Finance Homework Assignment
AmazingExpert
chapter-12-bonds-1.pptxINVESTING IN STOCKS AND BONDS
Why Consider Bonds?
Bonds reduce risk through diversification.
Bonds produce steady income.
Bonds can be a safe investment if held to maturity.
Your Rights as a Bondholder
Bondholders are creditors
Bond indenture
Protective covenants
Payment Characteristics of Bonds
Face value: The amount the issuer pays to redeem the bond
It is usually $1,000 for corporate bonds.
Coupon interest payments:
Most bonds have a fixed rate of return, which are the interest payments that are made every 6 months.
The amount of the payment is determined by multiplying the bond’s coupon rate by the face value of $1,000.
Example: An 8% bond pays $80 in interest per year (0.08 × $1,000) divided into two payments of $40 semiannually.
Retirement Methods
Redeemed at maturity
Call provision
Sinking fund provision
Convertible bonds can be converted into common stock.
Corporate Bonds
Corporate bonds - allow firms to borrow money, are a major source of funding.
Denominations in $1000.
Secured bond – backed by collateral.
Unsecured bond – a debenture.
Hierarchy of bonds – subordinated debentures are low on the list.
Government-Issued Bonds
U.S. Treasury Securities
U.S. Agency Bonds
Conventional
Mortgage-backed
Municipal Bonds
General obligation (GO) bonds
Revenue bonds
Special Types of U.S. Treasury Bonds
U.S. Treasury Strips
Inflation-Indexed Bonds
Intended to lessen price risk of bonds
The coupon rate is not changed.
The redemption value is adjusted periodically to reflect inflation. Example: If annual inflation is 3%, the redemption value is increased to $1,030.
Munis’ Income Tax Advantage
Example:
Muni Yield = 5.91% and Tax rate = 28% (0.28)
FTEY = 5.91/(1.00 – 0.28)
= 5.91/0.72 = 8.21%
Compare to yields on taxable bonds and choose the bond with the highest yield.
Special Situation Bonds
Zero Coupon Bonds
Junk bonds
Bond Ratings – A Measure of Riskiness
Moody’s and Standard & Poor’s provide ratings on corporate and municipal bonds.
Ratings involve a judgment about a bond’s future risk potential.
Default risk – ability to repay principal.
Inability to meet interest obligations.
The lower the rating, the higher the rate of return demanded by investors.
Safest bonds receive AAA, D is extremely risky.
Expected Return from Bonds
Current yield (CY): annual interest divided by current price
Example:
Bond price (P) = $900
Annual coupon interest (I) = $120
The current yield calculation:
CY = I/P = $120/$900 = 0.1333 or 13.3%
The advantage of this calculation is that it is easy.
The disadvantage is that ignores maturity.
Yield to Maturity (YTM)
Yield to maturity is the return you would earn by buying a bond today and holding it until it is redeemed by the issuer.
Formula (approximation)
YTM = [ I + (1,000 – P)/N]/ [(P + 1,000)/2]
Example: I = 120, P = 900, N = 5
YTM = [120+(1,000 – 900)/5]/ [(900 + 1,000)/2]
= [120 + 20]/ [950]
= 140/950 = 0.1474 or 14.74%
YTM Example..contd.
N 5
PMT 120
FV 1000
PV -900
CPT I/Y = 14.74%
If bond purchased at a discount, YTM > coupon rate.
If bond purchased at a premium, YTM < coupon rate.
If bond is purchased at face value, YTM = coupon rate.
Yield to Maturity (YTM)
Bond Prices
Present Value of a Coupon Bond
A coupon bond’s present value (PV) has two components:
Present value of the coupon interest payments
Present value of the future redemption value (usually $1,000)
But these payments are all in the future
The future cash flows are discounted using the bond’s yield to maturity (not the coupon rate) to determine the present value of the bond.
Present Value of a Coupon Bond: An Example
Data: YTM = 15%; coupon rate = 12% ($120 a Year); Redemption Value = $1,000; 5 Years to Maturity
Find:
PV of $1000 at 15%, in 5 Years = $497.18
PV of $120 Annuity at 15%, 5 years = $402.26
Present Value (Price):
= $899.44
Present Value of a Zero Coupon Bond
There is only one cash inflow with a zero coupon bond – the future redemption value.
Example: Find the PV of a zero coupon bond that matures in 10 years with a YTM of 8%.
PV of the bond = $463.19.
N=10, I/Y=8, FV=1000, PMT=0
Reading Corporate Bond Quotes in the Wall Street Journal
Selling price is quoted as a percent of par.
Price listed at 101 -- 101% x $1000 = $1010.
Include accrued interest.
Treasury and agency securities trade in thirty-seconds (1/32).
Price listed as 102:31 = 102 31/32
If par value is $10,000 then price is $10,296.88.
Quotes list both bid and ask prices.
Bond Valuation
What causes the required rate of return to change?
If the issuer becomes riskier, the required rate of return should rise.
A change in general interest rates, increase in expected inflation, the required rate of return should increase.
When interest rates rise, the value of outstanding bonds falls.
Risk in bond investment
Default risk is the possibility that the issuer will not make the interest payments and/or redeem the bonds at maturity.
Interest rate risk is the price volatility of a bond in relationship to the changes in market rates of interest.
Why Bonds Fluctuate in Value
Inverse relationship between interest rates and bond values.
Longer-term bonds fluctuate in price more than shorter-term bonds.
Preferred Stock
Hybrid security: Preferred stock has some characteristics of both bonds and stocks
Form of equity ownership – similar to common stock
Pays a fixed return – similar to bonds
Stockholders’ rights
Are provided in the offering agreement
This agreement is similar to a bond indenture but is weaker.
Preferred stock usually does not vote.
Preferred Stock Features
$100 par value is common but other par values can also be used.
Cumulative dividend (frequently used)
Participating dividends (rarely used)
Convertibility (sometimes used): Preferred stock may be exchanged for common stock.
Expected Return from Preferred Stock
Similar to common stock, most preferred stock does not have a maturity
The expected return is simply the preferred stock’s current return (CR):
CR = Dividend/Stock Price
Example: If the dividend = $2 and the price = $8, then CR = $2/$8 = 0.1111 or 11.11%.
Value of preferred = Dividend/ current return
