BOND FUNDAMENTALS
CHAPTER FOUR
Practical Investment Management
Robert A,Strong
1
4 - 2Strong C4 – Bond Fundamentals
Bond Principles,Identification of Bonds
? Bonds are identified by issuer,coupon
rate,and maturity.
? The face value of a bond is called its par
value.
? e.g,5 of,Hertz sevens of 03” (Hertz 7s03)
? A legal document called the indenture
contains the details of the bond issue.
4 - 3Strong C4 – Bond Fundamentals
a,government e.g,US Treasury,federal agency,
state,local
b,corporation e.g,industrial,utility,financial,
transportation
c,others e.g,foreign government,foreign
corporation,World Bank
Bond Principles,Classification of Bonds
Method 1,By issuer
4 - 4Strong C4 – Bond Fundamentals
Bond Principles,Classification of Bonds
Insert Table 4-1 here.
4 - 5Strong C4 – Bond Fundamentals
a,unsecured debt - backed by faith in the taxing
power of the government,or the good name of
the company (debenture)
b,secured debt e.g,revenue bond,assessment
bond,mortgage,collateral trust bond,
equipment trust certificate
Bond security sometimes comes from non-traditional
sources,Recently,some rock stars floated bonds
using their future earnings as backing.
Method 2,By security
Bond Principles,Classification of Bonds
4 - 6Strong C4 – Bond Fundamentals
Method 3,By term
a,short-term - ? a year e.g,US Treasury bills
b,intermediate-term e.g,US Treasury notes
(2 to 10 years )
c,long-term e.g,US Treasury bonds (? 10 years)
d,open-ended e.g,corporate line of credit
e,serial bond - a portfolio of bonds with
staggered terms
Bond Principles,Classification of Bonds
4 - 7Strong C4 – Bond Fundamentals
Bond Principles,Classification of Bonds
Insert Table 4-2 here.
4 - 8Strong C4 – Bond Fundamentals
? interest only - the periodic payments are
entirely interest
? sinking fund - periodically,a portion of the
debt principal is set aside or a
certain number of the bonds is
retired
? balloon loan - the debt may be partially
amortized with each payment
? income bond- interest is payable only if it is
earned
Bond Principles,Terms of Repayment
? annuities - most bonds are annuities plus an
ultimate repayment of principal
? zero coupon - only the par value is returned
at maturity
? variable (adjustable) rate - the rate fluctuates
in accordance with some market
index or predetermined schedule
? consols - a level rate of interest is paid
perpetually
? inflation-indexed Treasury bonds - the
principal value is adjusted based
on the consumer price index
South-Western / Thomson Learning ? 2004 4 - 9
Bond Principles,Bond Cash Flows
4 - 10Strong C4 – Bond Fundamentals
? convertible bond - may be exchanged for
common stock in the
company that issued the
bond
? exchangeable bond - may be exchanged for
shares in another firm
Bond Principles,Options
4 - 11Strong C4 – Bond Fundamentals
? bearer (coupon) bonds - belong to whomever
legally hold them; no longer
issued in the United States
because of tax considerations
? registered bonds - the bonds show the
bondholder’s name
? book entry bonds - bond ownership is
reflected only in the
accounting records
Bond Principles,Registration
4 - 12Strong C4 – Bond Fundamentals
Basic
Information
Cur Net Bonds Yld Vol Close Chg.
AMR 9s16 8.4 23 107 + ?
Footnotes
cv - convertible zr - zero coupon
vj - bankruptcy dc - deep discount
f - trading flat
Government
Bonds
Maturity AskRate Mo/Yr Bid Asked Chg,Yld.
6 Feb 26 86:09 86:11 - 9 7.11
The Financial Page Listing
4 - 13Strong C4 – Bond Fundamentals
? ? ? ?
p r e s e n t t h e f r o m p e r i o d s s e m i a n n u a l in t i m e
r a t ed i s c o u n t
p e r i o d s s e m i a n n u a l in b o n d t h e of t e r m w h e r e
1
v a l u e p a r
1
i n t e r e s t
a l )P V ( p r i n c i p t)P V ( i n t e r e s p r i c e b o n dc u r r e n t
1
?
?
?
?
?
?
?
??
?
?
t
r
n
rr n
n
t
t
22
1,Annuities
The bond pricing relationship is customarily
expressed in terms of semiannual periods.
Bond Pricing & Returns,Valuation Equations
4 - 14Strong C4 – Bond Fundamentals
2,Zero Coupon Bonds
? ? nr 1
v a l u e p a r a l )P V (p r i n c i p p r i c e bondc u r r e n t
?
??
3,Variable Rate Bonds
?
? ?
?
?
?
?
? ?
