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BOND FUNDAMENTALSCHAPTER FOUR
Practical Investment Management
Robert A. Strong
A
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Bond Principles Identification of Bonds Classification of Bonds
Issuer
Security Term Terms of Repayment
Interest Only
Sinking Fund
Balloon Loan
Income Bond
Outline
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Bond Principles continued Bond Cash Flows
Annuities
Zero Coupon
Variable Rate Consols
Inflation-Indexed Treasury Bonds Convertible and Exchangeable Bonds Registration
Bearer Bonds
Registered Bonds
Book Entry Bonds
Outline
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The Financial Page Listing Basic Information Footnotes Government Bonds
Bond Pricing and Returns Valuation Equations
Annuities
Zero Coupon Bonds
Variable Rate Bonds
Consols
Outline
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Bond Pricing and Returns continued Yield to Maturity
Calculating the Yield to Maturity
Misreading the Yield to Maturity
The Yield Curve Spot Rates
Realized Compound Yield
Current Yield
Accrued Interest
Outline
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Bond Risks Price Risks
Default Risk
Interest Rate Risk
Convenience Risks Call Risk
Reinvestment Rate Risk
Marketability Risk
Outline
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Bond Principles: Identification of Bonds
Bonds are identified by issuer, couponrate, and maturity.
The face value of a bond is called itspar
value.
e.g. 5 of Hertz sevens of 03 (Hertz 7s03)
A legal document called the indenture
contains the details of the bond issue.
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a. governmente.g. US Treasury, federal agency,
state, local
b. corporation e.g. industrial, utility, financial,
transportation
c. others e.g. foreign government, foreign
corporation, World Bank
Bond Principles: Classification of Bonds
Method 1: By issuer
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Bond Principles: Classification of Bonds
Insert Table 4-1 here.
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a. unsecured debt- backed by faith in the taxing
power of the government, or the good name of
the company (debenture)
b. secured debte.g. revenue bond, assessment
bond, mortgage, collateral trust bond,
equipment trust certificateBond security sometimes comes from non-traditional
sources. Recently, some rock stars floated bonds
using their future earnings as backing.
Method 2: By security
Bond Principles: Classification of Bonds
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Method 3: By term
a. short-term - a year e.g. US Treasury bills
b. intermediate-term e.g. US Treasury notes(2 to 10 years )
c. long-term e.g. US Treasury bonds ( 10 years)d. open-endede.g. corporate line of credit
e. serial bond- a portfolio of bonds with
staggered terms
Bond Principles: Classification of Bonds
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Bond Principles: Classification of Bonds
Insert Table 4-2 here.
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interest only- the periodic payments are
entirely interestsinking fund- periodically, a portion of the
debt principal is set aside or a
certain number of the bonds isretired
balloon loan - the debt may be partially
amortized with each paymentincome bond- interest is payable only if it is
earned
Bond Principles: Terms of Repayment
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annuities - most bonds are annuities plus an
ultimate repayment of principalzero coupon - only the par value is returned
at maturityvariable (adjustable) rate - the rate fluctuates
in accordance with some marketindex or predetermined schedule
consols - a level rate of interest is paid
perpetuallyinflation-indexed Treasury bonds - the
principal value is adjusted basedon the consumer price index
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Bond Principles: Bond Cash Flows
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convertible bond- may be exchanged for
common stock in the
company that issued the
bond
exchangeable bond- may be exchanged for
shares in another firm
Bond Principles: Options
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bearer (coupon) bonds - belong to whomever
legally hold them; no longer
issued in the United States
because of tax considerations
registered bonds - the bonds show thebondholders name
book entry bonds - bond ownership is
reflected only in theaccounting records
Bond Principles: Registration
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Bond Principles: Registration
Insert Figure 4-1 here.
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BasicInformation
Cur NetBonds Yld Vol CloseChg.
AMR 9s16 8.4 23 107 +
Footnotes cv - convertible zr - zero couponvj - bankruptcy dc - deep discountf - trading flat
Government
Bonds
Maturity AskRate Mo/Yr Bid Asked Chg.Yld.
6 Feb 26 86:09 86:11 - 9
7.11
The Financial Page Listing
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The Financial Page Listing
Insert Figure 4-2 here.
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( ) ( )presentthefromperiodssemiannualintime
ratediscount
periodssemiannualinbondtheoftermwhere
1
valuepar
1
interest
al)PV(principt)PV(interespricebondcurrent
1
===
+++=+
=t
r
n
rr n
n
t
t
22
1. Annuities
The bond pricing relationship is customarily
expressed in terms of semiannual periods.
