12/13/2015rd1 Bonds Bills – short term contracts usually one year or less Notes – from 1 to 10 years Bonds – 10 years or longer but "bonds" used loosely Time to mature, coupon rate, par (face) value More complicated bonds can be convertible or callable

12/13/2015rd2 Types of Bonds U.S. government securities, Municipal bonds, Corporate bonds, Mortgage and asset—backed securities, Federal agency securities and Foreign government bonds

12/13/2015rd3 Example A bond with a face amount of $20,000 maturing in 20 years might be purchased for about $5,050. At the end of the 20 years, the investor will receive $20,000. The difference between $20,000 and $5,050 represents the interest, based on an interest rate of 7%, which compounds automatically until the bond matures. If the bond is taxable, the interest is taxed as it accrues, even though it is not paid to the investor before maturity or redemption.

12/13/2015rd4 Maturity Short-term notes: up to 5 years; Intermediate notes/bonds: 5 to 12 years; Long-term bonds: 12 or more years.

12/13/2015rd5 Market Fluctuations: The Link Between Price and Yield From the time a bond is originally issued until the day it matures, its price in the marketplace will fluctuate according to changes in market conditions or credit quality. The constant fluctuation in price is true of individual bonds—and true of the entire bond market—with every change in the level of interest rates typically having an immediate, and predictable, effect on the prices of bonds. When prevailing interest rates rise, prices of outstanding bonds fall to bring the yield of older bonds into line with higher—interest new issues. When prevailing interest rates fall, prices of outstanding bonds rise, until the yield of older bonds is low enough to match the lower interest rate on new issues. The value of a bond can be higher or lower than its original face value if you sell it before it matures

12/13/2015rd6 Bond Parameters Face or par value ($: 100 1K 5K 10K) Redemption or Disposal Price Bond rate (nominal interest per period) Number of pay periods before redemption Bond yield rate per period (i eff ) Value (price) of bond number of interest periods before redemption. PW(i%)

12/13/2015rd7 Classification of Bonds ClassificationIssued byCharacteristicsExamples Treasury securities Federal government Backed by US government Bills(<= 1 year) Notes (2-10 years) Bonds(10-30 years) MunicipalLocal governmentsFederal tax-exempt Issued against taxes received General obligation Revenue Zero coupon MortgageCorporationBacked by specific assets or mortgage low rate/low risk on mortgage; Foreclosure First or Second mortgages Equipment trust DebentureCorporationNot backed by collateral, but by reputation; high interest rate Convertible Subordinated Junk or high yield

12/13/2015rd8 Bond Rating Moody'sS&P/FitchGradeRisk AaaAAAInvestmentHighest Quality AaAAInvestmentHigh Quality AAInvestmentStrong BaaBBBInvestmentMedium Grade Ba, BBB, BJunkSpeculative Caa/Ca/CCCC/CC/CJunkHighly speculative CDJunkIn Default

12/13/2015rd9 Example 1 P&G issued $5,00,000 worth of $5, year debenture bonds paying quarterly a 6% coupon rate. a) Determine what the buyer receives each 3 months and after 10 years. Suppose bond is bought when discounted by 2% to $4900. What are the quarterly interest amounts and the final payment at maturity? a) i = 5000*0.06/4 = $75 where the quarterly rate is 1.5%. After 10 years the buyer is paid the face value of $5,000. b) Original specs apply and the new buyer receives $75 each quarter and $5,000 at maturity.

12/13/2015rd10 Example 2 Find the current price of a 10-year, face value $1000 bond paying 6% per year (payable semiannually) that is redeemable at par value if bought by purchaser to yield 10% per year. Solution If the desired effective yield is 10% per year, the APR is 9.76% => i = 4.88% semiannual yield PW(4.88%) = 0.03 * 1000(P/A, 4.88%, 20) (P/F, 4.88%, 20) = $

12/13/2015rd11 Example 3 For $1000 you buy a 10-year $1000 face value bond with a coupon rate of 10% per year and sell it after 2 years for $990. Compute your effective rate of return = 100(P/A, i%, 2) + 990(P/F, i% 2) Let x = 1 + i and resolve at year x 2 – 100x – 1090 = 0 (quadratic )  ( ) => 9.52%. X = 1 + i = => i = 9.52%

