CHAPTER 14 Investments Bond Prices and Yields Slides by Richard D. Johnson Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Cover image

14- 2 Cover image  Face or par value  Coupon rate –Zero coupon bond  Compounding and payments –Accrued Interest  Indenture Bond Characteristics

14- 3 Cover image Different Issuers of Bonds  U.S. Treasury –Notes and Bonds  Corporations  Municipalities  International Governments and Corporations  Innovative Bonds –Floaters and Inverse Floaters –Asset-Backed –Catastrophe

14- 4 Cover image Figure 14.1 Listing of Treasury Issues

14- 5 Cover image Figure 14.2 Corporate Bond Listings

14- 6 Cover image  Secured or unsecured  Call provision  Convertible provision  Put provision (putable bonds)  Floating rate bonds  Sinking funds Provisions of Bonds

14- 7 Cover image Table 14.1 Principal and Interest Payments for Treasury Inflation Protected Security

14- 8 Cover image P B =Price of the bond C t = interest or coupon payments T = number of periods to maturity y = semi-annual discount rate or the semi-annual yield to maturity Bond Pricing

14- 9 Cover image C t = 40 (SA) P= 1000 T= 20 periods r= 3% (SA) Price: 10-yr, 8% Coupon, Face = $1,000

Cover image Prices and Yields (required rates of return) have an inverse relationship  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. Bond Prices and Yields

Cover image Figure 14.3 The Inverse Relationship Between Bond Prices and Yields

Cover image Table 14.2 Bond Prices at Different Interest Rates (8% Coupon Bond, Coupons Paid Semiannually

Cover image Yield to Maturity  Interest rate that makes the present value of the bond’s payments equal to its price. Solve the bond formula for r

Cover image Yield to Maturity Example 10 yr MaturityCoupon Rate = 7% Price = $950 Solve for r = semiannual rate r = %

Cover image Yield Measures Bond Equivalent Yield 7.72% = 3.86% x 2 Effective Annual Yield (1.0386) = 7.88% Current Yield Annual Interest / Market Price $70 / $950 = 7.37 % Yield to Call

Cover image Figure 14.4 Bond Prices: Callable and Straight Debt

Cover image Example 14.4 Yield to Call

Cover image Realized Yield versus YTM  Reinvestment Assumptions  Holding Period Return –Changes in rates affects returns –Reinvestment of coupon payments –Change in price of the bond

Cover image Figure 14.5 Growth of Invested Funds

Cover image Figure 14.6 Prices over Time of 30-Year Maturity, 6.5% Coupon Bonds

Cover image Holding-Period Return: Single Period HPR = [ I + ( P 0 - P 1 )] / P 0 where I = interest payment P 1 = price in one period P 0 = purchase price

Cover image Holding-Period Example CR = 8% YTM = 8%N=10 years Semiannual CompoundingP 0 = $1000 In six months the rate falls to 7% P 1 = $ HPR = [40 + ( )] / 1000 HPR = 10.85% (semiannual)

Cover image Figure 14.7 The Price of a 30-Year Zero-Coupon Bond over Time at a Yield to Maturity of 10%

Cover image  Rating companies –Moody’s Investor Service –Standard & Poor’s –Fitch  Rating Categories –Investment grade –Speculative grade Default Risk and Ratings

Cover image Figure 14.8 Definitions of Each Bond Rating Class

Cover image  Coverage ratios  Leverage ratios  Liquidity ratios  Profitability ratios  Cash flow to debt Factors Used by Rating Companies

Cover image Table 14.3 Financial Ratios and Default Risk by Rating Class, Long-Term Debt

Cover image Figure 14.9 Discriminant Analysis

Cover image  Sinking funds  Subordination of future debt  Dividend restrictions  Collateral Protection Against Default

Cover image Figure Callable Bond Issue by Mobil

Cover image Default Risk and Yield  Risk structure of interest rates  Default premiums –Yields compared to ratings –Yield spreads over business cycles

Cover image Figure Yields on Long-Term Bonds, 1954 – 2006