FINANC 3000 1st Edition Lecture 11 Outline of Last Lecture I. BondsII. Treasury Inflation-Protected SecuritiesIII. Bond PricingOutline of Current LectureI. Interest Rate RiskII. YieldIII. Municipal BondsIV. RiskCurrent LectureInterest Rate Risk- Interest Rate Risk – the chance of capital loss due to interest rate fluctuations- When interest rates change substantially(and quickly) bondholders can experience large gains or losses (article)- Short-term bonds are less affected by interest rate risk than longer term bonds- Can avoid interest rate risk by holding bond to maturityReinvestment Risk and Interest Rate Risk- Bonds with longer maturities and smaller coupon rate have the highest interest rate risk Reinvestment Rate Risk – the chance that future interest payments will have to be reinvested at a lower interest rate- Risk that interest payment received couldn’t be invested at the same rate as original investment- Risk that when you receive your principal back, you can’t invest it at the same high rate as beforeThese 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.- When interest rate increase bond prices of longer term bonds decline more than shorterterm bonds- Bonds with longer maturities and smaller coupon rate have the highest interest rate riskCurrent Yield- Current Yield measures the rate of return a bondholder would earn annually from the coupon interest payments alone if the bond were purchased at the current market price- Doesn’t account for capital gains or losses that will occur from purchasing the bond at premium or discount- Current Yield = Annual Coupon Rate/Current Market PriceYield to Maturity- Yield to Maturity – The discount rate equating price and PV of payments.- Shows total rate of return investors might expect from the bond including capital gains or losses and interest payments- To calculate, must solve for i in PV formula - Or find i/y using your calculator- Link between bond’s yield to maturity and market’s prevailing interest rate- If bond is priced correctly, the market interest rate will equal the yield to maturityBond Yields- Yield to Call – return earned before the bond gets repaid- Return calculated assuming par value and call premium received at the earliest possible date- Subject the bondholder to reinvestment risk and limit upside gaino Price of callable bond = Present value of interest payments to call data + Present value of call priceo N is the number of periods until the bond can be called and i is the prevailing market rateMunicipal Bonds- Par value is usually $5,000 instead of $1,000- Interest paid on municipal bonds is not subject to federal taxation, and often not subject to taxation in home state- Normally, yields are lower than for similar Treasuries because of tax effect, but not this year- Check out this article:- “Munis Yield as Much as Corporate Bonds -- Bargains for Tax Payers” on Barron’sMunicipal Bond- Compare after tax returns on 7% corporate bond and 5% municipal bond on $100,000 investment- Corporate: 7%x$100,000x(1-0.35)=$4,550- Municipal: 5%x$100,000=$5,000- For high income investors(subject to 35% tax) 5% muni is better than 7% corporate- Formula:Bond Yields- Rate of Return - Earnings per period per dollar invested.o Rate of Return = gain/paino Rate of return = total income/total investmento Rate of return = (coupon income + price change)/investmentCredit Risk- Credit Quality Risk(default risk) – the chance that issuer will not make timely interest payments or even default- Rating agencies: Moody’s, Standard and Poor and Fitch Ratingo Monitor corporate, U.S. Agency and municipal debt over bond’s lifetime and report their findings as a ratingo Get paid by issuers to issue a credit rating, so freely available to publico Possible conflict of interesto Important because defaults happen, for example AmeriServe Food DistributionCredit Rating- Bond carrying investment grade rating pay lower interest- Speculative grade bonds are also called junk bonds and pay high interest to attract investors- Once the rating is issued rating agencies continue to monitor the issuer and reevaluate rating every 6 to 12 months- Standard & Poor’s assigns outlooks, which may be “positive,” “negative,” “stable,” or “developing”, to its long-term credit rate. Bond Characteristics- Senior bond vs. junior bondo Senior is debt that takes priority over other unsecured or otherwise more "junior“ or subordinated debt owed by the issuero Senior debt is often secured by collateral on which the lender has put in place a first lien- Secured bond vs. unsecured bond(debentures)o Secured bond are secured by pledge of assets or collateralo Unsecured bonds have claim on the leftover assets- Convertible bond – can be swapped for a fixed number of shares any time before maturity- Bonds with warrants – warrants give the option to the bondholder to buy company’s stock at fixed price. Because of this feature, these bonds are issued with low coupon rateCredit Risk and Yield- Yield is affected by credit risko Lower quality bonds offer higher yieldso Higher quality bonds offer lower yieldso Spread(or credit risk premium) between differently rated bonds differs over timeBond Markets- Decentralized, over-the-counter trading- Total dollar amount of bonds outstanding is a lot larger than total amount of equity outstanding- Most trades occur between bond dealers and large institutions- In 2002 TRACE was implemented to improve price transparency- Dealers buy for their inventory and sell from inventory- Small number of corporate bonds are traded on