CHAPTER 6: Valuing Bonds 6.

1 Bonds and the Bond Market Governments and corporations borrow money for the long term by issuing securities called bonds. Bond is a security that obligates the issuer to make specified payments to the bondholder. The money governments or companies collect when bonds are issued is the amount of the debt. As borrowers they promise to make a series of interest payments and then to repay the debt at the maturity date. The interest payment paid to the bondholders is called the coupon The payment at the maturity of the bond is called the face value, principal or par value The date on which the loan will be paid off is the maturity date Coupon rate: annual interest payment as a percentage of face value or the annual interest payment divided by the face value of the bond Bonds are traded by a network of bond dealers, who quote bid and ask prices at which they are prepared to buy and sell. Electronic bond trading platforms increase the competitiveness reported in news papers and their websites are the prices at which bonds are traded among the dealers and institutional investors Dealers hold inventories of bonds and are typically part of financial institutions such as banks and brokerage houses. The interest rate or discount rate is the rate at which the cash flows from the bond are discounted to determine its present value The coupon rate and the discount rate are NOT necessarily the same! When they are not, the price of the bond is not the same as its face value. The settlement date for bond is typically three days after the bond deal is executed. This extra payment is called accrued interest Accrued interest: coupon interest earned from the last coupon payment to the purchase date of the bond o Accrued interest = coupon payment x (# of days from last coupon to settlement date/ # of days in coupon period) Bond prices are typically quoted without accrued interest and are known as clean prices. When the accrued interest is included the price is referred to as the dirty price.

6.2 Interest Rates and Bond Prices The price of a bond is the present value of all its future cash flows, that is, it is the PV of the coupon payments and the face value of the bond. In calculating the PV the appropriate opportunity cost has to be used when the coupon rate is EQUAL to the required return, the bond sells at face value (at par) when the coupon rate is HIGHER than the required return, the bond sells above face value (at a premium)

when the coupon rate is LOWER than the required return, the bond sells below face value (at a discount) PV (bond) = PV (coupons) + PV (face value) o = PV [1/r 1/r(1+r)^t] + PV (1/1+r^t)

INTEREST RATES AND BOND PRICES Key bond practicing rule: when the market interest rate exceeds the coupon rate, bonds sell for less than face value. When the market interest rate is below the coupon rate, bonds sell for more than face value. When the market rate of interest equals the coupon rate, the bond sells at face value. When market interest rate rises, the present value of the payments to be received by the bondholder falls, and bond prices fall. Conversely, declines in the interest rate increase the present value of those payments and result in higher bond prices People sometimes confuse the interest (coupon) payment on the bond with the interest rate! Semi annual payments o Semi annual coupon payments implies that the annual coupon payment is paid in two equal installments, every six months o Thus the time line must in six month periods and you need to compute the six month required return

6.3 Current Yield and Yield to Maturity Current yield: annual coupon payment divided by bond price o Coupon payment/bond price

Because it focuses only on current income and ignores prospective price increases or decreases, the current yield does not measure the bonds total rate of return. It overstates the return of premium bonds and understates the return of discount bonds Yield to maturity: interest rate for which the present value of the bonds payments equals the price

o o

o Premium bond: bond that sells for more than its face value o Investors who buy a bond at premium face a capital loss over the life of the bond, so the return on these bonds is always less than the bonds current yield Discount bond: bond that sells for less than its face value

Investors in discount bonds face a capital gain over the life of the bond; the return on these bonds is greater than the current yield.

6.4 Bond Rates of Return Rate of return: total income per period per dollar invested o When interest rates do not change, the bond price changes with time so that the total return on the bond is equal to the yield to maturity. If the bonds yield to maturity increases, the rate of return during the period will be less than that yield. If the yield decreases, the rate of return will be greater than the yield. Taxes and rates of return o Taxed reduce the rate of return on an investment

6.5 The Yield Curve Yield curve or term structure of interest rates: graph of the relationship between time to maturity, for bonds that differ only in their maturity dates Real Return bond(RRB): the bonds with variable nominal coupon payments, determined by a fixed real coupon payment and the inflation rate. Depends on the inflation share Fisher effect: the nominal interest rate is determined by the real interest rate and expected rate of inflation o 1+nominal interest rate= (1+real interest rate)x(1+expected inflation rate) Expectations theory: an explanatory theory that shows why there are different shapes of the yield Yield curve is upward sloping , major factor determining the shape of the yield curve is expected future interest rates (1+ real interest rate) = 1 + nominal interest rate/ 1 + inflation

THE YIELD CURVE AND INTEREST RATE RISK Interest rate risk is the risk in bond prices due to fluctuations in interest rates Different bonds are affected differently by interest rate change Longer term bonds get hit harder than the shorter term bonds. Lower coupon bonds get hit harder than bonds with higher coupons Liquidity theory: the yield curve will tend to upward-sloping, because of the liquidity premium needed to induce investors to buy the riskier longer bonds Expectations and liquidity theories: predict that the yield curve will tend to be upward sloping because of both increases in future inflation and the liquidity premium.

6.6 Corporate Bonds & the risk of default

Canadian governments and corporations borrow money in Canada and also in the US/other countries by issuing bonds o Corporate borrowers can run out of cash and default on their borrowings o The government of Canada cannot default or go bankrupt it just prints more money to cover its debts or raise taxes o Sovereign debt: when a gov borrows in foreign currency o A firm will never pay more than the promised cash flows but in hard times might pay less Default risk (or Credit Risk): the risk that a bond issuer may default on its bonds o compensate for it by promising a higher coupon interest than the Canadian gov when borrowing money default premium: or credit spread is the difference between the promised yield on a corporate bond and the yield on a Canada bond with the same coupon and maturity the safety of a corporate bond can be judged from its bond rating bonds rated BBB and above are called investment grade bonds by moodys or standards and poors or DBRS bonds rated BB and below are called speculative grade, high yield or junk bonds bonds with greater credit risk promise higher yields to maturity

VARIATIONS IN CORPORATE BONDS zero coupon bonds: the bond has a coupon rate of zero. Bonds are issued at prices considerably below face value and the investors return comes from the diff between the purchase price and the payment of face value at maturity Strip bonds: to meet the demand for single payment bonds, investment dealers split some conventional bonds into a series of mini bonds, each of which makes a single maturity payment. Floating rate bonds: the coupon rate can change over time. The bonds coupon rate always approximates current market interest rates Convertible bonds: you can choose later to exchange it for a specified number of shares of common stock. Because they offer the opportunity to participate in any price appreciation of the companys stock, investors will accept lower interest rates on convertible bonds Callable bonds: company has the option to buy them back early for the call price. Canada call or the doomsday call: the call price is not set in advance but is determined at the time of the call.

Appendix 6A A more detailed look at the yield curve Spot rates Forward rates The expectations theory The liquidity preference theory

Summary of chapter 6

Coupon rate is the bonds coupon divided by its face value Current yield is the bonds coupon divided by its current price Yield to maturity measures the average return to an investor who purchases the bond and holds it until maturity Bond prices and yield to maturity vary inversely Bond prices fluctuate in response to changes in interest rates. This risk of price change is called interest rate risk o Long term bonds have greater interest rate risk than short term bonds Investors use bond ratings to determine the risk of default on a bond The additional return that investors demand for bearing credit risk is called the default premium There are many variations in bond