How Do Bond Prices Change? Bonds are sensitive to interest rates It depends on the rate at which you issued the bond – A 1 year T-bill is paying 1.2% interest – A corporate bond pays 6% interest – Which one would you rather have? – The one paying more – if I was looking for a higher return on investment – The tax free one, if my taxes were an issue

Pricing and Safety In the previous example, a risk averse investor would have chosen the T-bill, regardless of the rate How does it affect price? The T-bill would be bought at discount Discount: lower than the face value The bond may be bought at a premium Premium: higher than the face value

Doing the Math The value of a bond can change many times before its maturity date Example: – Shawn purchases an AT&T bond that pays 4.5% interest based on a face value of $1,000 – A comparable new corporate bond is paying 7% – How much is Shawn’s bond worth? Formula: Dollar Amount of Annual Interest Interest Rate of Comp. New Bond = Market Value

Calculate First find your annual interest payment Face value of Bond x Rate = Annual Interest Then divide by the current market interest rate – $1,000 x 4.5% (or.045) = $45 – Solve for the approximate market value if interest in the open market is at 7% – $45 7% (or.07) = $ – The approximate value of Shawn’s bond is $642.86

Calculate You bought two $1,000 bonds Each earn a 5.5% interest rate New corporate bonds being issued are paying 8% interest What is the approximate market value of your bonds? Solution: $1,000 x 5.5% = $55 $55 / 8% = $ (x 2) = $1,375.00

Commission? Yes, both when you buy and when you sell Want to become a broker yet? Bonds trade on both the primary and secondary markets Primary – you buy straight from the investment bank Secondary – you trade with other investors Where are most stocks bought and sold? The secondary market

Yield Yield is expressed as a percentage You have to know the bond’s price and interest rate to calculate yield Yield = (Coupon Rate / Price) Example: A $1,000 bond is priced at $1,054, paying 8% interest What is the yield? Yield = 8 / $1,054 Answer: 7.6% Why is the yield lower than the interest rate? Because you paid a bond premium, lowering your yield What would the answer be if you paid a discount?

Legal Regulations for Bonds The company forms a legal agreement with investors The agreement is called an “indenture” The indenture requires the company to make interest payments An indenture can require a “sinking fund” The sinking fund is an account that stores the interest payment – a bank account It ensures that a payment won’t be missed

Calculating Interest Face value = $1,000 Coupon = 8% Maturity = 10 years You receive a $80 ($1,000*.08) of interest per year for the next 10 years Most bonds pay interest semi-annually, so you'll receive two payments of $40 a year for 10 years (every six months) When the bond matures after a decade, you'll get your $1,000 back.