September 9, 2012 Chapter Seven: Interest Rates and Bond Valuation Chapter Outline: Bonds and Bond Valuation

n More on Bond Features Bond Ratings Some Different Types of Bonds Bond Markets Inflation and Interest Rates Determinants of Bond Yields Bond Definitions (vocab is very important to know) Bond: a loan from the bond holder to the bond issuer; standardized debt o Can be traded in secondary markets, like stocks o Borrower= Issuer o Bond holder= lender Par value (face value): the amount of the loan, paid to the bond holder at maturity o US Treasury Debt is often $10,000 par value, corporate bonds are often $1,000 par Coupon rate: Laplantes definition (may vary from the book) the fixed fraction of the face value paid out annually as interest only; it is set when the bond is issued and never changes o It is a percentage Coupon payment = coupon rate * face value = annual interest only payment o Bonds come in two flavors: American, and European style; the style has to do with how often interest is paid (European once a year, American twice a year) o If American style, PMT= [(coupon rate * face value)/ 2] o If European style, PMT= (coupon rate * face value) o Example: $1000 face value, 10% coupon rate, American style bond pays out $100 of interest in two $50 payments in the span of year o Because you can reinvest the first interest payment you are able to earn more with American style bonds, therefore they are worth more Maturity date: the date on which the bond issuer pays the last interest payment and the face value of the bond to the bond holder o Times to maturity on bonds currently being issued seem to be increasing, this is to take advantage of the low cost of borrowing now in the market o At maturity, the holder is paid the last interest payment (coupon) and the face value o These are not amortized loans like a car loan. Never get the principal paid off until the very end! Yield or Yield to maturity (YTM): the APR that sets the present value of the bonds

expected future cash flows equal to its current market price; interest rate o Essentially a discount rate o The price of the bond can change all the time because it is in the open markets o Yield and price vary inversely; as the price of a bond increases, its yield decreases and vice-versa. o YTM is an opportunity cost and changes. DO NOT CONFUSE COUPON RATE AND YIELD-TO-MATURITY! They are similar but NOT THE SAME!

September, 12 2012 Present Value of Cash Flows as Rates Change Bond Value = PV of coupons + PV of par The price that you are willing to pay should be the sum of these two PVs, which you expect to receive in the future Bond = PV annuity + PV of lump sum You get a finite series of equal payments with a bond = annuity, and you receive the face value back at the maturity date = lump sum as interest rates increase, PV decreases causing bond value to decrease; As interest rates decrease, PV increases causing the bond value to increase! As interest rates increase, bond prices decrease and vice versa. The Bond-Pricing Equation 1 1- (1+ r) t F + Bond Value = C t r (1+ r) Bond value = PV of annuity formula + PV of lump sum formula There are 5 variables here: Bond value, C, r, t, F (On TI, 5 keys on the 3rd row) o T = number of payments until maturity o R = periodic rate (YTM= APR= r *m) If Euro style r= YTM; If American style r= YTM/ 2 o C = coupon payment amount o F = par value of lump sum o Bond value = price (AKA PV) Rearranging the formula, you can make it look like the equation of a line: Y = MX + B 1500 However, if you were 1400 to graph the line of the 1300 bond value it would 1200 look like this: 1100 Relationship Between Price and Yield-to1000 maturity 900
800 700 600 0% 2% 4% 6% 8% 10% 12% 14%

If Dr. Laplante were to take the slope at any point it would always be negative. The first things you should consider are the axes. They tell you what relationship you are establishing. X-axis: rate (yield to maturity) Y-axis: price of bond Tells you that how the price of the bond changes if you change the YTM This is not a straight line (like in the graph above), it is a convex function as r increases, price decreases (this is called monotonically decreasing always decreasing) The curvature of the line is called the convexity of the line. If youre finance major, you care about the shape of the line and the rate of change. The bond market is huge. Trillions of dollars tied up in bonds. All bonds are down sloping with rates. People care about how bond values will change. The sensitivity of interest rate changes differs. Valuing a Bond Example 1 Suppose you are looking at a bond that has a 10% coupon rate, annual coupons (European style- keyword is annual), and a face value of $1000. There are 5 years to maturity and the YTM is 11%. What is the price of this bond? Value = PV of annuity + PV of lump sum Value = 100[1 1/ (1.11)5] / .11 + 100/ (1.11)5 Value= 369.5897018 +593.4513281=963.0410298 100 PMT, 1000 FV, 5 N, 11 I/Y, CPT PV => -963.0410298 On the calculator, PAY ATTENTION TO THE SIGN! PMT AND FV MUST BE THE SAME SIGN! This number means you pay 963.04 to get your lump sum payment and interest payments over time. This is called a discount bond because the face value is more than the price. The reason this bond is sold at a discount is because the 10% coupon rate is less than the 11% YTM in the market at the time. Bonds currently in the market with the same face value have a coupon rate of 11%, meaning investors would receive greater coupon payments. Therefore this bond must be priced cheaper than those bonds in order to attract buyers. The bulk of the value is in the face value.

