Bonds, Bond Prices and the Determination of Interest Rates

1
Chapter 6

• Bonds, Bond Prices and the Determination of
  Interest Rates

2
Debt instruments in Capital Markets

• Capital Markets Trade financial instruments of
  maturity greater than 1 year
• Bonds Long-term debt obligations issued by
  corporations and government units
• Borrowers return the face value of the debt after
  a specified period (eg 10 yrs)
• Borrower also pay interest in the form of interim
  coupon payments (eg annual, semi-annual,
  quarterly)
• In the event of borrower default, the lender may
  have claim to the assets of the bond issuer.
• Bond Markets Secondary markets that allow
  investors to trade bonds prior to maturity, and
  include three major classifications of bond types
• Treasury notes and bonds (federal government)
  25 of market
• Municipal bonds (local government) 17 of
  market
• Corporate bonds 58 of market

3
Investing in Bonds
Note how much larger the market for new debt
is Even in the late 1990s, which were boom years
for new equity issuances New debt issuances still
outpaced equity by over 51.
4
Types of Bonds

• 1. Zero-coupon or discount bond
• Promise a single payment on a future date
• Treasury bill
• 2. Fixed-payment loan
• Sequence of fixed payments
• Mortgage or car loan
• 3. Coupon bond
• periodic interest payments principal repayment
  at maturity
• U.S. Treasury Bonds and most corporate bonds
• 4. Consol
• periodic interest payments forever, principal
  never repaid
• U.K. government has some outstanding

5
Bond PricesCoupon Bonds

• Price of Coupon Bond
• PV(Coupon payments) PV(Face value)
• Pzero PV(Face value)
• Price of Consol
• PV( infinite of Coupon payments)

6
Bond YieldsHolding Period Returns

• The holding period return is the return to
  holding a bond and selling it before maturity.
• Current Yield Capital Gain ()

7
Bond YieldsHolding Period Returns

• Examples
• 10 year bond
• 6 coupon rate
• Purchase at face value, 100
• Hold for one year and then sell it

8
Bond YieldsHolding Period Returns

• What if the selling price is 107.11
• 1yr Holding Period Return
• What is the interest rate at year one?

9
Bond YieldsHolding Period Returns

• What if the selling price is 5,
• 1yr Holding Period Return

10
Exercise Understanding returns!

• Question One year ago a 10-year zero coupon bond
  had a yield of 4.90. Today, that same security
  has a yield of 4.70. If someone had bought that
  10-year zero coupon instrument one year ago and
  sold it today, what would their holding period
  return have been for the year?

11
Exercise Understanding returns!

• Question You buy a 5 coupon bond that sells for
  1000. One year later you sell the bond.
  Assuming interest rates are now 6.25, what is
  your capital gain and total return?

12
The Bond Market
1. When P 900, i 5.3, Bs gt Bd (excess
supply) P ? to P, i ?to i 2. When P 700, i
33.0, Bd gt Bs (excess demand) P ? to P, i ?
to i Market Equilibrium 1. Occurs when Bd Bs,
at P 800, i 17.6
13
The Supply Of Bonds

• Profitability of Investment Opportunities
• Business cycle expansion, investment
  opportunities ?, Bs ?, Bs shifts out to right
• Expected Inflation
• ?e ?, Bs ?, Bs shifts out to right
• Government Activities
• Deficits ?, Bs ?, Bs shifts out to right

BS1
BS2
14
Summary of Shifts in the Supply of Bonds

• Expected Profitability of Investment
  Opportunities
• In a business cycle expansion, the supply of
  bonds increases
• Conversely, in a recession, when there are far
  fewer expected profitable investment
  opportunities, the supply of bonds falls
• Expected Inflation
• An increase in expected inflation causes the
  supply of bonds to increase
• Government Activities
• Higher government deficits increase the supply of
  bonds
• Conversely, government surpluses decrease the
  supply of bonds

15
Shifts in the Bond Demand Curve
Bd2
Bd1
16
Bond Market Shifting the Demand Curve

• These all shift demand to the right
• Increases/Decreases in wealth shift
• Increases/Decreases in expected inflation
• Fall/Rise in expected future interest rates
• Fall/Rise in expected return on bonds relative to
  alternatives.
• Fall/Rise in riskiness of bonds relative to
  alternatives
• Increases/Decreases in bond liquidity relative to
  alternatives
• Each of these raises bond prices,
• lowering interest rates.

17
Bond Risks

• Default Risk Issuer may not make promised
  payments
• Inflation Risk
• Inflation could turn out to be greater than
  expected.
• Interest-Rate Risk Interest rate may rise
  between the time of purchase and the time you
  sell the bond.
• Reinvestment risk
• Risk that a decline in interest rates will lead
  to a decline in the income from a bond portfolio

18
Interest Rate Risk
kd
1-year
Change
10-year
Change
5
10
1,000
1,000
15

• Why do bonds with longer maturities have more
  interest rate risk?

19
Value
10-year
1,500
.
.
1-year
.
.
.
1,000
.
500
kd
0
0
5
10
15
20
Maturity and the Volatility of Bond Returns
(cont.)

• Prices and returns more volatile for long-term
  bonds because have higher interest-rate risk
• No interest-rate risk for any bond whose maturity
  equals holding period

21
Reinvestment risk

• Example You won 500,000. Youll invest the
  money and live off the interest. You buy a
  1-year bond with a YTM of 10.
• What is your Year 1 income?
• At year-end how much do you reinvest?
• If rates fall to 7, what happens to you income?
• Had you bought 30-year bonds, income would have
  remained constant.
• You gain/loss from i ?, gain/lose when i ?

22
Government Bonds

• Types of Government Securities
• T-Bill Maturity lt 1 year, no coupon payment
• T-notes Maturity 2-10 yrs, semi-annual coupon
• T-bonds Maturity gt 10 years, semi-annual coupon
• TIPS (Treasury Inflation Protection Securities)
• Created in 1997 so that the government could
  survey the market for expected inflation.

23
Treasury Inflation Protected Securities (TIPS)

• Inflation creates risk that nominal return will
  be less than you expected.
• If i6 and ?6 ? r 0
• TIPS Treasury Inflation Protection Securities
• Pay a real interest rate
• Plus change in the CPI

24
Corporate Bonds

• Typically have a face value of 1,000,
• Some have a face value of 5,000 or 10,000
• Pay interest semi-annually
• Corporate bonds are taxable
• Cannot be redeemed anytime the issuer wishes,
  unless a specific clause states this (call
  option).
• Degree of risk varies with each bond, even from
  the same issue.
• Due to having lower claims on the assets of the
  firm or the collateral put up against the bond

25
Corporate Bonds Characteristics of Corporate
Bonds

• Restrictive Covenants
• Mitigates conflicts with shareholder interests
• May limit dividends, new debt, ratios
• Call Provisions
• Issuer has the right (not the obligation) to
  retire the bonds
• Higher yield
• Sinking fund
• Alternative opportunities
• Convertible Bonds
• Bondholder can convert the issue to issuer equity
• Bondholders pay for this feature convertible
  bonds are sold at a lower yield
• Similar to a stock option, but usually more
  limited