1 Requirements for a BOND IPO n a 2 Premium Discount Bonds a Premium Bonds Bonds that sell above par value i Coupon rate is greater than current yield YTM b Discount Bonds Bonds that sell below par value i Coupon rate is less than current yield YTM 3 Calculate Current Yield a Annual Coupon Bond Price i Ex 8 30 year bond selling at 1 276 76 ii current yield would be 80 1 276 76 0627 or 6 27 4 Bond Pricing Quote a The quoted bond price is net of accrued interest b In order to find the real price of the bond including accrued interest the formula is Annual Coupon Payment 2 Days since last coupon payment Days separating coupon payments 5 Attributes of a municipal bond Issued by state and local governments Interest payments are tax free a b c Equivalent Taxable Yield is the rate a taxable bond would need to offer in order to match the yield of a tax free MUNICIPAL BOND Rm i R Rm 1 t 6 Types of Secured Unsecured Bonds a Unsecured Bonds Debenture which are not backed by collateral b Corporate Bonds Issued by corporations given a rating by which safer bonds higher rated generally have lower yield value c Callable Bonds Bonds that may be repurchased by the issuer at a specific call price during the call period i Firms issue new bonds at lower coupon rates to generate revenue to repurchase callable bond this process is called refunding ii Because the risk of being called exists callable bonds are issued with higher coupons and yields than non callable bonds d Convertible Bonds A bond with the option allowing the bondholder to exchange the bond for a specified number of shares of common stock in the firm i Conversion Premium is the excess of the bond price over the conversion value ii Lower coupon rates than non convertibles iii Bondholders benefit from price appreciation e Puttable Bonds Bondholder may choose to cash in at par or extend the maturity date at f maturity Floating Rate Bonds The coupon rate adjusts or floats periodically according to a specified market rate g Preferred Stock Although technically not bonds preferred stock pays a fixed dividend to the stockholder therefore it is a perpetuity International Bonds Commonly divided into two categories Foreign and Eurobonds h i Foreign Bonds Issued from a borrower in a country other than where it is marketed sold Foreign Bonds sold in the U S are called Yankee Bonds Foreign Bonds sold in Japan are called Samurai Bonds Foreign Bonds sold in Britain are called Bulldog Bonds ii Eurobonds are issued in the currency of one country and sold in another nation Dollar denominated bonds sold outside the U S Falls outside U S jurisdiction and are not regulated by Federal Agencies Inverse Floaters works exactly like floating rate bonds except coupon rate is adjusted inversely to the market interest rate i e coupon falls when interest rises j Asset backed Bonds Fixed income comes from the cash flows of a specified group of assets used to service the debt k Pay in kind Bonds Issuers of this bond can pay interest in additional bonds instead of cash Catastrophe Bonds Bonds which revoke partial or all payment in the case of a catastrophe such as an earthquake or hurricane i Transfer catastrophe risk from insurance to capital markets ii Bondholders are compensated via higher coupon rates for higher risk i l m Indexed Bonds Make payments back by a general price index or a commodity market i Treasury issues Treasury Inflation Protected Securities TIPS which are tied to general prices levels so coupon and final par value are risk free as they increase with inflation Nominal Return Interest Price Appreciation Initial Price Real Return 1 Nominal Return 1 Inflation 7 Fixed vs Floating Rate Bonds Fixed rate provide one coupon rate and YTM no matter market conditions which raise or lower interest rates a Therefore if interest rates rise you will be not making any real profit off the bonds Floating Rate bonds have the coupon rate change along with the interest rates the bondholder can secure real gains from the investment 8 Put Call Features on Bonds a Put Feature Allows the bondholder to extend the maturity date of the bond b Call Feature Allows the Issuer to repurchase the bond before the maturity date i Deferred callable bonds have a initial period in which the bond cannot be called 9 Price Yield Coupon Relationships to Bonds a Price The present value of a bond price represents the value of future dollars as seen from today s interest rates i Bond Value Sum Coupon 1 r t Par Value 1 r t ii Price Coupon 1 r 1 1 1 r t Par Value 1 1 r t iii Bond price falls as the market interest rate rises iv The inverse relationship between prices and yields is a central feature of fixed income securities Interest rate fluctuations represent the main source of risk in the bond market b Yield The YTM is the discount rate that makes the present value of a bond s payments v equal to its price i Bond equivalent yields use simple interest to annualize rates ii EFFECTIVE annual yields account for compound interest iii The YTM can also be described as the internal rate of return on the investment in the bond iv Current Yield Annual Coupon Price of the Bond v Premium Bonds Bonds that sell above par value Coupon Rate Current Yield vi Discount Bonds Bonds that sell below par value Coupon Rate Current Yield c Coupon A bonds annual interest payment per dollar of par value i Realized Compound Rate of Return is the rate of return calculated on the premise all coupons are reinvested until maturity Realized Rate of Return V0 1 r 2 V2 ii Horizon Analysis Analysis of bond returns over a multi year timeline based on forecasts of a bond s YTM and reinvestment rate of coupons iii Reinvestment Rate Risk Uncertainty surrounding the cumulative future value of reinvested bond coupon payments iv Zero Coupon Bonds Treasury Strips Provides no cash flow or coupon except for the payment at maturity sold at a discount U S T bills are an example STRIPS are a series of independent coupons which are stripped from a larger coupon bearing bond and each reissued as zero coupon bonds 10 Calculate Present Value of a Bond Use your financial calculator and fill in all functions then hit calculate PV 11 Correlation Coefficient Risk measures a Correlation Coefficient 12 Expected Rate of Return a Expected return on the portfolio is the expected return on each weighted security in the portfolio i E rp wbE rb wsE rs 13 Types of Risks with Stock Portfolio a Risk factors common to the whole economy b Risks that can be