Valuing a Bond Example 2 Suppose you are looking at a bond that has a 9% coupon rate, semi-annual coupons (tells you this is an American style bond), and a face value of $1000. There are 20 years to maturity and the YTM is 9%. What is the price of this bond? Value = PV of annuity + PV of lump sum

Value = 45[1 1/ (1.045)40] / .045 + 1000/ (1.045)40 Value = 828.0712989 + 171.9287011 = 1000.00 90/twice a year = -45 PMT 1000 FV 20 years x twice/yr = 40 N 9/twice a year = 4.5 I/Y CPT PV => -1000.00 When coupon rate and YTM are the same the price will equal the face value. This is called a par bond. It will sell for its par value. Bulk of the value in this bond is in the coupon payments rather than the face value because the exponents. Note: If there are two identical bonds but the only difference is the difference between the style (Euro or American), you would prefer American style because TVM. You get your money 6 months earlier. Valuing a Bond Example 3 Suppose you are looking at a bond that has a 10% coupon rate, semi-annual coupons (American style, keyword= semiannual coupons), and a face value of $1000. There are 20 years to maturity and the YTM is 8%. What is the price of this bond? Value = PV of annuity + PV of lump sum Value = 50[1 -1/(1.04)40] / .04 + 1000/(1.04)40 Value= 989.6386942 + 208.2890447= 1197.927739 50 PMT, 1000 FV, 40 N, 4 I/Y, CPT PV => -1197.927739 This is called a premium bond because the current market price is greater than the face value. -Premium bonds carry coupon rates greater than rates carried by similar investments in the market. Because premium bonds offer better coupon payments, they cost more. *FOR AMERICAN-STYLE BONDS THE INTEREST RATE IS DIVIDED BY TWO BECAUSE THERE ARE TWO SEMI-ANNUAL PAYMENTS PER YEAR. (Use R = APR/m) **Bond Prices: Relationship Between Coupon Rate and Yield to Maturity 1. If YTM = coupon rate, par value = bond price PAR BOND 2. If YTM > coupon rate, par value > bond price Why? Traders impose these prices. Higher opportunity cost than coupon rate Selling at a discount, called a discount bond 3. If YTM < coupon rate, par value < bond price Why? Traders impose these prices. Higher coupon rate than opportunity cost Selling at a premium, called a premium bond Interest Rate/Price Risk Bonds have two kinds of risk (besides default risk): Price Risk Change in price due to changes in interest rates

o Interest rates go up, bond prices go down Long-term bonds have more price risk than short-term bonds o Long term bonds carry more price risk because the change in interest rates affect the bond over a longer period of time, therefore changing the value more than a short-term bond Risk comes from not knowing what the interest rates will be, and therefore not knowing what the bond will be worth in the future Dr. Laplante has floating mortgage rates- people thought he was crazy 6 years ago because they thought rates would only go up, but they were wrong! Reinvestment Rate Risk Uncertainty concerning rates at which cash flows can be reinvested Many people reinvest once bonds come to maturity However, since interest rates can change drastically in short-term, the value of a new bond could be much lower o Ex: you own a bond w/ a 10% coupon rate, but when the bond expires, rates may be 5%. Now you will not be able to find a similar investment that pays 10% interest. Long-term bonds lock in the interest rate for a longer period. Short-term bonds have more reinvestment rate risk than long-term bonds (tradeoff between the two) Think about face values: Bond with 1 year to maturity (means in 1 year 1K in face value back that will need to be reinvested), uncertainty what you will get when reinvest money, bonds that have short time to maturity can have low price risk but a lot of reinvestment risk. Figure 7.2 Shows relationship between price and interest rates; as rates go up, opportunity costs rise (that is reflected in the price) Y-axis: Bond value = price X-axis: Interest rate = yield to maturity Notice that a 5% change in interest rates causes a greater change in the price of long-term bonds than in short-term (Price Risk) As interest rate increases, bond value decreases (vice versa)

