual price paid for bond:  Quoted bond price  Accrued interest (unpaid interest from last interest date until sale date) 18

Accrued interest example 19 Buy XYZ bond on 3 April  Last coupon date 15 Dec 2009  Next coupon date 15 Dec 2011 See accrued interest computation to left.

YTM with accrued interest 20 Note: Actual price paid for bond is: Quoted price + accrued interest = $

U.S. Treasury Bills  Short-term securities issued by U.S. government  Typical maturity: less than a year  Bills are discounted: No explicit interest 21

22 Treasury bill issued on 2 Nov 2010 with maturity on 2 October Suppose price at issue = 99. Then YTM = 1.10%.

Zero-coupon bonds  Have only terminal payment (no coupons)  Treasury “strips”:  Each payment (coupon or return of principal) of a Treasury security is traded separately  See next slide 23

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Use Treasury strips to find term structure of interest rates  Page 475 of PFE  Each strip determines the interest rate to a specific date: 25

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