Chapter 7 (Bonds, interest rates)

Bonds

financial securities sold by companies or governments to borrow money from the public on a long-term basis

Seller (borrower)

company or government

Buyer (lender)

investors, other companies, Gov’ts

When yield to maturity goes down,

bond value goes up

If YTM > coupon rate, Bond value < $1,000

Discount bond

If YTM = coupon rate, Bond value = $1,000

Bond sells at par

If YTM < coupon rate. Bond value > $1,000

Premium bond

Higher TTM

higher interest rate sensitivity

Lower coupon rate

higher interest rate sensitivity

Indenture

written agreement between the company (Borrower) & bondholders (Creditors)

Term Structure of Interest Rates

Relationship between time to maturity and rates for different bonds

Real interest rate (factor affecting nominal interest rates for different bonds)

Bare minimum return that investors want to get

Interest rate risk

sensitivity of bond price to changes in interest rates. Increases with longer maturity or lower coupon rate

Inflation premium (factor affecting nominal interest rates for different bonds)

Additional return that investors want to get as a compensation for the erosion of their investment return due to expected inflation

Interest rate risk premium (factor affecting nominal interest rates for different bonds)

Additional return that investors want to get as a compensation for the interest rate risk which increases with time to maturity

• Longer time to maturity —> higher premium

Default risk premium (factor affecting nominal interest rates for different bonds)

Additional return that investors want to get as a compensation for the potential risk of default. Higher compensation for lower-rated bonds

Taxability premium (factor affecting nominal interest rates for different bonds)

Additional return that investors want to get as a compensation for unfavorable tax treatment

Liquidity premium (factor affecting nominal interest rates for different bonds)

Additional return that investors want to get as a compensation for buying bonds that can not be easily purchased or resold