Essentials of Investments © 2001 The McGraw-Hill Companies, Inc. All rights reserved. Fourth Edition Irwin / McGraw-Hill Bodie Kane Marcus 1 Chapter 10 Bond Prices and Yields

Essentials of Investments © 2001 The McGraw-Hill Companies, Inc. All rights reserved. Fourth Edition Irwin / McGraw-Hill Bodie Kane Marcus 2 Bond Characteristics Face or par value Coupon rate –Zero coupon bond Compounding and payments –Accrued Interest Indenture

Essentials of Investments © 2001 The McGraw-Hill Companies, Inc. All rights reserved. Fourth Edition Irwin / McGraw-Hill Bodie Kane Marcus 3 Provisions of Bonds Secured or unsecured Call provision Convertible provision Put provision (putable bonds) Floating rate bonds Sinking funds

Essentials of Investments © 2001 The McGraw-Hill Companies, Inc. All rights reserved. Fourth Edition Irwin / McGraw-Hill Bodie Kane Marcus 4 Default Risk and Ratings Rating companies –Moody’s Investor Service –Standard & Poor’s –Duff and Phelps –Fitch Rating Categories –Investment grade –Speculative grade

Essentials of Investments © 2001 The McGraw-Hill Companies, Inc. All rights reserved. Fourth Edition Irwin / McGraw-Hill Bodie Kane Marcus 5 Factors Used by Rating Companies Coverage ratios Leverage ratios Liquidity ratios Profitability ratios Cash flow to debt

Essentials of Investments © 2001 The McGraw-Hill Companies, Inc. All rights reserved. Fourth Edition Irwin / McGraw-Hill Bodie Kane Marcus 6 Protection Against Default Sinking funds Subordination of future debt Dividend restrictions Collateral

Essentials of Investments © 2001 The McGraw-Hill Companies, Inc. All rights reserved. Fourth Edition Irwin / McGraw-Hill Bodie Kane Marcus 7 Bond Pricing P B =Price of the bond C t = interest or coupon payments T = number of periods to maturity r = semi-annual discount rate or the semi-annual yield to maturity

Essentials of Investments © 2001 The McGraw-Hill Companies, Inc. All rights reserved. Fourth Edition Irwin / McGraw-Hill Bodie Kane Marcus 8 C t = 40 (SA) P= 1000 T= 20 periods r= 3% (SA) P B = $1, Solving for Price: 10-yr, 8% Coupon Bond, Face = $1,000 t=1 + 20= P B 40 1 ) ( 1+.03) t ( ) 20

Essentials of Investments © 2001 The McGraw-Hill Companies, Inc. All rights reserved. Fourth Edition Irwin / McGraw-Hill Bodie Kane Marcus 9 Bond Prices and Yields 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

Essentials of Investments © 2001 The McGraw-Hill Companies, Inc. All rights reserved. Fourth Edition Irwin / McGraw-Hill Bodie Kane Marcus 10 Prices and Coupon Rates Price Yield

Essentials of Investments © 2001 The McGraw-Hill Companies, Inc. All rights reserved. Fourth Edition Irwin / McGraw-Hill Bodie Kane Marcus 11 Approximate Yield to Maturity YTM = (Avg. Income) / (Avg. Price) Avg. Income = Int. +(Par-Price) / Yrs to maturity Avg. Price = (Price + Par) / 2 Using the earlier example Avg. Income = 80 + ( )/10 = Avg. Price = ( )/2 = Approx. YTM = 65.10/ =.0606 or 6.06% Actual YTM = 6.00%

Essentials of Investments © 2001 The McGraw-Hill Companies, Inc. All rights reserved. Fourth Edition Irwin / McGraw-Hill Bodie Kane Marcus 12 Term Structure of Interest Rates Relationship between yields to maturity and maturity Yield curve - a graph of the yields on bonds relative to the number of years to maturity –Usually Treasury Bonds –Have to be similar risk or other factors would be influencing yields

Essentials of Investments © 2001 The McGraw-Hill Companies, Inc. All rights reserved. Fourth Edition Irwin / McGraw-Hill Bodie Kane Marcus 13 Yield Curves Yields Maturity Upward Sloping Downward Sloping

Essentials of Investments © 2001 The McGraw-Hill Companies, Inc. All rights reserved. Fourth Edition Irwin / McGraw-Hill Bodie Kane Marcus 14 Theories of Term Structure Expectations Liquidity Preference –Upward bias over expectations Market Segmentation –Preferred Habitat