Bond Pricing & Returns: Valuation Equations
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2. Zero Coupon Bonds
( ) nr 1valuepar
al)PV(princippricebondcurrent +=
3. Variable Rate Bonds
= +=n
t ttr
t
12
1
timeatflowcashpricebondcurrent
Bond Pricing & Returns: Valuation Equations
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4. Consols
( )r
tr
t
t
t
timeatflowcash
timeatflowcashpricebondcurrent
= +=
=1 1
Bond Pricing & Returns: Valuation Equations
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The yield to maturityis the singleinterest rate that, when applied to
the stream of cash flows associated
with a bond, causes the present
value of those cash flows to equal
the bonds market price.
Bond Pricing & Returns: Yield to Maturity
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( )value)0.4(parprice)0.6(market
maturityuntilyears
valuepar-pricemarket-interestannual
YTMapprox +
A heuristic:
Bond Pricing & Returns: Yield to Maturity
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Bond Pricing & Returns: Yield to Maturity
The yield to maturity calculation carries anassumption that coupon proceeds are
reinvested at the yield to maturity.
If a bond pays periodic interest, it is notpossible to lock in a prescribed yield to
maturity.
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Bond Pricing & Returns: Yield to Maturity
Insert Table 4-3 here.
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A plot of interest rates against time to
maturity is known as a yield curve.
yield
time
Bond Pricing & Returns: Yield to Maturity
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Bond Pricing & Returns: Yield to Maturity
Insert Figure 4-4 here.
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A spot rate is the yield to maturity of
a zero coupon security of the
chosen maturity.
A treasury strip is a government bond or note
that has been decomposed into two parts, onefor the stream of interest payments and one
for the return of principal at maturity.
The yield to maturityis a derived statistic afterthe bond price is known.
Bond Pricing & Returns: Spot Rates
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The yield to maturity can be thought of as an
average of the spot rates, or as a flat yield
curve at some constant interest rate.
This single interest rate makes the present
value of the future cash flows equal to thebonds market price.
%
Term
Yield to Maturity
Spot Rate Curve
Bond Pricing & Returns: Spot Rates
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Bond Pricing & Returns: Spot Rates
Insert Figure 4-5 here.
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Realized Compound Yield:
yearperpaymentsofnumbermaturitytoyieldwhere
1rateannualeffective
== +
x
r
x
rx
1
How can two investments paying
interest on two different time
schedules be compared?
Bond Pricing & Returns
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The current yieldonly measures the return
associated with the bonds interest
payments.
A bond whose market price is less than its
par value is selling at a discount. The priceof such bonds rise as maturity approaches.
If the market price is more than the par
value, the bond is selling at apremium.
Bond Pricing & Returns: Current Yield
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Bond Pricing & Returns: Current Yield
Insert Figure 4-6 here.
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Interest is earned for each day that a bond
is held, although interest payments are
generally made twice a year only.
A bond buyer must pay the accrued interest
to the seller of the bond.
dirty price = bond price + accrued interest
clean price = bond price
By convention, accrued interest iscalculated using a 360-day year.
Bond Pricing & Returns: Accrued Interest
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Bond Pricing & Returns: Accrued Interest
Insert Figure 4-7 here.
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default risk - the possibility that the issuer
of the bond is unable to pay
- rated by agencies like Moodys
and Standard & Poors
Bond Risks: Price Risks
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Bond Risks: Price Risks
Insert Table 4-5 here.
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interest rate risk - the chance of loss due to
changing interest rates
Bond Risks: Price Risks
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call risk - the possibility that the company
will exercise a bonds call feature
Bond Risks: Convenience Risks
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Bond Risks: Convenience Risks
Insert Figure 4-8 here.
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Bond Principles Identification of Bonds Classification of Bonds
Issuer
Security
Term Terms of Repayment
Interest Only
Sinking Fund
Balloon Loan Income Bond
Review
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Bond Principles
continued
Bond Cash Flows
Annuities
Zero Coupon
Variable Rate
Consols
Inflation-Indexed Treasury Bonds Convertible and Exchangeable Bonds Registration
Bearer Bonds Registered Bonds
Book Entry Bonds
Review
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The Financial Page Listing Basic Information Footnotes Government Bonds
Bond Pricing and Returns Valuation Equations
Annuities
Zero Coupon Bonds
Variable Rate Bonds Consols
Review
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Bond Risks Price Risks Default Risk
Interest Rate Risk
Convenience Risks Call Risk
Reinvestment Rate Risk
Marketability Risk
Review