TAILIEUCHUNG - Lecture Investments (6/e) - Chapter 14: Bond prices and yields

In the previous chapters on risk and return relationships, we have treated securities at a high level of abstraction. We assumed implicitly that a prior, detailed analysis of each security already had been performed, and that its risk and return features had been assessed. in this chapter, we turn now to specific analyses of particular security markets. We examine valuation principles, determinants of risk and return, and portfolio strategies commonly used within and across the various markets. | Chapter 14 Bond Prices and Yields Face or par value Coupon rate Zero coupon bond Compounding and payments Accrued Interest Indenture Bond Characteristics Different Issuers of Bonds . Treasury Notes and Bonds Corporations Municipalities International Governments and Corporations Innovative Bonds Indexed Bonds Floaters and Inverse Floaters Secured or unsecured Call provision Convertible provision Put provision (putable bonds) Floating rate bonds Sinking funds Provisions of Bonds PB = Price of the bond Ct = interest or coupon payments T = number of periods to maturity y = semi-annual discount rate or the semi-annual yield to maturity Bond Pricing Ct = 40 (SA) P = 1000 T = 20 periods r = 3% (SA) Price: 10-yr, 8% Coupon, Face = $1,000 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. Bond Prices and Yields Price Yield Prices and Coupon Rates Yield to Maturity Interest rate that makes the present value of the bond’s payments equal to its price. Solve the bond formula for r Yield to Maturity Example 10 yr Maturity Coupon Rate = 7% Price = $950 Solve for r = semiannual rate r = Yield Measures Bond Equivalent Yield = x 2 Effective Annual Yield ()2 - 1 = Current Yield Annual Interest / Market Price $70 / $950 = % Realized Yield versus YTM Reinvestment Assumptions Holding Period Return Changes in rates affects returns Reinvestment of coupon payments Change in price of the bond Holding-Period Return: Single Period HPR = [ I + ( P0 - P1 )] / P0 where I = interest payment P1 = price in one period P0 = purchase price Holding-Period Example CR = 8% YTM = 8% N=10 years Semiannual Compounding P0 = $1000 In six months the rate falls to 7% P1 = $ HPR = [40 + ( - 1000)] / 1000 HPR = (semiannual) Holding-Period Return: Multiperiod Requires actual calculation of reinvestment income Solve for the Internal Rate of Return using the following: Future Value: sales price + future value of coupons Investment: purchase price Rating companies Moody’s Investor Service Standard & Poor’s Duff and Phelps Fitch Rating Categories Investment grade Speculative grade Default Risk and Ratings Coverage ratios Leverage ratios Liquidity ratios Profitability ratios Cash flow to debt Factors Used by Rating Companies Sinking funds Subordination of future debt Dividend restrictions Collateral Protection Against Default Default Risk and Yield Risk structure of interest rates Default premiums Yields compared to ratings Yield spreads over business cycles

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