What is debt?

• Introduction to Debt

  • Definition: Debt involves borrowing money to be repaid in the future.

  • Types of Debt Instruments:

    • Bill: Short-term debt with principal payments within a year.

    • Bond: Long-term debt with promised future payments and a maturity date.

  • Bondholders receive periodic interest payments and principal at maturity.

  • Default consequences: Failure to pay can lead to bankruptcy.

What are some bond terminologies?

• Bond Terminology

  • Face Value (Par Value): Principal amount borrowed, typically $1000 for corporate bonds.

  • Maturity: Final repayment date of the bond.

How does coupon payment work?

• Bond Terminology Continued

  • Coupon Payments (CPN): Interest payments on bonds. Pay twice a year.

    

    • Coupon Rate: Rate at which coupons are paid, expressed as APR.

      

  • Yield to Maturity (YTM): Market required rate of return for bonds, used as a discount rate. Yield twice a year.

How to calculate present value of bond?

• Bond Pricing

  • Bond present value = Present value of interest payments + Present value of principal.

  • Formula:

    

  • Where ( r_d ) is the yield to maturity, similar to EAR, only use it when the compounding effect is different.

    

What is a zero-coupon bond?

• Zero Coupon Bonds

  • No coupon payments; only one payment at maturity.

  • Pricing formula:

    

  • Typically sold at a discount.

What is bond yield?

• Bond Yields

  • Yield to maturity is the discount rate that equates present value of payments to bond price.

  • Changes daily with interest rate fluctuations.

What is the relationship between interest rates, bond yields and bond prices?

• Bond Price and YTM Relationship

  • Inverse relationship: As interest rates and bond yields rise, bond prices fall, and vice versa.

What is the relationship of coupon rate and yield to maturity?

• Coupon Rate vs. Yields to Maturity

  • If coupon rate = YTM, bond sells at face value (par bond).

  • If coupon rate < YTM, bond sells at a discount.

  • If coupon rate > YTM, bond sells at a premium.

What is the relationship of bond price and face value?

• If bond price = face value, bond sells at face value (par bond).

• If bond price < face value, bond sells at a discount.

• If bond price > face value, bond sells at a premium

How to invest in bonds?

• Bond Theorem Applications

  • If rates are expected to increase, avoid long-term/low coupon bonds.

  • If rates are expected to decline, consider investing in long-term/low coupon bonds.

What are some risks with bond?

• Bond Risk Characteristics: Maturity

  • Long-term bonds are more sensitive to interest rate changes than short-term bonds.

  • Interest rate risk increases with maturity.

• Bond Risk Characteristics: Coupon Payments

  • Lower coupon bonds are more sensitive to interest rate changes than higher coupon bonds.

• Corporate Bond Yields

  • Bonds with credit risk yield higher returns than default-free bonds.

Credit Risk in Bonds:

• Credit risk refers to the possibility that a bond issuer will default on its debt obligations, failing to make interest payments or repay the principal at maturity.

• Default risk is the risk of non-payment, risk that lender may not receive payments as promised.

How to rate bonds?

• Investment Grade Bonds

  • Aaa/AAA: Best quality, lowest risk.

  • Aa/AA: High quality, lower than Aaa.

  • A/A: Upper-medium grade.

  • Baa/BBB: Medium grade, some speculative characteristics.

• Speculative Bonds

  • Ba/BB: Speculative elements, moderate protection.

  • B/B: Lacks desirable investment characteristics.

  • Caa/CCC: Poor standing, may be in default.

  • C/C/D: Extremely poor prospects.