Transcript Chap 1 Background and Trend - University of Rhode Island

Bond Price, Yields, and Returns
 Different Bond Types
 Bond Price
 Bond Yield
 Bond Returns
 Bond Risk Structure
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Bond Characteristics
 Face or par value
 Coupon rate
 Zero coupon bond
 Compounding and payments
 Accrued Interest
 Indenture
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Accrued Interest
annual_ dollar_ coupon
Days _ in _ AI _ period
AI 

2
Days _ in _ coupon_ period
Example on page 447
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Different Issuers of Bonds
 U.S. Treasury

Notes and Bonds
 Corporations
 Municipalities
 International Governments and Corporations
 Innovative Bonds



Floaters and Inverse Floaters
Asset-Backed
Catastrophe
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Figure 14.2 Corporate Bond
Listings
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Provisions of Bonds
 Secured or unsecured
 Call provision
 Convertible provision
 Put provision (putable bonds)
 Floating rate bonds
 Sinking funds
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Principal and Interest Payments for TIPS
The above is index bond.
See pages 451-452.
Compute real returns in year 1, 2, 3
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Bond Pricing
Ct

t
t 1 (1 r )
T
PB


ParValueT
T
(1 r )
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
Accrued interest: page 459
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Price: 10-yr, 8% Coupon, Face = $1,000
20
1
t 1
1.03
P  40
t

1000
(1.03)
20
P  $1,148.77
Ct
P
T
r
= 40 (SA)
= 1000
= 20 periods
= 3% (SA)
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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.
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Inverse Relation Between Prices and Yields
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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
ParValue
T
C
t
PB  

T
t
(1 r )
t 1 (1 r )
T
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Yield Measures
Bond Equivalent Yield
7.72% = 3.86% x 2
Effective Annual Yield
(1.0386)2 - 1 = 7.88%
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Current Yield
Annual Interest / Market Price
$70 / $950 = 7.37 %
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Yield to Call
 For callable bonds
 See example on page 454
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Holding Period Return versus YTM
 Reinvestment Assumptions
 Holding Period Return



Changes in rates affects returns
Reinvestment of coupon payments
Change in price of the bond
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Figure 14.6 Prices over Time of 30-Year
Maturity, 6.5% Coupon Bonds
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Holding-Period Return: Single
Period
HPR = [ I + ( P0 - P1 )]
/ P0
where
I = interest payment
P1 = price in one period
P0 = purchase price
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Example (Single period analysis)
CR = 8%
YTM = 10%
N=10 years
Semiannual Compounding
What is HPR when the rate falls to 7% in six
months?
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Horizon Analysis (multiple period)
 Example 14.6 – page 456
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Mortgage Example
 Say you are interested in buying a 2-bedroom condo in
Boston. The price is $300,000. You have a 30-year 3.5%
APR mortgage with 20% down payment.
(1) What would be the monthly mortgage payment?
(2) What if you have 15-year mortgage with the same APR?
(3) Suppose you could rent the place out and the rent you
collect will cover your mortgage payment. What would
be the annual return of your investment if the condo
value stays constant.

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Zero-coupon Bonds and Treasury
Strips
 Zero coupon bonds – page 459



Short term treasuries
Long term zero coupons
Treasury may strip payments from treasury coupon
bonds -- STRIPS
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The Price of a 30-Year Zero-Coupon Bond over
Time at a Yield to Maturity of 10%
After-tax return – see page 478.
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Default Risk and Ratings
 Rating companies (P 461)
 Moody’s Investor Service
 Standard & Poor’s
 Fitch
 Rating Categories
 Investment grade
 Speculative grade
 Page 462
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Factors Used by Rating Companies
 Coverage ratios
 Leverage ratios
 Liquidity ratios
 Profitability ratios
 Cash flow to debt
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Protection Against Default
 Sinking funds
 Subordination of future debt
 Dividend restrictions
 Collateral
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Yields on Long-Term Bonds, 1954 – 2006
Understand default premium – page 473-474
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Credit Default Swaps
 A credit default swap (CDS) acts like an insurance
policy on the default risk of a corporate bond or loan.
 CDS buyer pays annual premiums.
 CDS issuer agrees to buy the bond in a default or pay
the difference between par and market values to the
CDS buyer.
Chapter 1: Overview
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Credit Default Swaps
 Institutional bondholders, e.g. banks, used CDS to
enhance creditworthiness of their loan portfolios, to
manufacture AAA debt.
 CDS can also be used to speculate that bond prices
will fall.
 This means there can be more CDS outstanding than
there are bonds to insure!
Chapter 1: Overview
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Figure 14.12 Prices of Credit Default
Swaps
Chapter 1: Overview
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Credit Risk and Collateralized Debt
Obligations (CDOs)
 Major mechanism to reallocate credit risk in
the fixed-income markets
 Structured Investment Vehicle (SIV) often
used to create the CDO
 Loans are pooled together and split into
tranches with different levels of default
risk.
 Mortgage-backed CDOs were an
investment disaster in 2007
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Figure 14.13 Collateralized Debt
Obligations
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