1. BONDS PRICES AND YIELDS FNCE 455 Class Session #9 Lloyd Kurtz Santa Clara University 1

2. Topics Bond Basics Bond Valuation Bond Ratings The Yield Curve 2

3. Bond Basics 3

4. Bond Characteristics Face or par value Coupon rate Zero coupon bond Compounding and payments Indenture 4

5. Provisions of Bonds Secured or unsecured Call provision Convertible provision Put provision (putable bonds) Floating rate bonds 5

6. Bond Market Innovations Reverse floaters Asset-backed bonds Pay-in-kind bonds Catastrophe bonds Indexed bonds TIPS (Treasury Inflation Protected Securities) 6

7. Bond Valuation 7

8. The Key Principle The fair value of a bond is the present value of its cash flows. 8

9. 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 9 P C r Par Value r B t T t T T T      () () 1 1 1

10. Price of 8%, 10-yr. w/ 6% yield 10 77.148,1 )03.1( 1 1000 )03.1( 1 40 20 1     P P B t t B Coupon = 4%*1,000 = 40 (Semiannual) Discount Rate = 3% (Semiannual) Maturity = 10 years or 20 periods Par Value = 1,000

11. 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 11

12. Bond Prices and Yields 12

13. Alternative Measures of Yield Current Yield Holding Period Yield Considers actual reinvestment of coupons Considers any change in price if the bond is held less than its maturity Yield to Call Call price replaces par Call date replaces maturity 13

14. Call Features and Pricing 14

15. Premium and Discount Bonds Premium Bond Coupon rate exceeds yield to maturity Bond price will decline to par over its maturity Discount Bond Yield to maturity exceeds coupon rate Bond price will increase to par over its maturity 15

16. 16 Price Change Over Time

17. Price of a Zero-Coupon Bond 17

18. Bond Spreads Risky bonds are often quoted based on their yield relative to a risk-free bond of comparable maturity. The yield difference between a risky bond and risk-free one is called a ‘spread’. 18

19. 19 Sources: Stone & McCarthy, Merrill-Lynch

20. A Yield Spread Index 20 Source: Bloomberg, Stone & McCarthy

21. 21 Source: Bloomberg

22. Bond Ratings 22

23. Ratings Rating companies Moody’s Investor Service Standard & Poor’s Fitch Rating Categories Investment grade Speculative grade 23

24. Ratings Definitions 24

25. Key Factors in Ratings Coverage ratios Leverage ratios Liquidity ratios Profitability ratios Cash flow to debt 25

26. Ratings Aren’t Perfect! In an interview with Sunday’s Frankfurter Allgemeine Zeitung, one of Germany’s most prominent newspapers, former Federal Reserve Chairman Alan Greenspan sharply criticized ratings agencies for their role in the current credit crisis. “People believed they knew what they were doing,” Mr. Greenspan says...“And they don’t.” - Wall Street Journal Real Time Economics, 9/23/2007 26

27. Conflict of interest? Issuers pay for ratings AIG and Lehman were highly rated…right before they failed The industry faces significant lawsuits 27

28. The Yield Curve 28

29. The Yield Curve Yield curve - a graph or listing of the yields on bonds relative to the number of years to maturity There are many yield curves Bonds should be of comparable risk The most-referenced is the Treasury curve 29

30. Examples – U.S. Treasuries

31. The Yield Curve and Recessions An inverted treasury bond curve often precedes an economic slowdown or recession. There have been three inversions of the 1/10 curve since 1987: The inversion of 1989 preceded the 1990-91 financial crisis and recession. The inversion of 2000 preceded the 2001 recession. The most recent inversion began in late 2005 and was followed in 2008-09 by a financial crisis and severe recession. 31

32. Bernanke’s View in 2006 32 “I would not interpret the currently very flat yield curve as indicating a significant economic slowdown to come, for several reasons. First, in previous episodes when an inverted yield curve was followed by recession, the level of interest rates was quite high, consistent with considerable financial restraint. This time, both short- and long-term interest rates--in nominal and real terms--are relatively low by historical standards.” - Speech Before the Economic Club of New York, March 20, 2006 Source: federalreserve.gov

33. Upon Further Review… 33 “ Information received since the Federal Open Market Committee met in January indicates that the economy continues to contract. Job losses, declining equity and housing wealth, and tight credit conditions have weighed on consumer sentiment and spending. Weaker sales prospects and difficulties in obtaining credit have led businesses to cut back on inventories and fixed investment. U.S. exports have slumped as a number of major trading partners have also fallen into recession...” FOMC Statement – March 18, 2009