12/13/2015rd12 Example 4 Joe buy a 10-year bond for $1000 with a coupon rate of 9% paid semiannually. After 2 years Joe sell the bond to Jane for $900. a) What was the yield on Joe's investment? b) What is Jane's yield if she keeps the bond to maturity? c) What was the current yield when Jane bought the bond? a) 1000 = 45(P/A, i% 4) + 900(P/F, i%, 4) 1K (quartic )  => i s = 2.08% => APR = 4.16% => i a = 4.20%. b) (UIRR )  i s = 5.45% => APR = 10.9% => i a = 11.2% c) 45/900 = 5% = i s => APR = 10% => i a = 10.25%.

12/13/2015rd13 Example 5 A $5,000 face value, 20-year bond pays 8% coupon rate per year. a) How much should be paid for the bond to receive a 10% per year yield? b) If purchased now for $4,586.27, find the annual yield. Solution a) Paid = 400(P/A, 10%, 20) + 5K(P/F, 10%, 20) = $4, b) 4, = 400(P/A, i%, 20) + 5K(P/F, i%, 20). Guess and test to get 8.9% or use the Genie command (UIRR )  8.9%.

12/13/2015rd14 Zero Coupon CDs Zero coupon CDs are sold at a discount to their face amount and pay the entire face amount at maturity. Example: You pay $900 for a $1,000 CD and receive the full $1,000 at maturity for $100 in interest.

12/13/2015rd15 Your firm needs capital to finance growth. Should you issue debt or equity or obtain a bank loan? If you choose debt, should the bonds be convertible? Callable? If you choose equity, should you use common or preferred stock? How will the stock market react to your decision? In 1998, IBM announced that it would repurchase $2.5 billion in stock. How should it structure the stock repurchase? IBM’s price jumped 7% after the announcement. Why? How would the market have reacted if IBM increased dividends instead? Suppose Intel made the same announcement. Would we expect the same price response?

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12/13/2015rd17 A 10-year bond with a face value of $5,000 pays a dividend of $250 every six months. Calculate the bond interest rate. If the bond is purchased for $4,000 at the end of year one, what is the effective interest rate? What is the nominal and effective annual interest rate? Solution: Face value = $5,000; Dividend = $250 every six months n = ½ Year. 250 = 5,000(i) (1/2) Pin (bond pays simple interest) i = 0.1 = 10%. Purchase price at the end of year 1 = $4,000 4,000 = 250(P/A, i%, 18) + 5,000 (P/F, i%, 18) (UIRR )  effective semi-annual or 14% APR or 14.5% effective annual rate.

12/13/2015rd18 Bond Value You buy a 10-year $1000 corporate bond at market price of $996.25, with coupon rate 9.625% paid semiannually. Find the yield to maturity and the current yield. Find value of bond 1 year later. Repeat if rate drops to 9%. Yield to maturity: = 48.13(P/A, i%, 20) + 1K(P/F, i%, 20) (UIRR )  % => % = APR I a = 9.92% effective annual yield Current yield: 2 * 48.13/ = 9.66% APR I a = 9.90%, 0.02% less than yield to maturity (P/A, 4.84%, 18) (P/F, 4.84%, 18) = $ (P/A, 4.5%, 18) (P/F, 4.5%, 18) = $1,038.06

12/13/2015rd19 Short Bond Glossary Coupon -- The rate of interest payable annually. Current Yield -- The ratio of interest to the actual market price of the bond, stated as a percentage. For example, a bond with a current market price of $1,000 that pays $60 per year in interest would have a current yield of 6%. Face or Par value -- The par value of a security, as distinct from its market value. Premium or Discount price -- When the dollar price of a bond is above its face value, it is said to be selling at a premium. When the dollar price is below face value, it is said to be selling at a discount. Yield -- The annual percentage rate of return earned on a security. Yield is a function of a security’s purchase price and coupon interest rate