CH 10: Bond Prices and Yields

Straight bond

An IOU that obligates the issuer of the bond to pay the holder of the bond. The lower the bond rating, the higher the coupon rate the issuer would have to pay.

Yield to maturity (YTM)

PV of bonds coupon payments + PV of bonds FV

The actual overall rate of return. Coupon rate is used to calculate the annual interest amount.

Convertible bonds

Protects the principle on the downside but provides an opportunity to participate in the upside if the company’s stock is rising.

Added benefit to investors; issued at lower coupon rates compared to standard bond issues.

Mostly issued by companies experiencing high growth, but with poor credit rating to entice investors.

Retractable bonds

Allows bondholders to redeem their bonds with the issuer at par before the maturity date.

Bondholders are protected from interest rate risk.

Pay lower coupon rates than standard bonds w/o the feature.

Like a bond with a put option (Forces issuer to buyback bond early)

Callable bonds

Allows issuer to call or buy back the bond issue prior to the maturity date at a specified call price.

A call will generally occur when the market interest rates drop below the issued coupon rate; issuer can reissue the bond at a lower coupon rate.

Issuers pay a higher coupon rate.

Some callable bonds have a make-whole provision.

Under the provision, the issuer must call back the bond at the NPV of the remaining scheduled coupon payments and the principle

Interest rate risk

the possibility that changes in interest rates will result in losses in the bonds value.

Bond prices move in the opposite direction to interest rate movements.

Premium bonds

Coupon rate > YTM ; Price > Face

Discount bonds

Coupon rate = YTM ; Price = Face

Macaulay Duration

measurement of how long it takes for the price of a bond to be repaid by its internal cash flows.

Also measures the sensitivity of a bond price to changes in bond yields

Reinvestment Risk

the uncertainty about the value of the portfolio on the target date due to fluctuating yields.

Immunization

the term for constructing a dedicated portfolio such that the uncertainty surrounding the target date value is minimized.