The document provides an overview of bond valuation and bond relationships. It defines what a bond is, including key features like par value, coupon interest rate, and maturity date. It then discusses how to value a bond by discounting both the annuity of coupon payments and lump sum maturity payment. The valuation depends on the yield to maturity (YTM), with the bond price being lower if YTM is higher. Bond prices are $1,000 if YTM equals the coupon rate. Higher inflation increases nominal interest rates through the Fisher effect. The term structure of interest rates shows the relationship between bond yields and maturity dates.
The document provides an overview of bond valuation and bond relationships. It defines what a bond is, including key features like par value, coupon interest rate, and maturity date. It then discusses how to value a bond by discounting both the annuity of coupon payments and lump sum maturity payment. The valuation depends on the yield to maturity (YTM), with the bond price being lower if YTM is higher. Bond prices are $1,000 if YTM equals the coupon rate. Higher inflation increases nominal interest rates through the Fisher effect. The term structure of interest rates shows the relationship between bond yields and maturity dates.
The document provides an overview of bond valuation and bond relationships. It defines what a bond is, including key features like par value, coupon interest rate, and maturity date. It then discusses how to value a bond by discounting both the annuity of coupon payments and lump sum maturity payment. The valuation depends on the yield to maturity (YTM), with the bond price being lower if YTM is higher. Bond prices are $1,000 if YTM equals the coupon rate. Higher inflation increases nominal interest rates through the Fisher effect. The term structure of interest rates shows the relationship between bond yields and maturity dates.
The document provides an overview of bond valuation and bond relationships. It defines what a bond is, including key features like par value, coupon interest rate, and maturity date. It then discusses how to value a bond by discounting both the annuity of coupon payments and lump sum maturity payment. The valuation depends on the yield to maturity (YTM), with the bond price being lower if YTM is higher. Bond prices are $1,000 if YTM equals the coupon rate. Higher inflation increases nominal interest rates through the Fisher effect. The term structure of interest rates shows the relationship between bond yields and maturity dates.
7-3 A bond is a contract between two parties: one is the investor (you) and the other is a company or a government agency (like a municipal 7-4 bond) You are the investor
The company (or government) is 7-5 borrowing the A bond contains three key items: 1. The par value (usually $1,000)
2. The length of time (often 10
or 20 years)
3. A coupon interest rate
7-6 You lend money to the borrower and you will get back your original investment plus interest.
The interest is determined
by the coupon interest rate.
7-7 For example: A 6% coupon interest rate yields:
(the coupon interest rate) x ( the par value)
(6%) x ($1,000) = $60 per year for each
year of the bond.
7-8 Let’s look at this visually using the time line:
0 1 2 3 4 5
$60 $60 $60 $60 $60
7-9 Let’s look at this visually using the time line:
Now let’s add the maturity
value… 1 2 3 4 5
$60 $60 $60 $60 $60
$1,000
7-10 So the investor receives the principal ($1,000) and earned interest ($60 per year) as payment for loaning the company money.
7-11 Types of Bonds 1. Government Bonds 2. Zero Coupon Bonds 3. Floating-Rate Bonds 4. Catastrophe (Cat) Bonds 5. Income Bonds 6. Convertible Bond 7. Put Bond 8. Sukuk 9. James Bond
7-12 Our task: To Value a Bond
7-13 And how will we accomplish this task?
7-14 B Bring A All E Expected F Future E Earnings I Into P Present V Value 7-15 T Terms Just remember:
BAEFEIPVT
7-16 From the previous chapters on the time value of money you know how to bring back a single payment (lump sum) and an annuity. To value a bond, just put both pieces together!
7-17 Let’s look at this visually using the time line: 1.The annuity 2.The single payment (lump sum) 0 1 2 3 4 5
$60 $60 $60 $60 $60
$1,000 7-18 Now bring each back into present value terms: First the annuity… Secondly, the lump sum…
0 1 2 3 4 5
$60 $60 $60 $60 $60
$1,000 7-19 The Bond Pricing Equation
1 1 - (1 r) t FV Bond Value C (1 r) t r Notice that r = the discount rate used to bring back the future dollars. This discount rate has a name in bonds: The Yield to Maturity (YTM). 7-20 Your finance calculator can compute both parts (the annuity and the lump sum) simultaneously
7-21 A bond valuation example:
• 5 year bond • 14% as the discount rate (YTM) • 6% coupon interest rate • $1,000 maturity value
7-22 TI BA II Plus
5 years = N
-725.35 14% = Discount rate (YTM)
$60 = Payment (PMT)
$1,000 = FV
1st PV = ? 2nd
7-23 Your finance calculator can compute both parts (the annuity and the lump sum) simultaneously
7-24 A bond valuation example:
• 5 year bond • 14% as the discount rate (YTM) • 6% coupon interest rate • $1,000 maturity value
7-25 5 years = N HP 12-C 14% = Discount rate (or YTM) $60 = Payment (PMT) PV = ? $1,000 = FV
-725.35
7-26 Using Excel to value a bond • There is a specific formula for finding bond prices on a spreadsheet – PRICE(Settlement,Maturity,Rate,Yld,Redemption, Frequency,Basis) – YIELD(Settlement,Maturity,Rate,Pr,Redemption, Frequency,Basis) – Settlement and maturity need to be actual dates – The redemption and Pr need to be input as % of par value • Click on the Excel icon for an example:
7-27 Student alert! Notice that we have two “interest numbers” in our bond problem: 1. The coupon interest rate (6% in our example) and 2. The discount rate (14% in our example) to bring future values back into the present value.