?
n
t
ttr
t
1 21
t i m ea t f l o w c a s h
p r i c e bondc u r r e n t
Bond Pricing & Returns,Valuation Equations
4 - 15Strong C4 – Bond Fundamentals
4,Consols
? ?
r
t
r
t
t
t
ti meat fl o w cash
ti meat fl o w cash
p r i ce bondcu r r en t
?
?
? ?
?
? 1 1
Bond Pricing & Returns,Valuation Equations
4 - 16Strong C4 – Bond Fundamentals
The yield to maturity is the single
interest rate that,when applied to
the stream of cash flows associated
with a bond,causes the present
value of those cash flows to equal
the bond’s market price.
Bond Pricing & Returns,Yield to Maturity
4 - 17Strong C4 – Bond Fundamentals
? ?
val u e) 0,4(p ar p r i ce) 0,6(mar ket
matu r i ty u n ti l year s
val u e p ar - p r i cemar ket -i n ter est an n u al
Y T M ap p r o x
?
?
A heuristic:
Bond Pricing & Returns,Yield to Maturity
4 - 18Strong C4 – Bond Fundamentals
Bond Pricing & Returns,Yield to Maturity
? The yield to maturity calculation carries an
assumption that coupon proceeds are
reinvested at the yield to maturity.
? If a bond pays periodic interest,it is not
possible to lock in a prescribed yield to
maturity.
4 - 19Strong C4 – Bond Fundamentals
? A plot of interest rates against time to
maturity is known as a yield curve.
yield
time
Bond Pricing & Returns,Yield to Maturity
4 - 20Strong C4 – Bond Fundamentals
Bond Pricing & Returns,Yield to Maturity
Insert Figure 4-4 here.
4 - 21Strong C4 – Bond Fundamentals
? A spot rate is the yield to maturity of
a zero coupon security of the
chosen maturity.
? A treasury strip is a government bond or note
that has been decomposed into two parts,one
for the stream of interest payments and one
for the return of principal at maturity.
? The yield to maturity is a derived statistic after
the bond price is known.
Bond Pricing & Returns,Spot Rates
4 - 22Strong C4 – Bond Fundamentals
? The yield to maturity can be thought of as an
“average” of the spot rates,or as a flat yield
curve at some constant interest rate.
? This single interest rate makes the present
value of the future cash flows equal to the
bond’s market price.
%
Term
Yield to Maturity
Spot Rate Curve
Bond Pricing & Returns,Spot Rates
4 - 23Strong C4 – Bond Fundamentals
Bond Pricing & Returns,Spot Rates
Insert Figure 4-5 here.
4 - 24Strong C4 – Bond Fundamentals
Realized Compound Yield:
y ea rp e r p a y m e n ts of n u m b e r
m at u r i ty to y i e l d wh e r e
1 r a te a n n u a l e f fec t i v e
?
?
??
?
?
?
?
?
??
x
r
x
r
x
1
How can two investments paying
interest on two different time
schedules be compared?
Bond Pricing & Returns
4 - 25Strong C4 – Bond Fundamentals
? The current yield only measures the return
associated with the bond’s interest
payments.
? A bond whose market price is less than its
par value is selling at a discount,The price
of such bonds rise as maturity
approaches.
? If the market price is more than the par
value,the bond is selling at a premium,
Bond Pricing & Returns,Current Yield
4 - 26Strong C4 – Bond Fundamentals
Bond Pricing & Returns,Current Yield
Insert Figure 4-6 here.
4 - 27Strong C4 – Bond Fundamentals
? Interest is earned for each day that a bond
is held,although interest payments are
generally made twice a year only.
? A bond buyer must pay the accrued interest
to the seller of the bond.
? dirty price = bond price + accrued interest
clean price = bond price
? By convention,accrued interest is
calculated using a 360-day year,
Bond Pricing & Returns,Accrued Interest
4 - 28Strong C4 – Bond Fundamentals
? default risk - the possibility that the issuer
of the bond is unable to pay
- rated by agencies like Moody’s
and Standard & Poor’s
Bond Risks,Price Risks
4 - 29Strong C4 – Bond Fundamentals
Bond Risks,Price Risks
Insert Table 4-5 here.
4 - 30Strong C4 – Bond Fundamentals
? interest rate risk - the chance of loss due to
changing interest rates
Bond Risks,Price Risks
4 - 31Strong C4 – Bond Fundamentals
? call risk - the possibility that the company
will exercise a bond’s call feature
Bond Risks,Convenience Risks
4 - 32Strong C4 – Bond Fundamentals
? reinvestment rate risk - the chance that the
interest received cannot be
reinvested to earn as much as the
bond’s original yield to maturity
- the higher the coupon on a bond,
the higher its reinvestment rate risk
? marketability risk - the difficulty of selling a
bond in the secondary
market
Bond Risks,Convenience Risks
CHAPTER FOUR
Practical Investment Management
Robert A,Strong
1
4 - 2Strong C4 – Bond Fundamentals
Bond Principles,Identification of Bonds
? Bonds are identified by issuer,coupon
rate,and maturity.
