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Definition of a Bond

■ A bond is a security that obligates the issuer to make specified


interest and principal payments to the holder on specified dates.
 Coupon rate
 Face value (or par)
 Maturity (or term)
■ Bonds are sometimes called fixed income securities.
Types of Bonds
■ Pure Discount or Zero-Coupon Bonds
 Pay no coupons prior to maturity.
 Pay the bond’s face value at maturity.
■ Coupon Bonds
 Pay a stated coupon at periodic intervals prior to maturity.
 Pay the bond’s face value at maturity.
■ Perpetual Bonds (Consols)
 No maturity date.
 Pay a stated coupon at periodic intervals.
Bond Issuers

■ Government
■ Financial Institutions
■ Countries
■ Corporations
Government Bonds

■ Treasury Bills (Gilts)


 No coupons (zero coupon security)
 Face value paid at maturity
 Maturities up to one year
■ Treasury Notes
 Coupons paid semiannually
 Face value paid at maturity
 Maturities from 2-10 years
Government Bonds
■ Treasury Bonds
 Coupons paid semiannually
 Face value paid at maturity
 Maturities over 10 years
 The 30-year bond is called the long bond.
Government Bonds

■ No default risk. Considered to be riskfree.


■ Exempt from state and local taxes.
■ Sold regularly through a network of primary dealers.
■ Traded regularly in the over-the-counter market.
Corporate Bonds

■ Secured Bonds (Asset-Backed)


 Secured by real property
 Ownership of the property reverts to the bondholders upon
default.
■ Debentures
 General creditors
 Have priority over stockholders, but are subordinate to
secured debt.
Common Features of Corporate
Bonds

■ Senior versus subordinated bonds


■ Convertible bonds
■ Callable bonds
■ Putable bonds
■ Sinking funds
Bond Ratings
Moody’s S&P Quality of Issue
Aaa AAA Highest quality. Very small risk of default.

Aa AA High quality. Small risk of default.

A A High-Medium quality. Strong attributes, but potentially


vulnerable.
Baa BBB Medium quality. Currently adequate, but potentially
unreliable.
Ba BB Some speculative element. Long-run prospects
questionable.
B B Able to pay currently, but at risk of default in the
future.
Caa CCC Poor quality. Clear danger of default .

Ca CC High specullative quality. May be in default.

C C Lowest rated. Poor prospects of repayment.

D - In default.
Valuing Zero Coupon Bonds
● What is the current market price of a U.S. Treasury strip that
matures in exactly 5 years and has a face value of £1,000. The
yield to maturity is rd=7.5%.

1000
5 = £696.56
1.075

● What is the yield to maturity on a U.S. Treasury strip that pays


£1,000 in exactly 7 years and is currently selling for £591.11?

1000
591.11 = 7
1 + rd
Bond Yields and Prices
The case of zero coupon bonds

● Consider three zero-coupon bonds, all with


» face value of F=100
» yield to maturity of r=10%, compounded annually.
We obtain the following table:
Bond 1 Bond 2 Bond 3
Time / Bond value 10% $90.91 $75.13 $62.09
1 100 0 0
2 0 0
3 100 0
4 0
5 100
The Impact of Price Responses

● Suppose the yield would drop suddenly to 9%, or increase to 10%.


How would prices respond?

Yield Bond 1 Bond 2 Bond 3


1 Year 3 Year 5 Year
10% $90.91 $75.13 $62.09
9% $91.74 $77.22 $64.99
% change 0.91% 2.70% 4.46%
11% $90.09 $73.12 $59.35
% change -0.91% -2.75% -4.63%
● Bond prices move up if the yield drops, decrease if yield rises
● Prices respond more strongly for higher maturities
Bond Valuation:
An Example
● What is the market price of a U.S. Treasury bond that has a coupon
rate of 9%, a face value of £1,000 and matures exactly 10 years from
today if the required yield to maturity is 10% compounded
semiannually?

0 6 12 18 24 ... 120 Months

45 45 45 45 1045

45  1  1000
B= 1 − + = $937.69
0.05  1.05 20 
1.05 20
Relationship Between Bond
Prices and Yields
■ Bond prices are inversely related to interest rates (or yields).
■ A bond sells at par only if its coupon rate equals the coupon
rate
■ A bond sells at a premium if its coupon is above the coupon
rate.
■ A bond sells a a discount if its coupon is below the coupon
rate.
Volatility of Coupon Bonds

● Consider two bonds with 10% annual coupons with maturities of 5


years and 10 years.
● The yield is 8%
● What are the responses to a 1% price change?

Yield 5-year bond 10-year bond


8% $1,079.85 $1,134.20
9% $1,038.90 $1,064.18
% Change -3.79% -6.17%
7% $1,123.01 $1,210.71
% Change 4.00% 6.75%
Average 3.89% 6.46%
● The sensitivity of a coupon bond increases with the maturity?
Bond Prices and Yields

Bond Price

Longer term bonds are more


sensitive to changes in interest
rates than shorter term bonds.
F

c Yield