1. Definition of a Bond • A bond is a security that obligates the issuer to make specified interest and principal payments to the holder on specified dates. • Coupon rate • Face value (or par) • Maturity (or term) • Bonds are sometimes called fixedincome securities.

2. Types of Bonds • Pure Discount or Zero-Coupon Bonds • Pay no coupons prior to maturity. • Pay the bond’s face value at maturity. • Coupon Bonds • Pay a stated coupon at periodic intervals prior to maturity. • Pay the bond’s face value at maturity. • Perpetual Bonds (Consols) • No maturity date. • Pay a stated coupon at periodic intervals.

3. Bond Issuers • Government • Financial Institutions • Countries • Corporations

4. Government Bonds • Treasury Bills (Gilts) • No coupons (zero coupon security) • Face value paid at maturity • Maturities up to one year • Treasury Notes • Coupons paid semiannually • Face value paid at maturity • Maturities from 2-10 years

5. Government Bonds • Treasury Bonds • Coupons paid semiannually • Face value paid at maturity • Maturities over 10 years • The 30-year bond is called the long bond.

6. Government Bonds • No default risk. Considered to be riskfree. • Exempt from state and local taxes. • Sold regularly through a network of primary dealers. • Traded regularly in the over-the-counter market.

7. Corporate Bonds • Secured Bonds (Asset-Backed) • Secured by real property • Ownership of the property reverts to the bondholders upon default. • Debentures • General creditors • Have priority over stockholders, but are subordinate to secured debt.

8. Common Features of Corporate Bonds • Senior versus subordinated bonds • Convertible bonds • Callable bonds • Putable bonds • Sinking funds

9. Bond Ratings

10. 1000  £696 . 56 5 1 . 075 1000 591 . 11  7 1  r d Valuing Zero Coupon Bonds • What is the current market price of a U.S. Treasury strip that matures in exactly 5 years and has a face value of £1,000. The yield to maturity is rd=7.5%. • What is the yield to maturity on a U.S. Treasury strip that pays £1,000 in exactly 7 years and is currently selling for £591.11?

11. Bond Yields and PricesThe case of zero coupon bonds • Consider three zero-coupon bonds, all with • face value of F=100 • yield to maturity of r=10%, compounded annually. We obtain the following table:

12. The Impact of Price Responses • Suppose the yield would drop suddenly to 9%, or increase to 10%. How would prices respond? • Bond prices move up if the yield drops, decrease if yield rises • Prices respond more strongly for higher maturities

13. Bond Valuation:An Example What is the market price of a U.S. Treasury bond that has a coupon rate of 9%, a face value of £1,000 and matures exactly 10 years from today if the required yield to maturity is 10% compounded semiannually? 0 6 12 18 24 ... 120 Months 45 45 45 45 1045

14. Relationship Between Bond Prices and Yields • Bond prices are inversely related to interest rates (or yields). • A bond sells at par only if its coupon rate equals the coupon rate • A bond sells at a premium if its coupon is above the coupon rate. • A bond sells a a discount if its coupon is below the coupon rate.

15. Volatility of Coupon Bonds • Consider two bonds with 10% annual coupons with maturities of 5 years and 10 years. • The yield is 8% • What are the responses to a 1% price change? • The sensitivity of a coupon bond increases with the maturity?

16. Bond Prices and Yields Longer term bonds are more sensitive to changes in interest rates than shorter term bonds. Bond Price F c Yield