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Learning Objectives
Overview
This chapter presents a discussion of the key characteristics of bonds, and
then uses time value of money concepts to determine bond values. Bonds
are one of the most important types of securities to investors and a major
source of financing for corporations and governments.
The value of any financial asset is the present value of the cash flows
expected from that asset. Therefore, once the cash flows have been
estimated and a discount rate determined, the value of the financial asset
can be calculated.
A bond is valued as the present value of the stream of interest payments (an
annuity) plus the present value of the par value that is received by the
investor on the bonds maturity date. Depending on the relationship
between the current interest rate and the bonds coupon rate, a bond can
sell at its par value, at a discount, or at a premium. The total rate of return
on a bond is comprised of two components: an interest yield and a capital
gains yield.
The bond valuation concepts developed earlier in the chapter are used to
illustrate price and reinvestment risk. In addition, default risk, various types
of corporate bonds, bond ratings, and bond markets are discussed.
Outline
1. Here N is the number of years until the company can call the
bond; call price is the price the company must pay in order to
call the bond (which is often set equal to the par value plus one
years interest); and rd is the YTC.
2. Whether a company calls its callable bonds depends on what the
going interest rate is when they become callable and whether
the benefit (interest savings) is greater than the cost of calling
the bonds.
D. Brokerage houses occasionally report a bonds current yield.
1. The current yield is defined as the annual interest payment
divided by the current price.
2. The current yield does not represent the actual return that
investors should expect because it does not account for the
capital gain or loss that will be realized if the bond is held until it
matures or is called.
V. When a coupon bond is issued, the coupon is generally set at a
level that causes the bonds market price to equal its par value.
A. A new issue is the term applied to a bond that has just been issued.
1. Once the bond has been on the market for a while, it is classified
as an outstanding bond, or a seasoned issue.
B. The total rate of return on a bond consists of a current yield plus a
capital gains yield.
1. A bonds current yield is calculated as the coupon interest
divided by the bonds price.
2. A bonds capital gains yield is calculated as the bonds annual
change in price divided by the beginning-of-year price.
3. In the absence of default risk and assuming market equilibrium,
the total return is also equal to YTM and the market interest
rate.
4. The market value of a bond will always approach its par value as
its maturity date approaches, provided the firm does not go
bankrupt.
VI. The bond valuation model must be adjusted when interest is
paid semiannually.
A. Divide the annual coupon interest payment by 2 to determine the
dollars of interest paid each six months; multiply the years to
maturity by 2 to determine the number of semiannual periods; and
divide the nominal interest rate by 2 to determine the periodic
interest rate.
B. The value with semiannual interest payments is larger than the
value when interest is paid annually.
1. This higher value occurs because interest payments are received
somewhat faster under semiannual compounding.
VII. Interest rates fluctuate over time, and an increase in interest
rates leads to a decline in the value of outstanding bonds.
A. People or firms who invest in bonds are exposed to risk from
changing interest rates, or price risk.
1. For bonds with similar coupons, the longer the maturity of the
bond, the greater the exposure to price risk.
2. Even if the risk of default on two bonds is exactly the same, the
bond with the longer maturity is typically exposed to more risk
from a rise in interest rates.
a. This follows because the longer the maturity, the longer
before the bond will be paid off and the bondholder can
replace it with another bond having a higher coupon.
B. The risk of a decline in income due to a drop in interest rates is
called reinvestment risk.
1. Reinvestment risk is high on callable bonds.
2. It is also high on short-term bonds, because the shorter the
bonds maturity, the fewer the years before the relatively high
old-coupon bonds will be replaced with new low-coupon bonds.
C. Price risk relates to the current market value of the bonds in a
portfolio, while reinvestment risk relates to the income the portfolio
produces. No fixed-rate bond can be considered totally riskless.
D. A bonds risk depends critically on how long the investor plans to
hold the bond, which is referred to as the investors investment
horizon.
1. Even a small change in interest rates can have a large effect on
the prices of long-term securities.
2. Investors with shorter investment horizons view long-term bonds
as risky investments.
3. Short-term bonds tend to be riskier than long-term bonds for
investors who have longer investment horizons.
E. To account for the effects related to both a bonds maturity and
coupon, many analysts focus on a measure called duration. Web
Appendix 7B discusses duration and its calculation in greater detail.
1. A bonds duration is the weighted average of the time it takes to
receive each of the bonds cash flows.
2. A zero coupon bond whose only cash flow is paid at maturity has
a duration equal to its maturity.
3. A bonds duration is calculated as follows:
N
t (CFt )
(1 r )
t 1
t
Duration d
VB