Chapter 5 – Bonds and Bond Pricing

1. Chapter 5 – Bonds and Bond Pricing • Learning Objectives • Apply the TVM Equations in bond pricing • Understand the difference between annual bonds and semi-annual bonds • Differentiate between different types of bonds • Calculate yields on bonds Bond Features • Understand basic features of bonds • Delineate Bond Ratings

2. Real vs. Financial Assets • Real Assets have physical characteristics that determine the value of the asset • Size, Shape, Material, Color, etc. • Price based on the benefits of the physical characteristics • Financial Assets physical characteristics are inconsequential • Value based on claim to promised or anticipated cash flows • TVM concepts used to price financial assets

3. Application of TVM – Bond Pricing • Bond instrument is a long-term debt instrument (long-term liability) of a company • Bond issuer promises a specific set of cash payments in the future • Coupon (interest) payments • Principal repayment • Timing and amount of future cash payments stated on the bond…see Figure 5.2 for time line of cash flow promises

4. Application of TVM – Bond Pricing • Timeline for promised cash flows • Example, Patel Corporation Bond • $1,000 par value (principal) • 8% annual coupon payments (interest) • Twenty year bond • Principal $1,000 due 12/31/23 is lump sum • Coupons of $80 annually are annuity • What is the current value (present value) of these promised future cash payments?

5. Application of TVM – Bond Pricing • Steps to price a bond • Determine annuity stream • Coupon Rate times Par Value • 8% x $1,000 = $80 • Find PV of annuity stream • Find PV of principal repayment • Add PVs together for bond price • Patel Corporation Bond • PV of coupons is $917.59 • PV of principal is $311.80 • Price of Patel Corporation bond is $1,229.39

6. Application of TVM – Bond Pricing

7. Key Components of a Bond • Par Value or Face Value or Principal • Coupon Rate (annual interest rate percent) • Coupon (regular interest payment) • Maturity Date or Expiration Date (bond is totally repaid) • Yield or Yield to Maturity or Discount Rate

8. Semi-Annual Bonds • Corporations and governments elect how often they will make coupon payments • Most common choice is every six months • Consistent with interest rates from chapter 4 • Coupon rate is stated annually • Coupon payment = (Coupon Rate x Par Value) / 2 • Discount rate for TVM is the yield to maturity / 2 • Number of periods (n) is years x 2 • Timeline of promised cash flows, Figure 5.5 page 117

9. Semi-Annual Bond

10. Three Methods to Bond Pricing • Equations or Formula • Solve the two pieces separately and add them up (coupons and principal present values) • TVM Keys on a Calculator • Note with TI BAII Plus…use of P/Y variable • Compute price directly • Spreadsheet • Function is PV and variables require time preference • Compute price directly

11. Types of Bonds • By Issuer • Corporate Bonds – Companies • Treasury Bonds – U.S. Government • Municipal Bonds – State and Local Governments • By Features – Table 5.1, page 120 • Standard, Semi-Annual, Floating Rate (coupon rate changes), Zero, Consol, • Callable, Putable, Convertible

12. Pricing a Zero-Coupon Bond • Special Pricing Feature of Zero-Coupon Bond • No coupon payments • Priced as Semi-Annual Bond for Principal repayment • Also know as deep discount bond • Price of bond is the initial principal • Difference between price and final payment is interest on bond • Interest is implied each year as bond price changes using the original yield to maturity • Amortization schedule (Table 5.2) shows implied interest payments each six months

13. Finding Yield to Maturity • Yield to maturity – return on the bond if held to maturity • Discount rate for pricing the bond • If price and cash flows are known you can find YTM • Iterative Process – can not isolate r in TVM formula • Calculator or Spreadsheet fast and accurate • Relationship of Coupon Rate and YTM (see Table 5.3)

14. Bond Features • Variables • Price, Principal, YTM, Coupon Rate, Maturity Date, Frequency of Coupon Payments • Need all but one variable to determine missing variable • Indenture or Deed of Trust (Bond Contract) • Collateral or Security of Bond • Real Property is Collateral – Mortgage Bond • No Collateral - Debenture

15. Bond Features • Senior Debt versus Junior Debt • Older Issue is Senior • Junior Debt paid off after Senior Debt • Protective Covenants • Prohibits actions of bond issuer • Designed to protect bondholder • Added Features to Bond (Options) • Call, Put, Conversion • Provides issuer or holder future choices

16. Bond Ratings • Agencies Rate Bonds • Ratings based on potential default • Best rating AAA • Categories based on ratings (Table 5.4) • Investment Grade (AAA to BBB- or Baa3) • Speculative Grade (BB+ or Ba1 to B- or B3) • Also known as Junk Bonds • Extremely Speculative (C rating group) • Default (D rating by Standard and Poor’s)

17. Quoting Conventions and Markets • Bonds usually trade in a dealer market • Dealers state buying and selling prices • Dealers usually in money center banks • Some bonds listed on NYSE • Bonds listed by issuing company • Bond’s coupon rate and maturity date part of the bond name • Current yield • Volume, Closing Price, and Net Change

18. Homework • Problem 1 – Pricing with Annual Coupons • Problem 2 – Pricing with Semi-Annual Coupons • Problem 6 – Yield on Semi-Annual Bonds • Problem 10 – Coupon Rates • Problem 12– Pricing Semi-Annual Bond • Problem 14 – Zero Coupon Bond

19. Appendix – Government Bonds • Names of federal government bonds based on maturity dates at issue: • U.S. Treasury Bill, maturity less than one year • U.S. Treasury Note, maturity between two and ten years • U.S. Treasury Bonds, maturity over ten years • Pricing for Notes and Bonds… • Semi-annual coupon bonds • Another application of TVM equations

20. U.S. Treasury Bills • Treasury Bills are short term pure discount bills (pay no interest) • Pricing formula discounts but ignores compounding and conventional return calculation methods • Formula: