Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide 11-1 Chapter 11

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide 11-2 Chapter Summary  Objective:To review the principles of bond pricing and to examine the determinants of credit risk. Bond Characteristics Bond Pricing and YTM Taxation Issues Default Risk and Ratings

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide 11-3  Face or par value  Coupon rate Zero coupon bond  Compounding and payments Accrued Interest, “dirty price”  Indenture Bond Characteristics

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide 11-4 Different Issuers of Bonds  Canada bonds  Provincial government bonds  Corporations  Municipalities  International Governments and Corporations  Innovative Bonds Indexed Bonds Floaters and Reverse Floaters

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide 11-5  Secured or unsecured  Registered or bearer bonds (Canada)  Call provision  Convertible provision  Retractable and extendible (putable) bonds  Floating rate bond Provisions of Bonds

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide 11-6 Summary Reminder  Objective:To review the principles of bond pricing and to examine the determinants of credit risk. Bond Characteristics Bond Pricing and YTM Taxation Issues Default Risk and Ratings

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide 11-7 P B =price of the bond C t = interest or coupon payments T = number of periods to maturity r = the appropriate semi-annual discount rate Bond Pricing

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide 11-8 C t = 40 (SA) P= 1000 T= 60 periods r= 5% (SA) P B = $ Solving for Price: 10-yr, 8% Coupon Bond, FV = $1,000

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide 11-9  Prices and market interest rates have an inverse relationship  When interest rates get very high the value of the bond will be very low  When rates approach zero, the value of the bond approaches the sum of the cash flows Bond Prices and Interest Rates

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide Price Interest Rate Prices and Interest Rates

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide Yield to Maturity  Interest rate that makes the present value of the bond’s payments equal to its price Solve the bond price formula for r

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide Yield to Maturity Example 10 yr MaturityCoupon Rate = 7% Price = $950 Solve for r = semiannual rate r = %

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide Yield Measures Bond Equivalent Yield 3.86% x 2 = 7.72% Effective Annual Yield (1.0386) = 7.88% Current Yield (Annual Interest/Market Price) $70 / $950 = 7.37 %

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide Realized Yield versus YTM  Reinvestment Assumptions  Holding Period Return Changes in rates affects returns Reinvestment of coupon payments Change in price of the bond

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide Holding-Period Return: Single Period where I = interest payment P 1 = price in one period P 0 = purchase price

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide Holding-Period Example CR = 8% ; YTM = 8%; N=10 years Semiannual Compounding P 0 = $1000 In 6M the rate falls to 7%; P 1 =$ HPR = 10.85% (semiannual)

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide Realized Compound Yield vs. YTM  Requires actual calculation of reinvestment income  Solve for the Internal Rate of Return using the following: Future Value: sale price + future value of coupons Investment: purchase price

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide Example  Two-year bond selling at par, 10% coupon paid once a year. First coupon is reinvested at 8%. Then:

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide Price Paths of Coupon Bonds Price 1,000 Maturity date 0 Discount bond Time Premium bond

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide Summary Reminder  Objective:To review the principles of bond pricing and to examine the determinants of credit risk. Bond Characteristics Bond Pricing and YTM Taxation Issues Default Risk and Ratings

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide Zero-Coupon Bonds and Taxation Issues  For constant yields, discount bond prices rise over time and premium bond prices decline over time  Original issue discount bonds’ price appreciation (based on constant yield) is taxed as ordinary income  Price changes stemming from yield changes are taxed as capital gains if the bond is sold

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide Example  30-year bond with 4% coupon rate, issued at an 8% YTM; if sold one year later, when YTM=7%, for a 36% income tax and a 20% capital gains tax: P 0 =549.69; P 1 (8%)=553.66; P 1 (7%)=631.67

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide Example (continued)

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide Summary Reminder  Objective:To review the principles of bond pricing and to examine the determinants of credit risk. Bond Characteristics Bond Pricing and YTM Taxation Issues Default Risk and Ratings

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide  Rating companies Moody’s Investor Service Standard & Poor’s Fitch IBCA Canadian Bond Rating Service (CBRS)  Rating Categories Investment grade Speculative grade Default Risk and Ratings

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide  Coverage ratios  Leverage ratio  Liquidity ratios  Profitability ratios  Cash flow to debt Factors Used by Rating Companies

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide Financial Ratios by Rating Class US Industrial LT Debt, Medians AAAABBBB EBIT interest coverage EBITDA interest coverage Funds flow/total debt (%) Free operating CF/debt (%) (4.6) Return on capital (%) Operating income/sales (%) LT debt/capital (%) Total debt/capital (%)

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide The Altman Discriminant Analysis Method  Observe a sample of bankrupt firms one year prior to default  Observe a sample of similar solvent firms  Find a function of ROE and coverage ratios that separates the bankrupt from the solvent firms  Use the function to predict default/solvency for any off-sample firm (high/low values)

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide Example of the Altman Method (Canada)  Predicting equation:  Firms with Z>1.626 were “safe”, and firms with Z<1.626 were in risk of default

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide  Sinking funds  Subordination of future debt  Dividend restrictions  Collateral Protection Against Default

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide Default Risk and Yield  Risk structure of interest rates  Default premiums Yields compared to ratings Yield spreads over business cycles Flight to quality