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Econ 181
Corporate Finance
1
Bond Valuation An Overview
Coupon bonds
» Valuation
» Interest rate sensitivity
3
Repayment Schemes
4
Types of Bonds: Issuers
Bonds Issuer
Government Bonds US Treasury, Government Agencies
Mortgage-Backed Securities Government agencies (GNMA etc)
Municipal Bonds State and local government
Corporate Bonds Corporations
Asset-Back Securities Corporations
5
U.S. Government Bonds
Treasury Bills
» 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
6
U.S. Government Bonds (Cont.)
Treasury Bonds
» Coupons paid semiannually
» Face value paid at maturity
» Maturities over 10 years
» The 30-year bond is called the long bond.
Treasury Strips
» Zero-coupon bond
» Created by “stripping” the coupons and principal from Treasury
bonds and notes.
No default risk. Considered to be risk free.
Exempt from state and local taxes.
Sold regularly through a network of primary dealers.
Traded regularly in the over-the-counter market.
7
Agency and Municipal Bonds
9
Seniority of Corporate Bonds
Debentures
» Same priority as general creditors.
» Have priority over stockholders, but subordinate to secured debt.
10
Bond Ratings
Moody’s S&P Quality of Issue
Aaa AAA Highest quality. Very small risk of default.
D - In default.
11
The US Bond Market
Mortgages 12757.7
Value a 5 year, U.S. Treasury strip with face value of $1,000. The APR is
R=7.5% with annual compounding? What about quarterly compounding?
What is the APR on a U.S. Treasury strip that pays $1,000 in exactly 7 years
and is currently selling for $591.11 under annual compounding? Semi-annual
compounding?
14
Interest Rate Sensitivity:
Zero Coupon Bonds
16
Measuring Interest Rate Sensitivity
Zero Coupon Bonds
Method 3:
B $1,000 1
0.0001 T 0.0001 T * $0.10 *
R 1.10 T 1 1.10 T 1
18
DV01: A Graphical Approach
10-Year
$1,200.00
$1,000.00
$800.00
$600.00
$400.00
$200.00
$0.00
Interest Rate
20
Valuing Coupon Bonds
Example 1: Amortization Bonds
0 1 2 3 4
Buy Coupon Bond -$3,545.95 $1,000.00 $1,000.00 $1,000.00 $1,000.00
Buy 6-Month Zero -$952.38
Buy 1-Year Zero -$907.03
Buy 1.5-Year Zero -$863.84
Buy 2-Year Zero -$822.70
Portfolio -$3,545.95
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A First Look at Arbitrage
22
A First Look at Arbitrage
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 interest rate is 10% compounded semiannually?
45 45 45 45 1045
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Valuing Coupon Bonds
The General Formula
What is the market price of a bond that has an annual coupon C, face
value F and matures exactly T years from today if the required rate of
return is R, with m-periodic compounding?
» Coupon payment is: c = C/m
» Effective periodic interest rate is: i = R/m
» number of periods N = Tm
0 1 2 3 4 ... … N
c c c c… … c+F
B Annuity Zero
c 1 F
1 N
i 1 i N 1 i
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The Concept of a “Yield to Maturity”
So far we have valued bonds by using a given interest rate,
then discounted all payments to the bond.
Prices are usually given from trade prices
» need to infer interest rate that has been used
Definition: The yield to maturity is that interest rate that
equates the present discounted value of all future payments
to bondholders to the market price:
Algebraic:
c 1 F
B 1
N
yield / m 1 yield / m 1 yield / mN
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Yield to Maturity
A Graphical Interpretation
$2,500.00
$2,000.00
$1,500.00
$1,000.00
$500.00
$0.00
0%
2%
4%
6%
8%
10%
12%
14%
16%
18%
20%
22%
24%
Consider a U.S. Treasury bond that has a coupon rate of 10%, a face value of
$1,000 and matures exactly 10 years from now.
» Market price of $1,500, implies a yield of 3.91% (semi-annual
compounding); for B=$1,000 we obviously find R=10%.
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Interest Rate Sensitivity:
Coupon Bonds
c 1 F
B 1 N
i 1 i 1 i N
Similarly:
If R=12%: B=$ 827.95
If R= 9%: B=$1,000.00
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Relationship Between Coupon Bond
Prices and Interest Rates
Bond prices are inversely related to interest rates (or
yields).
Does the sensitivity of a coupon bond always increase with the term to
maturity?
31
Bond Prices and Interest Rates
$2,500.00
5-Year Bond
$2,000.00 10-Year Bond
Price (P)
$1,500.00
$1,000.00
$500.00
$0.00
0%
2%
4%
6%
8%
10%
12%
14%
16%
18%
20%
22%
24%
Interest Rate (R)
Why do we get different answers for two bonds with the same yield
and same maturity?
33
Maturity and Price Risk
The duration of a bond is less than its time to maturity (except for
zero coupon bonds).
The duration of the bond decreases the greater the coupon rate.
This is because more weight (present value weight) is being given
to the coupon payments.
As market interest rate increases, the duration of the bond
decreases. This is a direct result of discounting. Discounting at a
higher rate means lower weight on payments in the far future.
Hence, the weighting of the cash flows will be more heavily
placed on the early cash flows -- decreasing the duration.
Modified Duration = Duration / (1+yield)
36
A Few Bond Markets Statistics
U.S. Treasuries, May 20th 2007.
Bills
MATURITY DISCOUNT/YIELD DISCOUNT/YIELD TIME
DATE CHANGE
3-Month 08/16/2007 4.72 / 4.84 0.01 / .010 13:41
6-Month 11/15/2007 4.78 / 4.98 0.01 / .015 13:41
Notes/Bonds
COUPON MATURITY CURRENT PRICE/YIELD TIME
DATE PRICE/YIELD CHANGE
2-Year 4.500 04/30/2009 99-121⁄4 / 4.84 -0-02 / .03514:08
3-Year 4.500 05/15/2010 99-081⁄2 / 4.77 -0-031⁄2 / .040 14:06
5-Year 4.500 04/30/2012 98-281⁄2 / 4.75 -0-06 / .04314:07
10-Year 4.500 05/15/2017 97-15 / 4.82 -0-091⁄2 / .038 14:07
30-Year 4.750 02/15/2037 96-17+ / 4.97 -0-17 / .03514:07
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Spot Rates
38
The Term Structure of Interest Rates
An Example
Yield
6.00
5.75
5.00
1 2 3 Maturity
39
Term Structure, July 1st 2005.
40
Term Structure, September 12th, 2006
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Term Structure, May 20th, 2007
42
Term Structure of Interest Rates
43
44
Summary