Interest Rates and Bond Valuation 1 BOND BASICS IBM $1,000 LOAN Interest each year at coupon rate$1,000 at maturity

Interest Rates and Bond Valuation 2 Bond Valuation Discount bond cash flows at required rate of return (yield to maturity)  Don’t use coupon rate  If you do, you’ll find value is $1,000 Interest rates increase, bond values decrease Interest rates decrease, bond values increase

Interest Rates and Bond Valuation 3 Bond Valuation

Interest Rates and Bond Valuation 4 Interest Rate Risk Longer time to maturity, more interest rate risk (bond price more volatile) Lower coupon rate, more interest rate risk (bond price more volatile) CT: Why 100-year bonds?

Interest Rates and Bond Valuation 5 Bond Valuation Discount bond cash flows at required rate of return (yield to maturity)  Don’t use coupon rate  If you do, you’ll find value is $1,000 Interest rates increase, bond values decrease Interest rates decrease, bond values increase

Interest Rates and Bond Valuation 6 Calculating YTM (Required Return) and Bond Price Bond has 7% coupon rate, 5 years to maturity and is priced at $1,257. What is yield to maturity? Bond has 3% coupon rate, 30 years to maturity and is priced at $985. What is yield to maturity? Bond has 6% coupon rate, a YTM of 10% and 20 years to maturity. What is the price? Bond has 5% coupon rate, a YTM of 4% and 3 years to maturity. What is the price?

Interest Rates and Bond Valuation 7 Bond Features Terms Call provision Protective covenants

Interest Rates and Bond Valuation 8 Bond Terms Most bonds…  $1,000 face value at maturity  Interest is paid semi-annually We’ll ignore this in our calculations  Debentures: unsecured Remember bonds are loans

Interest Rates and Bond Valuation 9 Call Provision Allows company to repay loan early  Call price is generally above face value  Call price declines over time Often can’t call bond for a period of years after bond issued Most corporate bonds are callable Most Treasury bonds are not

Interest Rates and Bond Valuation 10 Call Provision Why would a bond with a coupon rate of 6% be called? Will interest rates on callable bonds generally be higher or lower than rates on bonds that can’t be called? CT 5: Costs and benefits of call provision.

Interest Rates and Bond Valuation 11 Protective Covenants Protect lender (purchaser of bond) Negative covenants  Limit dividends  Limit issuing additional debt Positive covenants  Maintain times interest earned ratio  Maintain debt ratio What happens if covenants violated?

Interest Rates and Bond Valuation 12 Bond Ratings S&P and Moodys paid to rate creditworthiness of bond issuer  Corporate and government bonds  Less biased evaluation than stock analysts Junk bonds: not investment grade  Pension funds and some mutual funds only buy investment grade bond  High-yield, high risk bonds CT 8 and 9: Why gave bonds rated? Why are junk bonds and U.S. bonds not rated?

Interest Rates and Bond Valuation 13 Government Bonds U.S. Treasury  Two year notes to 30-year bonds  Generally not callable  No default risk??? Biggest borrower in the world…  Interest is not subject to state income tax Illinois tax rate is 3%

Interest Rates and Bond Valuation 14 Municipal Bonds Issued by state and municipal governments  Some default risk??? Orange County, Bridgeport, CN After-tax yield  6% IBM coupon vs. 5% Illinois coupon  Taxpayer with 30% marginal tax rate

Interest Rates and Bond Valuation 15 Zero Coupon Bonds Just receive $1,000 at maturity Issuer deducts imputed interest each year even though pays no cash  Generally increase in value of bond is imputed interest Owner of bond pays tax on interest each year even though none received Very volatile (risky) bonds Sinking fund

Interest Rates and Bond Valuation 16 Bond Prices Price quoted is percent of face value  97 ½ is $975; 103 is $1,030 Current yield = required rate of return Remember bond prices converge towards $1,000 at maturity  Discount bonds increase; premium bonds decrease

Interest Rates and Bond Valuation 17 Investing In Bonds $1,000 per bond How many bonds to diversify? Market not transparent Difficulty in assessing default risk CT 13: Implications for investors since bond market not transparent?

Interest Rates and Bond Valuation 18 Bond Mutual Funds Pool investors funds Professional management Specialize in certain types of bonds  Government  High Yield (Junk)  Municipal Don’t blindly chase higher yields unless…

Interest Rates and Bond Valuation 19 What Determines Interest Rates? Real rate of return Inflation risk premium Default risk premium Maturity risk premium Liquidity risk premium

Interest Rates and Bond Valuation 20 Real Rate of Return Inflation-adjusted Treasury bills  No inflation risk  No default risk  No maturity risk  No liquidity risk Rates:  1.20% as of 01/09  Over 4%, in 10/01

Interest Rates and Bond Valuation 21 Inflation Risk Premium Inflation reduces value of future dollars Add premium for anticipated inflation

Interest Rates and Bond Valuation 22 Inflation Risk Premium Steep yield curve Inverted yield curve  Figure 6.7, Page 175  Future economic activity?

Interest Rates and Bond Valuation 23 Default Risk Premium Higher risk, higher required return GM and Ford

Interest Rates and Bond Valuation 24 Maturity Risk Premium Long-term bonds more volatile  More risk, demand higher return CT 1: Are Treasury securities risk- free?

Interest Rates and Bond Valuation 25 Liquidity Premium Corporate bonds don’t trade on an exchange like stocks  Treasury bonds very liquid  Many corporate bonds not very liquid

Interest Rates and Bond Valuation 26 What Determines Interest Rates? Real rate of return + Inflation risk premium + Default risk premium + Maturity risk premium + Liquidity risk premium + = Required Rate of Return