Bond Sensitivity Case 2 An American-style bond has a 5% coupon rate, face value of $1000, and 20 years to maturity. What is the price of this bond for the YTMs 8% and 10%? 8%: 25 PMT, 1000 FV, 40 N, 4 I/Y, CPT PV => -703.1083917 10%: 25 PMT, 1000 FV, 40 N, 5 I/Y, CPT PV => -571.0228412 Price drops by 18.8% if yield jumps. o .188= [(Ending value- Beginning value)/ Beginning value] Calculate this with change in price/starting price (703.1083917571.0228412=) 132.0855505/703.1083917 = 0.187) You know that this is a discount bond because YTM > coupon rate. An American-style bond has a 10% coupon rate, face value of $1000, and 20 years to maturity. What is the price of this bond for the YTMs 8% and 10%? 8%: 50 PMT,1000 FV, 40 N, 4 I/Y, CPT PV => -1197.927739 10%: 50 PMT,1000 FV, 40 N, 5 I/Y, CPT PV => -1000.00 Price drops by 16.5% if yield jumps. Calculate this with change in price/starting price. You know that the second one is a par bond because coupon rate = YTM. The 5% coupon rate bond has a price drop of 18.8% while the 10% coupon rate bond declines by 16.5%. Why? The only thing that is different between them is the coupon rate (C = the payment amount) o The bonds have two parts: lump sum and PV of annuity o 5% Bond: Initial Price = 494.82 + 208.29

o o

% PV Annuity 70.4% % PV Lump 29.6% 10% Bond: Initial Price = 989.64 + 208.29 % PV Annuity 82.6% % PV Lump 17.4% Therefore, you get more of your money earlier in the 10% bond because over 80% of its value is tied up in the coupons, making its price less sensitive to interest rate changes. More of the value is tied up in interest payments. The 5% bond is more sensitive because more of the value is tied up in the future lump sum payment. If you know that the interest rate is going to go down, what bond would give you the best return? A small coupon is more sensitive to interest rate change A long-time to maturity is more sensitive to interest rate change Therefore the safest bet is a long-time to maturity bond with small coupon payments.

Computing Yield-to-maturity Also called Cost of Debt, r D Yield-to-maturity is the rate (APR) implied by the current bond price, sets price of bond equal to PV of expected future cash flows Finding the YTM requires trial and error o Why do you need trial and error when looking at the bond-pricing equation? Because you cant get r on the left side to solve for it. The exponents stop you. The PV of an annuity formula (Ch. 6) wont let you remove r. This formula is basically just that formula, expanded to include the PV of a lump sum as well. If you have a financial calculator, enter N, PV, PMT and FV, remembering the sign convention (PMT and FV need to have the same sign, PV the opposite sign) Remember, YTMs are reported as APRs YTM with Semiannual Coupons o Suppose a bond with a 9% coupon rate and semiannual (American!) coupons has a face value of $1000, 20 years to maturity and is selling for $1197.93. What is the YTM? Is the YTM more or less than 9%? We know the bond price > face value, so it must be a premium bond. This means the YTM must be less than the coupon rate (9%) 45 PMT, 1000 FV, -1197.93 PV, 40 N; CPT I/Y => YTM = 3.56393454 This is not the yield because it is at a 6-month rate. You have to multiply this amount by 2 to get your annual yield. 3.563 x 2 = 7.12786908% (< 9%) September 17, 2012 Current Yield vs. Yield to Maturity

Current Yield = annual coupon / price o Current yield is the rate of return on coupon payments o Dividend yield is analogous to current yield. Capital Gains Yield = % change in price in a year YTM = current yield + capital gains yield (this method only approximates the YTM for American style bonds) o Overall rate of return o So, YTM = rate of return on coupon pmts + the rate of return on the price change Consider 20-year European bond with $1,000 face value, 8% coupon rate, and a price of $1066. What is the YTM? 7.35949358% o 80= PMT 1000= FV -1066= PV 20=N; CPT I/Y= 7.35949358%

Current Yield = 80/1066 = .07504690 Therefore, the capital gains yield must be negative because YTM= CY + CGY 7.26%= 7.5% + (has to be negative) Capital Gains Yield = (Price 1 - Price 0)/ Price 0 o Price 0= 1066 o Solve for Price 1: 80 PMT; 1000 FV; 19 N; 7.35949358 I/Y; CPT PV => -1064.452202 o Price 1= 1064.452202 o Capital gains yield= 1064.452202-1066/1066 = -.00145197 or -.145197%

