Chapter 8: Interest Rates and Bond Valuation
Municipal notes and bonds risk
Varying degree of default risk.
The price you actually pay, including the accrued interest, is called the
Dirty price, aka "full" or "invoice" price
r
Discount rate/yield to maturity
Bond Value Formula
Bond Value = PV of Coupons + PV of the face value
Interest rate risk sensitivity depends on (2) things:
1- the time to maturity, 2 - the coupon rate
Zero Coupon Bonds
A bond that pays no coupons at all (offered at a price much lower than its face value)
What is a discount bond?
A bond that sells for less than its face value
What is a premium bond?
A bond that sells for more than its face value
Fisher effect
A rise in the rate of inflation causes the nominal rate to rise just enough so that the real rate of interest is unaffected. The real rate is invariant to the rate of inflation.
Debt Ratings
AAA - Highest rating, capacity to pay interest and principal is extremely strong AA A BBB BB CCC CC C D - Debt is in default, payment of interest and/or repayment of principal is in arrears
What are debt ratings?
An assessment of the creditworthiness of the corporate issuer
What is a bond?
An interest-only loan; the borrower will pay the interest every period, but none of the principal will be repaid until the end of the loan
Coupon Rate
Annual coupon divided by the face value
Bid and Ask Price
Bid price is what a dealer is willing to pay for a security. Ask price is what a dealer is willing to take for it
What is the difference between the bid and ask price?
Bid-Ask Spread (Spread) - represents the dealer's profit
Finding the value of a Bond
Bond value = C x [1-1/(1+r)^t]/r+F/(1+r)^t C = Coupon paid each period r = Discount rate per period t = number of periods F = Bond's face value
How do we calculate the PV of a bond?
Calculate the PV of face value + the PV of the annuity stream (the coupon payment) ie: 1000/1.08^10 = 463.19 80 X (1-1/1.08^10)/.08 = 536.81 463.19+536.81 = $1000 = Total bond value
The quoted price is called the
Clean Price
What are the regular interest payments called from a bond?
Coupons
When interest rates rise, the present value of the bond's remaining cash flows (increase/decline)
Decline - the bond is worth less. When interest rates fall, the bond is worth more
Municipal issues are exempt from (state/federal/both/none) taxes
Exempt from federal, not necessarily state income taxes.
Treasury issues are exempt from (state/federal/both/none) taxes
Exempt from state, not federal. Coupons received on a Treasury notes or bond are taxed only at the federal level
The amount repaid at the end of a bond loan is called what?
Face value, par value
All other things being equal, the longer the time to maturity the (greater/less) the interest rate risk
Greater
All other things being equal, the lower the coupon rate, the (greater/less) the interest rate risk
Greater
Municipal issues are attractive to who?
High income, high tax bracket investors
The bond with the (higher/lower) coupon has a (larger/smaller) cash flow early in its life?
Higher, Larger - it's value is less sensitive to changes in the discount rate.
Creditworthiness
How likely the firm is to default and the protection creditors have in the event of a defualt
The one year bond price is relatively (sensitive/insensitive) to interest rate changes
Insensitive
Municipal notes and bonds
Issued by state and local governments
Treasury notes and bonds
Issued by the federal government, relatively risk free
If two bonds with different coupon rates have the same maturity, the value of the (lower/higher) coupon bond is proportionately (more/less) dependent on the face value
Lower, More
Two leading bond-rating firms
Moody's and Standard & Poor's (S&P)
Bond ratings are concerned with (interest rate risk/default risk/both/none)
Only the possibility of default
Cash flows from a bond (change/stay the same)?
Stay the same
Relatively small changes in interest rates will lead to a (small/substantial) change in the 30 year bond's value?
Substantial
Current yield
The bond's annual coupon divided by its price. ie: annual coupon = $80 price = $955.14 current yield = 80/955.14 = 8.38%
To calculate the PV of a bond at a particular point in time, we need to know what?
The number of periods remaining until maturity, the face value, the coupon, and the market interest rate for bonds with similar features.
Maturity
The number of years until the face value is paid
The real rate on an investment is what?
The percentage change in how much you can buy with your dollar.s The real rate is the percentage change in your buying power.
The nominal rate on an investment is what?
The percentage change in the number of dollars you have
What is interest rate risk?
The risk that arises for bond owners from fluctuating interest rates
If you buy a bond between coupon payment dates, the price you pay is usually more than the price you are quoted. Why?
The standard convention in the bond market is to quote prices net of "accrued interest" - the accrued interest is deducted to arrive at the quoted price
Treasury issues vs. municipal bonds
Treasury issues are default free, municipal bonds face the possibility of default
Treasury notes and bonds risk
Virtually risk free
How much interest rate risk a bond has depends on...
how sensitive its price to interest rate changes