? The face value of a bond is called its par
value.
? e.g,5 of,Hertz sevens of 03” (Hertz 7s03)
? A legal document called the indenture
contains the details of the bond issue.
4 - 3Strong C4 – Bond Fundamentals
a,government e.g,US Treasury,federal agency,
state,local
b,corporation e.g,industrial,utility,financial,
transportation
c,others e.g,foreign government,foreign
corporation,World Bank
Bond Principles,Classification of Bonds
Method 1,By issuer
4 - 4Strong C4 – Bond Fundamentals
Bond Principles,Classification of Bonds
Insert Table 4-1 here.
4 - 5Strong C4 – Bond Fundamentals
a,unsecured debt - backed by faith in the taxing
power of the government,or the good name of
the company (debenture)
b,secured debt e.g,revenue bond,assessment
bond,mortgage,collateral trust bond,
equipment trust certificate
Bond security sometimes comes from non-traditional
sources,Recently,some rock stars floated bonds
using their future earnings as backing.
Method 2,By security
Bond Principles,Classification of Bonds
4 - 6Strong C4 – Bond Fundamentals
Method 3,By term
a,short-term - ? a year e.g,US Treasury bills
b,intermediate-term e.g,US Treasury notes
(2 to 10 years )
c,long-term e.g,US Treasury bonds (? 10 years)
d,open-ended e.g,corporate line of credit
e,serial bond - a portfolio of bonds with
staggered terms
Bond Principles,Classification of Bonds
4 - 7Strong C4 – Bond Fundamentals
Bond Principles,Classification of Bonds
Insert Table 4-2 here.
4 - 8Strong C4 – Bond Fundamentals
? interest only - the periodic payments are
entirely interest
? sinking fund - periodically,a portion of the
debt principal is set aside or a
certain number of the bonds is
retired
? balloon loan - the debt may be partially
amortized with each payment
? income bond- interest is payable only if it is
earned
Bond Principles,Terms of Repayment
? annuities - most bonds are annuities plus an
ultimate repayment of principal
? zero coupon - only the par value is returned
at maturity
? variable (adjustable) rate - the rate fluctuates
in accordance with some market
index or predetermined schedule
? consols - a level rate of interest is paid
perpetually
? inflation-indexed Treasury bonds - the
principal value is adjusted based
on the consumer price index
South-Western / Thomson Learning ? 2004 4 - 9
Bond Principles,Bond Cash Flows
4 - 10Strong C4 – Bond Fundamentals
? convertible bond - may be exchanged for
common stock in the
company that issued the
bond
? exchangeable bond - may be exchanged for
shares in another firm
Bond Principles,Options
4 - 11Strong C4 – Bond Fundamentals
? bearer (coupon) bonds - belong to whomever
legally hold them; no longer
issued in the United States
because of tax considerations
? registered bonds - the bonds show the
bondholder’s name
? book entry bonds - bond ownership is
reflected only in the
accounting records
Bond Principles,Registration
4 - 12Strong C4 – Bond Fundamentals
Basic
Information
Cur Net Bonds Yld Vol Close Chg.
AMR 9s16 8.4 23 107 + ?
Footnotes
cv - convertible zr - zero coupon
vj - bankruptcy dc - deep discount
f - trading flat
Government
Bonds
Maturity AskRate Mo/Yr Bid Asked Chg,Yld.
6 Feb 26 86:09 86:11 - 9 7.11
The Financial Page Listing
4 - 13Strong C4 – Bond Fundamentals
? ? ? ?
p r e s e n t t h e f r o m p e r i o d s s e m i a n n u a l in t i m e
r a t ed i s c o u n t
p e r i o d s s e m i a n n u a l in b o n d t h e of t e r m w h e r e
1
v a l u e p a r
1
i n t e r e s t
a l )P V ( p r i n c i p t)P V ( i n t e r e s p r i c e b o n dc u r r e n t
1
?
?
?
?
?
?
?
??
?
?
t
r
n
rr n
n
t
t
22
1,Annuities
The bond pricing relationship is customarily
expressed in terms of semiannual periods.
Bond Pricing & Returns,Valuation Equations
4 - 14Strong C4 – Bond Fundamentals
2,Zero Coupon Bonds
? ? nr 1
v a l u e p a r a l )P V (p r i n c i p p r i c e bondc u r r e n t
?
??
3,Variable Rate Bonds
?
? ?
?
?
?
?
? ?
