Ch 7

• bonds are debts or liabilities
• bonds are an interest only loan
• coupons are regular interest payments investors pay usually semi-annually or annually
• price of a bond today is the sum of the present value of the coupon annuity payments (interest) and the present value of the principal (future value)
• INT is the coupon per period
• Par is the face value
• r(d) is the yield to maturity per period
• N is the number of periods
• it is standard to assume coupon payments are made semi-annually and that the par value is $1000 unless otherwise noted
• yield to maturity is the rate of return you should expect to earn on a bond if you buy it today and hold it until its maturity date
• if the bond has annual coupons, the YTM will be expressed as an EAR
• if the bond has semi-annual coupons, the YTM will be expressed as an APR
• current yield = annual coupon payment / current bond price
• capital gains yield = change in price / beginning price
• change in price = (end price - beginning price) / beginning price
• if the coupon rate > YTM, then bond price > par, which is selling at premium
• if the coupon rate < YTM, then bond price < par, which is selling at discount
• if the coupon rate = YTM, then bond price = par, which is selling at par value
• bond price and the YTM have an inverse relationship
• as the YTM increases, the bond price decreases
• as the YTM decreases, the bond price increases
• interest rate risk causes bonds to be sensitive to a change in yields
• longer maturity bonds and lower coupon bonds are more sensitive to a change in bond yields
• four main bond types: US treasury bills, US corporate bonds, municipal bonds, foreign bonds
• US treasury bills have maturities of less than one year
• US treasury notes have maturities between 2 and 10 years
• US treasury bonds have maturities greater than 10 years
• US treasury bills/notes/bonds are free of default risk
• US corporate bonds have default risk measured by credit rating - higher risk means higher yield demanded by investors
• municipal bonds have interest that is tax free and state tax free for residents of that state
• foreign bonds are issued by foreign governments or corporations
• all bonds face price risk and interest rate risk
• all bonds besides treasuries face default risk
• foreign bonds have currency risk in addition to default risk and price risk
• premium bonds decrease in value if yield remains constant over life of bond so at maturity the price of the bond will be $1000
• discount bonds increase in value if yield remains constant over life of bond so at maturity the price of bond will be $1000
• expected total return = expected current yield + expected capital gains yield
• mortgage bonds: bonds that pledge a specific asset as collateral
• debentures: bond with no specific collateral
• subordinated debentures: debenture that gets paid after all other debt claims are paid for that period