Module 04

What determines the shape/slope of the term structure?

(1) Real interest rate (R) (relatively steady) (2) Inflation (h) risk (strong influence) (3) Interest rate risk

Determining an acceptable bond yield (YTM) considers

(1) real rate of interest (2) expected future inflation (3) interest rate risk (4) default risk (5) taxability (6) liquidity

Bond prices & interest rates always move in __ directions

opposite

Bond Value Formula

present value of the coupons + present value of the face (par) amount

Fisher effect

the one-for-one adjustment of the nominal interest rate to the inflation rate; nominal interest rate should rise enough to keep the real interest rate constant

Principal value of a bond that is repaid at the end of the term. Also referred to as par value.

Face Value

Risk that arises for bond owners from fluctuating interest rates

Interest rate risk 1. Longer time to maturity, greater risk (slows further in time) 2. Lower coupon rate, greater risk

What are the implications for bond investors of the lack of transparency in the bond market?

Lack of transparency means that a buyer or seller can't see recent transactions, so it is much harder to determine what the best bid and ask prices are at any point in time.

The yield of a government bond is typically __ than a corporate bond because the corporate bond has default risk while the government bond does not.

Less than

Is it true that a US Treasury security is risk-free?

No. As interest rates fluctuate, the value of a Treasury security will fluctuate. Long-term Treasury securities have substantial interest rate risk.

Long-term rates > short-term rates

Term structure is upward sloping

Zero coupon bonds

bonds that pay no annual interest but are sold at a discount below par, thus compensating investors in the form of capital appreciation

real rate of interest

change in purchasing power 1+R = (1+r) x (1+h) R = r + h + rxh R~r+h

Promised yield

ignores the probability of default. (expected return considers this)

Treasury notes are highly ___

liquid

All else being the same, which has more interest rate risk: a long-term bond or a short-term bond? What about a low coupon bond compared to a high coupon bond? What about a low coupon bond compared to a high coupon bond? What about a long-term, high coupon bond compared to a short-term, low coupon bond?

A long-term bond has more interest rate risk compared to a short-term bond, all else the same. A low coupon bond has more interest rate risk than a high coupon bond, all else the same. When comparing a high coupon, long-term bond to a low coupon, short-term bond, we are unsure which has more interest rate risk. Generally, the maturity of a bond is a more important determinant of the interest rate risk, so the long-term, high coupon bond probably has more interest rate risk. The exception would be if the maturities are close, and the coupon rates are vastly different.

Which has a greater interest rate risk, a 30-year Treasury bond or a 30-year BB corporate bond?

All else the same, the Treasury security will have lower coupons because of its lower default risk, so it will have greater interest rate risk.

How does a bond issuer decide on the appropriate coupon rate to set on its bonds? Explain the difference between the coupon rate and the required return on a bond.

Bond issuers look at outstanding bonds of similar maturity and risk. The yields on such bonds are used to establish the coupon rate necessary for a particular issue to initially sell for par value. Bond issuers also ask potential purchasers what coupon rate would be necessary to attract them. The coupon rate is fixed and determines what the bond's coupon payments will be. The required return is what investors actually demand on the issue, and it will fluctuate through time. The coupon rate and required return are equal only if the bond sells for exactly par.

Current yield

Bond's annual coupon / market price Considers only coupon portion - does not consider build in gain (or loss) from price discount or premium price

Municipal bonds

Bonds issued by state and local governments - typically tax free

Companies pay rating agencies such as Moody's and S&P to rate their bonds, and the costs can be substantial. However, companies are not required to have their bonds rated; doing so is strictly voluntary. Why do you think they do it?

Companies pay to have their bonds rated because unrated bonds can be difficult to sell; many large investors are prohibited from investing in unrated issues.

Bond selling for less than face (par) value

Discount bond (coupon rate < market YTM)

Bond selling for greater than face (par) value

Premium bond (coupon rate > market YTM)

term structure of interest rates

Relationship between short- and long-term interest rates; based on nominal (r) interest rates on default-free, pure discount (zeroes) bonds of all maturities Tells us the pure time value of money for different lengths of time

a) what is the relationship between the price of a bond and its YTM? b) Explain why some bonds sell at a premium over par value while other bonds sell at a discount. What do you know about the relationship between the coupon rate and the TYM for premium bonds? What about for discount bonds? For bonds selling at par value? c) What is the relationship between the current yield and YTM for premium bonds? For discount bonds? For bonds selling at par value?

The bond price is the present value of the cash flows from a bond. The YTM is the interest rate used in valuing the cash flows from a bond. b. If the coupon rate is higher than the required return on a bond, the bond will sell at a premium, since it provides periodic income in the form of coupon payments in excess of that required by investors on other similar bonds. If the coupon rate is lower than the required return on a bond, the bond will sell at a discount since it provides insufficient coupon payments compared to that required by investors on other similar bonds. For premium bonds, the coupon rate exceeds the YTM; for discount bonds, the YTM exceeds the coupon rate, and for bonds selling at par, the YTM is equal to the coupon rate. c. Current yield is defined as the annual coupon payment divided by the current bond price. For premium bonds, the current yield exceeds the YTM, for discount bonds the current yield is less than the YTM, and for bonds selling at par value, the current yield is equal to the YTM. In all cases, the current yield plus the expected one-period capital gains yield of the bond must be equal to the required return.

U.S. Treasury bonds are not rated. Why? Often, junk bonds are not rated. Why?

Treasury bonds have no credit risk since they are backed by the U.S. government, so a rating is unnecessary. Junk bonds often are not rated because there would be no point in an issuer paying a rating agency to assign its bonds a low rating (it's like paying someone to kick you!).

Treasury Inflation-Protected Securities (TIPS)

Treasury issues in which the principal amount is tied to the Consumer Price Index to protect the buyer against the effects of inflation Quoted in real yields

Interest rate required in the market on a bond

Yield to Maturity (or yield for short)

treasury yield curve

a plot of the yields on treasury notes and bonds relative to maturity; reflective of the term structure of interest rates; term structure is based on zeroes, whereas yield curve is based on coupon bond yields