FINANC 3000 1st Edition Lecture 10 Outline of Last Lecture I. Financial InstitutionsII. Federal ReserveIII. Interest RateIV. InflationV. RiskVI. Yield CurveVII. TheoriesOutline of Current Lecture I. BondsII. Treasury Inflation-Protected SecuritiesIII. Bond PricingCurrent LectureBonds- Loans issued by corporations, US treasury, and state and local governments- Also known as fixed income securities – produces a fixed income stream- Requires a regular interest payment and eventually a repayment of principal- Indenture agreement outlines the precise terms between the issuer and the bondholder- Terminologyo Bond: security that obligates the issuer to make specified payments to the bondholdero Coupon: the interest payments made to the bondholdero Coupon Rate: annual interest payment, as a percentage of the face valueo Par Value or Face Value: the principal loan amount that the borrower must repayThese notes represent a detailed interpretation of the professor’s lecture. GradeBuddy is best used as a supplement to your own notes, not as a substitute.o Current Yield: coupon payment divided by current priceo Yield to Maturity: the discount rate equating price and PV of paymentso Maturity date: the date the principal will be repaido Time to maturity: time that is remaining till maturity, i.e. 2 years, 5 years, 10 years. Bond can be classified as short-term, medium-term, or long-term.o Call Feature: issuers can “call” back the loan and repay the principal before the maturity date. Pay call premiumCash Flows of a Typical Bond- In 1995, Advanced Micro Devices issued a 6% semi-annual coupon bond that matured January 1, 2005.- To calculate interest incomeo $1000 * 6% = $60- $30 was payable every January 1 and July 1- The face value was $1000Bonds- WARNINGo The coupon rate IS NOT the discount rate used in the Present Value calculationso The coupon rate merely tells us what cash flow the bond will produceo Since the coupon rate is listed as a percentage, this misconception is quite commonBond Issuers- US Treasuryo Sells treasury bills, notes and bonds to financial deficit- Corporationso Issue bonds to finance investments in plant and equipment, R&D and general business development- Municipalitieso State and local governments borrow money to build, repair and improve infrastructure General obligation bonds- Used for projects that benefit the whole community, such as schools and courthouses. Repaid using tax revenue Revenue Bonds- Used for projects that benefit certain group of people such as toll road or airports. Repaid from user feesTreasury Inflation-Protected Securities (TIPS)- Interest rate (coupon rate) is fixed but part value is indexed to inflation by using CPI index- Though the rate is fixed, interest payments vary because the rate is applied to the adjusted principal- The amount of each interest payment is determined by multiplying the adjusted principal by one-half the interest rate- To calculate interest payments on TIPSo Compute TIPS index ratio by dividing current CPI by at-issue CPIo Multiply your original principal amount by the index ratio. This is your inflation-adjusted principalo Multiply your inflation-adjusted principal by half the stated coupon rate on your security (i.e. 2%). The resulting number is your semi-annual interest paymentOther Types of Bonds- US Government agency securities issue agency bondso Fannie Mae, Freddie Mac, Federal Farm Credit system, Federal Home Loan Banko To provide low cost financing for desirable private sector activitieso Have implicit government backing, very safeo Have higher interest rate than US treasuries- Mortgage backed securitieso Securities whose interest and par value payments originate from real estate mortgage payments Fannie Mae and Freddie MacBond Price- At issue trades at par value, usually initial par value is $1000- At maturity date, investors receive par value- In between price of bond can vary depending on the interest rate- Bonds rarely trade at par value on the secondary market- Bond prices are quoted as percentages of par value rather than dollar terms- Bond quoted at 115 actually cost $1150, quoted at 87 costs $870Coupon Rate- Coupon rate set at time of issue, depends on:o The default risk of the companyo The term of the loan (interest rate risk)o The level of interest in the overall economyBond Pricing- The price of a bond is the Present Value of all cash flows generated by the bond (i.e. coupons and face value) discounted at the prevailing market interest rate. Prevailing market interest rate depends on bonds term to maturity, credit quality and tax status-Zero Coupon Bond- Bond pays no interest payments- Pays only par value at maturity ->sells at substantial discount- To find sales price of zero coupon bond, use PV formula- Find price of zero coupon bond that is priced to yield 6% and matures in 20 yearsCompound interest: Compounding Periods- Find price of zero coupon bond that is priced to yield 6% and matures in 20 years. Pays semi-annually-Bond Pricing- Ex.o What is the price of a 6% annual coupon bond, with a $1000 face value, which matures in 3 years? Assume a required return of 5.6%.oDeep thoughts on Bond Pricing- If the coupon rate < discount rate then the bond sells for a discount (price < par).- If the coupon rate = discount rate then the bond sells for par (price=par)- If the coupon rate > discount rate then the bond sells for a premium (price >par)Pricing Semi-Annual Coupon BondsPV =$ 60(1. 056 )1+$ 60(1. 056 )2+$ 1 , 0 60(1 . 056)3PV =$ 1, 010 . 77- What is the price of our bond if the required rate of return is 5.6% and the coupons are paid semi-annually?o Semi-annual N=6, I/Y=5.6/2, PV= -$1,010.91, PMT=30, FV=$1000o Annually N=3, I/Y=5.6, PV= -$1,010.77, PMT = 60, FV =