YTM= Current Yield + Capital Gains Yield 7.50469-.145197% = 7.35949343% =YTM If the bond had been American, YTM is approximately Current Yield + Capital Gains Yield The difference is b/c the pmts occur twice a year, so the 1st interest payment the 2nd b/c of TVM The Bond Indenture Indenture: the contract specifying the relationship between borrower and lender. Contract between the company and the bondholders and includes: 1. The basic terms of the bonds (face value, coupon rate, etc.) Bonds are loans, and no one can get a loan without a contract. 2. The total amount of bonds issued -A greater number of bond issuances imply a higher probability of default, because the company is borrowing more money 3. A description of property used as security, if applicable -Collateral 4. Sinking fund provisions - require the issuer to set aside money to retire the debt; can be done in two ways

1. Set money aside every year to make sure there is enough to pay the face value of the bonds at maturity 2. Spend a certain amount every year to buy back bonds on the secondary market 5. Call provisions - Allow the borrower to repay the bonds face value early, forgoing future interest payments -Get money to pay back the bond by issuing new bonds at lower rate typically -This is bad for the bondholder. -if interest rates are falling, a bond issuer will invoke call provisions (essentially refinancing the debt) - Call provisions create reinvestment risk for lenders; therefore bonds w/ them carry a higher coupon rate 6. Details of protective covenants -Dos and donts for the borrower - Restrictions on bond issuer to protect lenders Ex) may set current asset to current liability ratios that help keep the risk of default down Dont: Firm in trouble, writes big dividend check to owner, creditors have nothing Bond Classifications Registered (most common today) vs. Bearer Forms o Registered bonds are linked to certain individuals and the payments will only be made to whomever the bond is registered to o Bearer bonds pay out to whomever is holding them (whoever held the physical paper); these are becoming less and less common Security Collateral secured by financial securities Can be financial (sometimes a borrower might have to hold t-bills in trust as collateral) Mortgage secured by real property, normally land or buildings Debentures unsecured loans o Different than indenture (contract)!! o No specific asset a creditor can collect in the event of a default o All US treasury debt is debenture; you cannot prosecute them for defaulting because taxpayers technically back the government. Notes unsecured debt with original maturity less than 10 years (Short-term debts: Bills or financial notes) Seniority o Senior debt is repaid first, subordinated debt paid after senior debt o Seniority typically spelled out in the protective covenants

Bond Ratings (Heart of Financial Crisis in 2008) The big firms that evaluate: Moodys, Fitch, and Standard & Poors the debt issuer pays these companies for their ratings

Investment Quality (many bondholders (ex: pensions) are required to hold investment grade bonds; if their rating falls below BBB they must sell those bonds off) o High Grade Moodys Aaa and Aa, S&P AAA and AA Lowest probability of defaulting on debts is AAA o Medium Grade Moodys A and Baa, S&P A and BBB Speculative (AKA junk bonds) o Low Grade Moodys Ba, B, Caa and Ca, S&P BB, B, CCC, CC o Very Low Grade Moodys C and S&P C no interest being paid Moodys D and S&P D in default AAA firms can go bankrupt; all this rating says is whether the likelihood of them being able to pay their debts off is high or low on the scale from AAAD Lower rating corresponds to a higher interest rate In 2008, bonds rated AAA were suddenly a $0 value.

Bond Characteristics and Required Returns The coupon rate depends on the risk characteristics of the bond when issued Which bonds will have the higher coupon, all else equal? Secured debt versus a debenture Its riskier to not have collateral so the debenture will have to have a higher coupon rate. Subordinated debenture versus senior debt Subordinated debt in lower position down the chain (will then have to pay higher coupons) A bond with a sinking fund versus one without Without a sinking fund is riskier A callable bond versus a non-callable bond Callable bond is riskier and has a higher coupon rate - Any feature that increases risk will increase the coupon and vice-versa - Bonds can differ along many dimensions, making comparisons difficult Government Bonds Treasury Securities: Federal government debt T-bills: pure discount bonds with original maturity of one year or less T-notes: coupon debt with original maturity between one and ten years T-bonds: coupon debt with original maturity greater than ten years --Right now the longest time to maturity is 30 years (Bell-weather Bonds, no default risk) --No default risk because US government has strong power to tax (principal reason of not defaulting). Municipalities dont have this option because people can move

