Notes_Bonds and Interest Rates

Investment Policy Overview

  • Key Focus Areas:

    • Bonds: Traded Debt, Bond Pricing, Interest Rates, Credit, and Yield Curves.

    • Corporate finance's role in maximizing firm value through financial policies.

Bonds

  • Definition: Bonds are tradable debt instruments issued by corporations or governments to raise funds.

  • Types of Bonds:

    • Marketable Securities: Bills, notes, and bonds.

    • Non-Marketable Securities: Loans, mortgages, insurance policies, and private equity.

  • How Bonds Work: They promise to pay the par value back at maturity along with periodic interest payments (coupons).

Bond Pricing

  • Bond Value Calculation:

    • Bonds are priced as present values of future cash flows:[ \text{Bond Value} = PV(Coupons) + PV(Par Value) ]

    • Cash flows include periodic interest payments and the par value paid at maturity.

  • Impact of Interest Rates:

    • Inversely related to bond prices:

      • When interest rates rise, bond prices fall and vice versa.

    • Rates can vary based on bond maturity; longer maturities generally carry higher risk.

Yield to Maturity (YTM)

  • Definition: YTM is the rate that equates the present value of a bond's cash flows to its price. It represents the internal rate of return for an investor if the bond is held to maturity.

  • Calculation methods involve:

    • Using Excel functions like YIELD or GOAL SEEK to determine the yield rate.

Default Risk & Credit Spreads

  • Default Risk: Refers to the risk that a bond issuer will not make the required payments.

    • Bonds can be categorized by credit ratings:

      • Investment-Grade Bonds: High credit ratings (e.g., BBB and above).

      • Speculative-Grade (Junk) Bonds: Low credit ratings (e.g., BB and below).

  • Credit Spreads: The extra yield that investors demand to compensate for default risk.

Term Structure of Interest Rates

  • Yield Curves: Graphs that depict the relationship between bond yields and maturities.

    • Normal Yield Curve: Ascending; indicates a growing economy.

    • Inverted Yield Curve: Descending; may signal a recession.

  • Changes Over Time: Yield curves vary based on economic conditions and central bank policies.

Practical Examples

  • Bond Pricing Examples:

    • Bonds priced at par, discount, or premium depending on the relationship between the coupon rate and the market interest rate.

    • Examples include calculations of present values of cash flows at different interest rates for straightforward bond valuation.

  • Bonds and Accrued Interest: When bonds are bought or sold, accrued interest since the last coupon payment must be accounted for:

  • [ \text{Accrued Interest} = \frac{\text{Coupon Payment}}{\text{Days in Coupon Period}} \times \text{Days Since Last Coupon} ]

Conclusion

  • Understanding bonds requires knowing how they are priced, the risks involved (especially default risks), yield calculation methods, and how interest rates affect bond values. This foundational knowledge is crucial for anyone involved in financial sectors, particularly those focusing on corporate finance and investment strategies.