Chapter 10 Bond Prices and Yields 10.1 Bond Characteristics 10-2 U.S. Credit Market Instruments O/S 2008 Q3 U.S. Equity Market (Common) $19,648 Billion U.S. Credit Market Debt $51,796 Billion Debt by Selected Major Borrowers: U.S. Government Securities $13,850 Billion (27%) (Includes Agency & GSE) %s are percent of Total U.S. Credit Market Debt, source is Federal Reserve Flow of Funds 10-3 U.S. Credit Market Instruments O/S 2008 Q3 By Selected Major Borrowers Corporate & Foreign Bonds $11,262 Billion (22%) Municipal Bonds $2,669 Billion (5%) Mortgages $14,720 Billion (28%) 10-4 Bond Characteristics Bond: A security that obligates the issuer to make specified payments to the holder over a period of time. - Face or par value - Coupon rate: Determine interest payment Zero coupon bond: Issued at prices considerably below par value. - Maturity 10-5 Treasury Notes and Bonds T Note maturities range up to 10 years T bond maturities range from 10 to 30 years Make semiannual coupon payment. Bid and ask price - Quoted in dollars and 32nds as a percent of par EX) 100:10 = 10010/32 = 100.313% of par value = $1,003.13 - Typical par = $1,000 Yield to Maturity : Interpreted as a measure of the average rate of return to an investor. 10-6 Figure 10.1 Prices and Yields of U.S. Treasuries 10-7 Corporate Bonds & Debt Most bonds are traded over the counter Par = $1,000 As a general rule, safer bonds with the higher ratings promise lower yields to maturity. 10-8 Corporate Bonds & Debt Call provisions - Allow the issuer to repurchase the band at a specified call price before maturity date. - Callable bonds typically come with a period of call protection, deferred callable bonds . Convertible bonds - Give bondholders an option to exchange each bond for a specified number of shares of common stock of the firm. - Conversion ratio – the number of shares for which each bond may be exchanged. - Benefit from price appreciation of the company’s stock. 10-9 Corporate Bonds & Debt Puttable bonds - Allows the bondholder to extend or retire the bond at the put date. EX) If coupon rate > current market yield, extend the bond’s life. If coupon rate < current market yield, not extend the bond and instead reclaims principal, which can be invested at current yields. Floating-rate bonds - Make interest payments that are tied to some measure of current market rates. EX) T-bill rate + 2% - While the bond adjusts to changes in the general level of market interest rates, it does not adjust to changes in the financial condition of the firm. 10-10 [...]... maturity 10- 23 10. 4 BOND PRICES OVER TIME 10- 24 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 Can you explain why these price change will occur? 10- 25 Figure 10. 6 Premium and Discount Bonds over Time 10- 26 10. 5 DEFAULT RISK AND. .. well as price increase or decrease over the bond life YTM is the standard measure of the total rate of return 10- 19 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 10- 20 Promised Yield to Maturity (YTM) YTM... $311.80 = $885.30 35.2% 10- 17 Bond Pricing  At a higher interest rate, the PV of the payments to be receive d by the bondholder is lower Therefore, the bond price will f all as market interest rates rise  the main source of risk in t he bond market 10- 18 10. 3 BOND YIELDS The current yield of a bond measures only the cash income provided b y the bond as a percentage of bond price and ignores any capital... = $1 X (1.03)2 -1 = 0.0609 = 6.09% 10- 21 Figure 10. 3 The Inverse Relationship Between B ond Prices and Yields Click to edit Master text styles Second level Third level Fourth level Fifth level 10- 22 Current Yield Annual dollar coupon divided by the price Premium bonds (bonds selling above par value) - Coupon rate > Current yield > Yield to maturity Discount bonds (bonds selling below par value) - Coupon... par value of the bond increases with the Consumer Price Index  A risk-free real rate 10- 14 10. 2 BOND PRICING 10- 15 BOND PRICING   The price depends on the value of dollars to be received in the future compared to • dollars in hand today  Present Value • Bond Value = Present value of coupons + Present value of par value • If we call the maturity date T and call the discount rate r, the bond value can... The first term is the PV of an annuity and the second term is PV of the final payment of the bond s par value • Price = Coupon + Par Value = Coupon Annuity factor(r,T ) + Par value PV factor(r,T ) 10- 16 Bond Pricing EX) Bond Price for a corporate bond: C = Coupon = 10% , Interest rate = YTM = r = 12%, Maturity = N or T = 10 years, P = price, Par = $1,000 What is the bond s price using semiannual compounding?... Bonds over Time 10- 26 10. 5 DEFAULT RISK AND BOND PRICING 10- 27 Default Risk and Ratings Main Ratings Companies Moody’s Investor Service Standard & Poor’s Fitch Main Rating Categories Investment grade Speculative grade (junk bonds) 10- 28 Figure 10. 8 Definitions of Bond Rating Classes Click to edit Master text styles Second level Third level Fourth level Fifth level 10- 29 Factors Used by Rating Companies... performance of asset Pay-in-kind bonds - Bond issuer may choose to pay interest by giving the investor a bond rather than cash 10- 13 Innovations in the Bond Market Catastrophe bonds - In the event of a specified ‘disaster’, the bond issuer’s required payments are reduced or eliminated : Receive compensation in the form of higher coupon rates for taking on the risk Indexed bonds - Payments are tied to a... - A specific asset pledged against possible default on a bond - Bondholders receive collateral if the firm defaults 10- 34 Figure 10. 9 Callable Bond Issued by Mobil Click to edit Master text styles Second level Third level Fourth level Fifth level 10- 35 Yield to Maturity and Default Risk To compensate for the possibility of default, corporate bonds must offer a defa ult premium The default premium is... equity (=net income / equity) - Indicators of a firm’s overall performance Cash flow to debt - Total cash flow to outstanding debt 10- 31 Financial Ratios and Default Risk 10- 32 Bond Indentures: Protection against Defaults : Specify a set of restrictions that protect the rights of the bondholders Sinking funds - To help ensure that the commitment does not create a cash flow crisis, the fi rm may agree . over the bond life. YTM is the standard measure of the total rate of return. 10- 19 Bond Prices and Yields Prices and Yields (required rates of return) have an inverse relationship. When yields. an investor. 10- 6 Figure 10. 1 Prices and Yields of U.S. Treasuries 10- 7 Corporate Bonds & Debt Most bonds are traded over the counter Par = $1,000 As a general rule, safer bonds with the. Chapter 10 Bond Prices and Yields 10. 1 Bond Characteristics 10- 2 U.S. Credit Market Instruments O/S 2008 Q3 U.S. Equity Market