practical investment management by robert.a.strong slides ch04

8/14/2019 Practical Investment Management by Robert.A.Strong slides ch04

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BOND FUNDAMENTALSCHAPTER FOUR

Practical Investment Management

Robert A. Strong

A

1 3


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South-Western / Thomson Learning 2004 4 - 2

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


7/47South-Western / Thomson Learning 2004 4 - 7

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.



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




Insert Table 4-1 here.



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




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




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


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



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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



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4. Consols

( )r

tr

t

t

t

timeatflowcash

timeatflowcashpricebondcurrent

= +=

=1 1



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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:



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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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A plot of interest rates against time to

maturity is known as a yield curve.

yield

time



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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



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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



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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



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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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interest rate risk - the chance of loss due to

changing interest rates



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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



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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

practical investment management by robert.a.strong slides ch04

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