from the area to an area with lower taxes (mobility). Most people wont move out of the US to avoid taxes. Very hard to avoid (evade) US federal tax. Even if you revoke citizenship and move, you are still not off the hook for federal tax. US Treasury can print bills. Greece is about to default on their bonds- people wont get anything if they were holding Greek bonds (has no ability to print its own money). --Cannot tax interest payment on municipal coupons because they cannot be taxed, prices on these bonds go up (yields then go down) - These bonds are not rated b/c everyone knows theyre riskless - b/c Treasuries are taxed they carry a high yield even though they are riskless The rate depends on which characteristic dominates (risk or tax) Municipal Securities: Debt of state and local governments Varying degrees of default risk, rated similar to corporate debt Interest (coupon payments) received is tax-exempt at the federal level --Run the possibility of default more so than federal government because the state and local governments cannot tax as heavily as federal government can. They cant print money like the federal government can. If you had high property taxes in Clarke County you can move to Oconee. --Will just default if they cant pay (has happened in history: New York, Orange County, etc) -Bonds have credit ratings because different abilities to pay - the federal govt has said it wont bail out states who default Ex: Treasure $50 coupon After-Tax: $50 x (1-40%) = $30 GA: $50 coupon After-Tax: $50 (But riskier) Tax effect: increases price of muni bond Decreases Yield Risk effect (Dominating Now, 2012): Price of muni bond decreases increases yield

Bond Markets Primarily over-the-counter (OTC) transactions with dealers connected electronically o OTC means not having a physical location (ex: NASDAQ) o Dealers hold inventories of various bonds and buy/sell as they see fit in this market Extremely large number of bond issues, but generally low daily volume in single issues (Thin Market, illiquid) o Very hard to find a buyer that will pay you the fair market value in a short amount of time (Illiquidity) o Some bonds might not trade for weeks or months because one firm can have multiple bonds (issuing of debt) and there is not always a buyer ready to trade for asset (this is called a THIN or ILLIQUID market) o Stale quotes very common (the price that you see the bonds were traded at might not be representative of actually value today because the transactions dont happen with a lot of frequency) Treasury securities are an exception (Deep Market, liquid) o Always a buyer ready to buy US debt at fair market value (called a DEEP or

LIQUID market) One of the most liquid markets there is. o Extremely deep/liquid (can sell very quickly at fair market value) Trading quickly does not make something liquid (you can sell anything at a low enough price) but if you can sell it quickly at fair market value, then that thing is called liquid Foreign exchange (currency) markets are the deepest

Inflation and Interest Rates Fundamental Chapter 5 equation: FV=PV(1+r)t o Where the units are in dollars this is a growth rate in dollars Nominal rate of interest (r): percentage change in dollars, all periodic rates to now o PERIODIC RATE, also the YTM is one o The nominal rate of interest is not what you care about. Currency doesnt give you value; its the consumption of goods/services that gives the value. They are not the same because o Nominal interest rate is a change in dollars but an increase in that does not mean you will be able to buy more things with it in the future. o In the book it says big R is the nominal rate, nominal rates are little r for us!! The real rate is big R for us! Real rate of interest (R): percentage change in purchasing power, consumption o What you care about!! Expected inflation (h): expected percentage change in prices, CPI o 1913: Average income was $800 when the first income tax was levied o Now, average income is ~$46,000 Bottom line: Prices change! (Usually get higher) To make estimate for inflation, look at the past. It could be wrong. CPI measures what happened to prices in the past. Nominal rate of interest includes our desired real rate of return plus an adjustment for expected inflation (compensates for both real rate and inflation) o Because the price of stuff will be different in the future

Inflation and Interest Rates Intuitive Example You are offered an investment that pays a 25% return per year risk free. Is it a good deal? What if inflation is 25% per year? The implication here is that your investment will just offset inflation and you wont be able to consume more stuff one year from now than you can consume today. o So a 25% return in this case does not seem like such a good deal. Paper doesnt mean anything i.e. in Hungary people burning money for warmth. Nominal interest rates are supposed to compensate lenders for inflation and for waiting to receive their money The Fisher Effect/The Fisher Equation