?
n
t
ttr
t
1 21
t i m ea t f l o w c a s h
p r i c e bondc u r r e n t
Bond Pricing & Returns,Valuation Equations
4 - 15Strong C4 – Bond Fundamentals
4,Consols
? ?
r
t
r
t
t
t
ti meat fl o w cash
ti meat fl o w cash
p r i ce bondcu r r en t
?
?
? ?
?
? 1 1
Bond Pricing & Returns,Valuation Equations
4 - 16Strong C4 – Bond Fundamentals
The yield to maturity is the single
interest rate that,when applied to
the stream of cash flows associated
with a bond,causes the present
value of those cash flows to equal
the bond’s market price.
Bond Pricing & Returns,Yield to Maturity
4 - 17Strong C4 – Bond Fundamentals
? ?
val u e) 0,4(p ar p r i ce) 0,6(mar ket
matu r i ty u n ti l year s
val u e p ar - p r i cemar ket -i n ter est an n u al
Y T M ap p r o x
?
?
A heuristic:
Bond Pricing & Returns,Yield to Maturity
4 - 18Strong C4 – Bond Fundamentals
Bond Pricing & Returns,Yield to Maturity
? The yield to maturity calculation carries an
assumption that coupon proceeds are
reinvested at the yield to maturity.
? If a bond pays periodic interest,it is not
possible to lock in a prescribed yield to
maturity.
4 - 19Strong C4 – Bond Fundamentals
? A plot of interest rates against time to
maturity is known as a yield curve.
yield
time
Bond Pricing & Returns,Yield to Maturity
4 - 20Strong C4 – Bond Fundamentals
Bond Pricing & Returns,Yield to Maturity
Insert Figure 4-4 here.
4 - 21Strong C4 – Bond Fundamentals
? A spot rate is the yield to maturity of
a zero coupon security of the
chosen maturity.
? A treasury strip is a government bond or note
that has been decomposed into two parts,one
for the stream of interest payments and one
for the return of principal at maturity.
? The yield to maturity is a derived statistic after
the bond price is known.
Bond Pricing & Returns,Spot Rates
4 - 22Strong C4 – Bond Fundamentals
? The yield to maturity can be thought of as an
“average” of the spot rates,or as a flat yield
curve at some constant interest rate.
? This single interest rate makes the present
value of the future cash flows equal to the
bond’s market price.
%
Term
Yield to Maturity
Spot Rate Curve
Bond Pricing & Returns,Spot Rates
4 - 23Strong C4 – Bond Fundamentals
Bond Pricing & Returns,Spot Rates
Insert Figure 4-5 here.
4 - 24Strong C4 – Bond Fundamentals
Realized Compound Yield:
y ea rp e r p a y m e n ts of n u m b e r
m at u r i ty to y i e l d wh e r e
1 r a te a n n u a l e f fec t i v e
?
?
??
?
?
?
?
?
??
x
r
x
r
x
1
How can two investments paying
interest on two different time
schedules be compared?
Bond Pricing & Returns
4 - 25Strong C4 – Bond Fundamentals
? The current yield only measures the return
associated with the bond’s interest
payments.
? A bond whose market price is less than its
par value is selling at a discount,The price
of such bonds rise as maturity
approaches.
? If the market price is more than the par
value,the bond is selling at a premium,
Bond Pricing & Returns,Current Yield
4 - 26Strong C4 – Bond Fundamentals
Bond Pricing & Returns,Current Yield
Insert Figure 4-6 here.
4 - 27Strong C4 – Bond Fundamentals
? Interest is earned for each day that a bond
is held,although interest payments are
generally made twice a year only.
? A bond buyer must pay the accrued interest
to the seller of the bond.
? dirty price = bond price + accrued interest
clean price = bond price
? By convention,accrued interest is
calculated using a 360-day year,
Bond Pricing & Returns,Accrued Interest
4 - 28Strong C4 – Bond Fundamentals
? default risk - the possibility that the issuer
of the bond is unable to pay
- rated by agencies like Moody’s
and Standard & Poor’s
Bond Risks,Price Risks
4 - 29Strong C4 – Bond Fundamentals
Bond Risks,Price Risks
Insert Table 4-5 here.
4 - 30Strong C4 – Bond Fundamentals
? interest rate risk - the chance of loss due to
changing interest rates
Bond Risks,Price Risks
4 - 31Strong C4 – Bond Fundamentals
? call risk - the possibility that the company
will exercise a bond’s call feature
Bond Risks,Convenience Risks
4 - 32Strong C4 – Bond Fundamentals
? reinvestment rate risk - the chance that the
interest received cannot be
reinvested to earn as much as the
bond’s original yield to maturity
- the higher the coupon on a bond,
the higher its reinvestment rate risk
? marketability risk - the difficulty of selling a
bond in the secondary
market
Bond Risks,Convenience Risks
