Zara Mahmood Roberts FE101 BOND TERMINOLOGY Chapter 6 Bonds Bond is a security sold by governments and corporations to raise money from investors today in exchange for a promised future payment Bond Certificate States the terms of a bond as well as the amounts and dates of all payments to be made Payments on the bond are made until a final repayment date Maturity Date The final repayment date of a bond Term Time remaining until the repayment date Bonds typically make two types of payments to their holders Face value notional amount we use to compute the interest payments o Typically repaid at maturity Generally denominated in standard increments The promised interest payments of a bond paid periodically until the Coupons maturity date of the bond o Interest payments on bond are called coupon payments Exchange coupon for payment in past today electronic Coupon Rate Determines the amount of each coupon payment of a bond o Expressed as an APR set by issuer and stated on bond certificate ZERO COUPON BONDS Not all bonds have coupon payments Zero Coupon bonds A bond that makes only one payment at maturity Simplest type of bond only cash value is face value of bond at maturity date Treasury Bills US government bonds with a maturity of up to one year zero coupon bonds STRIPS general name for risk free zero coupon bond o Separately Tradable Registered Interest and Principal Securities Zero Coupon Bond Cash Flows Only two cash flows if we purchase and hold a zero coupon bond Pay the bonds current market price at time of purchase At maturity date receive the bond s face value o Bond pays no direct interest investor is compensated for the time value of their money by purchasing the bond at a discount to its face value Present value of future cash flow is less than cash flow itself Prior to maturity date zero coupon bond price is always less than face value Zara Mahmood Roberts FE101 Pure Discount Bond Zero coupon bonds Trade at a price lower than face value discount Yield to Maturity of a Zero Coupon Bond Can calculate the rate of return of buying a bond and holding it until maturity Zero coupon bond price is cost of the bond o Rate of return is the discount rate that makes the present value of the future cash flow received equal to the cost of the bond Yield to Maturity YTM The rate of return of an investment in a bond that is held to its maturity date or the discount rate that sets the present value of the promised bond payments equal to the current market price for the bond YTM for zero coupon is return you will earn by receiving the promised face value payment Risk Free Interest Rates Law of One Price guarantees that the risk free interest rate equals the yield to maturity on such a bond Zero coupon risk free bond the risk free interest rate or spot interest rate Spot Interest Rate default free zero coupon yields Rates are offered on the spot at that point in time Risk free interest rates correspond to the yields of risk free zero coupon bonds Zero Coupon Yield Curve A plot of the yield of risk free zero coupon bonds STRIPS as a function of the bond s maturity date Can use a bond s yield to compute its price Zero coupon price is equal t the present value of the bond s face value discounted at the bond s yield to maturity COUPON BONDS Coupon Bonds Bonds that pay regular coupon interest payments up to maturity when the face value is also paid Two types of coupon securities are currently traded in financial markets Treasury Notes Treasury Bonds have original maturities from 1 10 years Have original maturities of over 10 years o Original maturity is the term of the bond at the time it was originally used Coupon Bond Cash Flows Investors return on a zero coupon bond Buying it at a discount to its principal value Return on a coupon bond Any difference between the purchase price and the principal value Its periodic coupon payments Yield to Maturity of a Coupon Can determine its yield to maturity Yield to maturity of the bond is the single discount rate that equates the present value of the bond s remaining cash flows to its current price Zara Mahmood Roberts FE101 Coupon bonds have many cash flows o No simple formula to solve for YTM directly Use calc Coupon Bond Price Quotes Prices and yields are often used interchangeably Yield is independent of the face value of bond o Advantage of yield over price WHY BOND PRICES CHANGE Zero coupon bonds always trade for a discount Coupons may trade at a discount or at a premium Premium A price at which coupon bonds trade that is greater than their face value Par A price at which coupon bonds trade that is equal to their face value Interest Rate Changes and Bond Prices If bond sells at par return is only coming from coupons the bond pays Bond s coupon rate will exactly equal its YTM Interest rates fluctuate yield that investors demand to invest in bonds will also change Trading at a discount trading below par o Earn a return from receiving coupons and from receiving face value that o Return from coupon is diminished by receiving a face value less than paid exceeds price paid o YTM will exceed its coupon rate Trading at a premium trading above par price o YTM is less than its coupon rate Interest rates and bond yields rise bond prices will fall Interest rates and bon yields fall bond prices will rise Always move in the opposite direction Zara Mahmood Roberts FE101 Time and Bond Prices Effect of time on the price of a bond As next payment grows nearer price of the bond increases o Reflects the increasing present value of the cash flow Price drops abruptly after the payment is made o Pattern continues for the life of the bond Interest Rate Risk and Bond Prices Effect of time on bond prices is predictable Unpredictable changes in interest rates will also affect bond prices o Bonds with different characteristics will respond differently to changes in interest rates Some bonds react more strongly than others Investors view long term loans as riskier than short term loans Same is true for short and long term bonds Bond Prices in Practice Bond prices are subject to the effects of both the passage of time and changes in interest rates Bond prices converge to the bond s face value due the time effect o Simultaneously move up and down due to unpredictable changes in bond yields Prior to maturity the bond is exposed to interest rate risk Investor sells and bond YTM decreases o Investor receives high price and earns high return Investor sells and bond YTM increases o