**THIS IS DIFFERENT FROM THE BOOKs NOTATION; USE LAPLANTES WAY! (In the book, r and R are reversed) Defines relationship between real rates (R), nominal rates (r), and expected inflation (h): (1 + r) = (1 + R)(1 + h) Or, 1 + r = 1 + h + R + R*h r = h + R + R*h (in decimal form) Approximation: Only use this equation outside of class (in the real world you will usually see r first, inflation second, and then use this to INFER what the R is not a technical calculation) r R + h if R*h is very small (h is an estimate) Ultimately you care about the R most because it gives you more utility (more consumption = more happiness in theory). Also be aware of the fact that this is EXPECTED inflation (no guarantees that inflation will change to be any certain amount or that it will be there at all)

Fisher Effect Example A 20 oz Diet Coke costs $1 and I drink 10 a day. One year from now they are expected to cost $1.05 each. If I invest today I would like to be able to consume 10% more Diet Cokes in a year. What nominal rate do I need to get on my investment? a. Direct Calculation (normal calculation) Today: $1 x 10/day = $10/day (PV) In a Year: 11 Cokes/day x $1.05/Coke = $11.55 (FV) Target Nominal Rate: 15.5% (PV = 10, FV = 11.55, N = 1, CPT I/Y) b. Fisher Equation Real Rate = 10% Inflation = 5% (from 1.00 to 1.05) 1 + r = (1+.10)(1+.05) r = .155 (or 15.5%) Approximation: r R + h 15% 10% + 5% 15.5% IS NOT THE SAME THING AS 15%!! This number is off by 50 basis points, which can translate into a lot of money. Term Structure of Interest Rates Term structure is the relationship between time to maturity and yields, all else equal Yield curve graphical representation of the term structure Real rates, inflation, and risk Differential risk between investments should be taken in consideration but it is not (Very hard to calculate, like same math as Einstein and relativity) Figure 7.6 Upward-Sloping Yield Curve (Normal Case)

@?( # % C% D57 0# &4 52 ?% " 4 F ( # % 2 " AB > 9E * - <2 9% =" G # 04F 0. " I H* $ %

! # 0. ( # <2 4 F ( # % 2:% M 8% " 9% =" K5#4 LM N "

September 19, 2012 Figure 7.6 Downward-Sloping Yield Curve (Uncommon)

YTM on the Y-axis You infer all of these things from the nominal rate. Longer times to maturity convey greater price risk, therefore, these bonds have greater interest rates to compensate for this risk The Fisher Effect explains the relationship between the real rate and inflation and interest rate risk (although US T-Bills have low default risk, so not in every case) (1+R)(1+h) Called the upward sloping yield curve because the widening wedge on the top compensates people for carrying more risk (risk premium). The real rate ( R ) is related to productivity; it is the % change in consumption Expectations about inflation can change. Now, people think it will go up (not always the case- Japan has had deflation for ten years- so hard to break that cycle)

@?( # % C% J * 7 - 7 0# &4 52 ?% " 4 F ( # % 2 " AB > 9E * - <2 9% =" G )*$ $ *- I D-

@?( # % C% D57 0# &4 52 ?% " 4 F ( # % 2 " AB > 9E * - <2 9% =" G # 04F 0. " I H* $ %

Downward sloping b/c inflation is expected to be radically lower in the future Wedge associated with interest rate risk gets fatter as time increases Uncommon, like 1980s war on inflation Saying yield on 3-month bond would be higher than a 30-year bond, but that is not great because you have to reinvest it once you get the face value back, as you reinvest you get less and less. Productivity is key! Technology can increase the real rate for good if technology gains are huge and shocking! Real rate hovers around 2% Real rate, wedge for risk compensation, expectation for inflation all can change which effects the nominal rate!

! # 0. ( #Yield " 4 F ( # 2004 2:% M " <2 9% =" K5#4 LM N Treasury 8% Curve April %

Factors Affecting Required Return Things people care about: (which will affect the price they are willing to pay for that asset) Default risk premium remember bond ratings (municipal bonds have a higher default risk than treasury bonds) Taxability premium remember municipal versus taxable o Do T-bills or munis have higher yields? It depends on which factor dominates: default risk or taxability. If munis have a higher yield then investors are most worried about default. If T-bills have a higher yield then investors are more worried about taxes. Liquidity premium bonds that have more frequent trading will generally have lower required returns (municipal bonds are less liquid than treasury bonds) Anything else that affects the risk of the cash flows to the bondholders, will affect the required returns AAA bonds actually had a higher return than AA bonds for a while during the financial crisis because AAA bonds were the ones defaulting

Additional notes: The US government issues 30-year bonds called bell weather bonds The nominal rate of return on government debt is pre-tax FOR EXAM: o HAVE IDS