7-28 Student alert! Keep it simple:
Once you have computed the
annuity amount, you can throw away the “coupon interest rate”. You need the dollar amount of the annuity, not the coupon interest rate itself.
7-29 Bond Relationships Key concept:
If the coupon interest rate
exactly equals the discount rate, then the bond value today will ALWAYS = the par value ($1,000)
7-30 Bond Relationships Key concept:
In our example, if the discount rate was not
14% but instead 6% then the coupon interest rate would exactly equal the discount rate (6% = 6%) and the value of the bond today would be…. $1,000.00!
7-31 Bond Key concept: Relationships If the YTM is greater (>)than the coupon interest rate, then the value of the bond will be less than < $1,000.
Conversely, if the YTM is < the coupon interest
rate, then the value of the bond will be > $1,000. 7-32 Bond Relationships (using the previous numerical example)
Discount Coupon Present
Rate Interest Value of (YTM) Rate the Bond
6% 6% $1,000 4% 6% >$1,000
9% 6% <$1,000 7-33 Bond Remember:Relationships If the discount rate If the discount rate goes goes DOWN, UP, the present value of the present value of the the bond goes UP. bond goes DOWN.
7-34 Price and Yield-to-maturity (YTM) Bond Price
Yield-to-maturity (YTM)
7-35 Bond Relationships Key concept:
Are there any relationships regarding time (the
length of a bond’s life) and the value of a bond?
7-36 Bond Valuation
7-37 7-38 Chapter Outline
• Bond Definition • Bond Features • Valuation of a Bond • Bond Relationships • Inflation and Interest Rates • Determinants of Bond Yields • Bond Ratings • Bond Markets 7-39 The Fisher Effect The Fisher Effect defines the relationship between real rates, nominal rates, and inflation (1 + R) = (1 + r)(1 + h), where R = nominal rate r = real rate h = expected inflation rate Approximation R = r + h
7-40 Fisher Effect Example If we require a 10% real return and we expect inflation to be 8%, what is the nominal rate?
R = (1.1)(1.08) – 1 = .188 = 18.8%
An Approximation: R = 10% + 8% = 18%
Because the real return and expected inflation
are relatively high, there is significant difference between the actual Fisher Effect and the approximation.
7-41 Chapter Outline • Bond Definition • Bond Features • Valuation of a Bond • Bond Relationships • Inflation and Interest Rates • Determinants of Bond Yields • Bond Ratings • Bond Markets
7-42 Term Structure of Interest Rates The term structure is the relationship between time to maturity and yields, all else equal (It is important to recognize that we have pulled out the effect of default risk, different coupons, etc.)
7-43 Term Structure of Interest Rates Yield curve – graphical representation of the term structure Normal – upward-sloping; long-term yields are higher than short-term yields Inverted – downward-sloping; long- term yields are lower than short-term yields
7-44 Upward-Sloping Yield Curve
7-45 Downward-Sloping Yield Curve
7-46 Chapter Outline • Bond Definition • Bond Features • Valuation of a Bond • Bond Relationships • Inflation and Interest Rates • Determinants of Bond Yields • Bond Ratings • Bond Markets
7-47 Bond Ratings – Investment Quality
High Grade – Moody’s Aaa and S&P AAA – capacity to pay is extremely strong – Moody’s Aa and S&P AA – capacity to pay is very strong Medium Grade – Moody’s A and S&P A – capacity to pay is strong, but more susceptible to changes in circumstances – Moody’s Baa and S&P BBB – capacity to pay is adequate, adverse conditions will have more impact on the firm’s ability to 7-48 pay Bond Ratings - Speculative • Low Grade – Moody’s Ba and B – S&P BB and B – Considered possible that the capacity to pay will degenerate. • Very Low Grade – Moody’s C (and below) and S&P C (and below) • income bonds with no interest being paid, or • in default with principal and interest in arrears
7-49 Chapter Outline • Bond Definition • Bond Features • Valuation of a Bond • Bond Relationships • Inflation and Interest Rates • Determinants of Bond Yields • Bond Ratings • Bond Markets
7-50 Work the Web Example Bond quotes are available online One good site is http://www.bondsonline.com/ Click on the web surfer to go to the site Follow the bond search, corporate links Choose a company, enter it under Express Search Issue and see what you can find!
7-51 Terminology
• Bond • Par value (face value) • Coupon rate • Coupon payment • Maturity date • Yield or Yield to Maturity (YTM)
7-52 Formulas
1 1 - (1 r) t FV Bond Value C (1 r) t r Fisher Effect: (1 + R) = (1 + r)(1 + h) Fisher Effect (approximation): R = r + h 7-53 Key Concepts and Skills • Bond definition • Computation of bond’s value • Inverse relationship between YTM and bond value • Impact of inflation on bonds • Term structure of interest rates
7-54 What are the most important topics of this chapter?
1. A bond’s value is the present value of
all expected future earnings.
2. As the risk of a bond goes up, the
price or value goes down.
3. The closer the bond is to maturity,
the more likely the value will approach the par value.
