BEHAVIORAL FINANCE FNCE 455 Class Session #8 Lloyd Kurtz Santa Clara University 1.
BONDS PRICES AND YIELDS FNCE 455 Class Session #9 Lloyd Kurtz Santa Clara University 1.
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Transcript of BONDS PRICES AND YIELDS FNCE 455 Class Session #9 Lloyd Kurtz Santa Clara University 1.
Bonds Prices and Yields
FNCE 455Class Session #9Lloyd KurtzSanta Clara University
1
Topics
• Bond Basics
• Bond Valuation
• Bond Ratings
• The Yield Curve
2
Bond Basics
3
Bond Characteristics
• Face or par value
• Coupon rate
• Zero coupon bond
• Compounding and payments
• Indenture
4
Provisions of Bonds
• Secured or unsecured
• Call provision
• Convertible provision
• Put provision (putable bonds)
• Floating rate bonds
5
Bond Market Innovations
• Reverse floaters
• Asset-backed bonds
• Pay-in-kind bonds
• Catastrophe bonds
• Indexed bonds • TIPS (Treasury Inflation Protected Securities)
6
Bond Valuation
7
The Key Principle
• The fair value of a bond is the present value of its cash flows.
8
Bond Pricing
PB = Price of the bond
Ct = interest or coupon payments
T = number of periods to maturity
r = semi-annual discount rate or the semi-annual yield to maturity
9
P Cr
Par Valuer
B tT
t
T
TT
( ) ( )1 11
Price of 8%, 10-yr. w/ 6% yield
10
77.148,1
)03.1(
11000
)03.1(
140 20
20
1
P
P
B
ttB
Coupon = 4%*1,000 = 40 (Semiannual)
Discount Rate = 3% (Semiannual)
Maturity = 10 years or 20 periods
Par Value = 1,000
Bond Prices and Yields
Prices and Yields (required rates of return) have an inverse relationship
• When yields get very high the value of the bond will be very low
• When yields approach zero, the value of the bond approaches the sum of the cash flows
11
Bond Prices and Yields
12
Alternative Measures of Yield
• Current Yield
• Holding Period Yield• Considers actual reinvestment of coupons• Considers any change in price if the bond is held less than its
maturity
• Yield to Call• Call price replaces par• Call date replaces maturity
13
Call Features and Pricing
14
Premium and Discount Bonds
• Premium Bond• Coupon rate exceeds yield to maturity• Bond price will decline to par over its maturity
• Discount Bond• Yield to maturity exceeds coupon rate• Bond price will increase to par over its maturity
15
16
Price Change Over Time
Price of a Zero-Coupon Bond
17
Bond Spreads
• Risky bonds are often quoted based on their yield relative to a risk-free bond of comparable maturity.
• The yield difference between a risky bond and risk-free one is called a ‘spread’.
18
19
So
urce
s: Sto
ne
& M
cCa
rthy,
Me
rrill-Lyn
ch
A Yield Spread Index
20
Source: Bloomberg, Stone & McCarthy
21
So
urce
: Blo
om
be
rg
Bond Ratings
22
Ratings
• Rating companies• Moody’s Investor Service• Standard & Poor’s• Fitch
• Rating Categories• Investment grade• Speculative grade
23
Ratings Definitions
24
Key Factors in Ratings
• Coverage ratios
• Leverage ratios
• Liquidity ratios
• Profitability ratios
• Cash flow to debt
25
Ratings Aren’t Perfect!
In an interview with Sunday’s Frankfurter
Allgemeine Zeitung, one of Germany’s most
prominent newspapers, former Federal Reserve
Chairman Alan Greenspan sharply criticized
ratings agencies for their role in the current credit
crisis. “People believed they knew what they were
doing,” Mr. Greenspan says...“And they don’t.”
- Wall Street Journal Real Time Economics, 9/23/2007
26
Conflict of interest?
• Issuers pay for ratings
• AIG and Lehman were highly rated…right before they failed
• The industry faces significant lawsuits
27
The Yield Curve
28
The Yield Curve
• Yield curve - a graph or listing of the yields on bonds relative to the number of years to maturity
• There are many yield curves• Bonds should be of comparable risk
• The most-referenced is the Treasury curve
29
Examples – U.S. Treasuries
The Yield Curve and Recessions
• An inverted treasury bond curve often precedes an economic slowdown or recession.
• There have been three inversions of the 1/10 curve since 1987:
• The inversion of 1989 preceded the 1990-91 financial crisis and recession.
• The inversion of 2000 preceded the 2001 recession.
• The most recent inversion began in late 2005 and was followed in 2008-09 by a financial crisis and severe recession.
31
Bernanke’s View in 2006
32
“I would not interpret the currently very flat yield curve as indicating a significant economic slowdown to come, for several reasons. First, in previous episodes when an inverted yield curve was followed by recession, the level of interest rates was quite high, consistent with considerable financial restraint. This time, both short- and long-term interest rates--in nominal and real terms--are relatively low by historical standards.”
- Speech Before the Economic Club of New York, March 20, 2006
Source: federalreserve.gov
Upon Further Review…
33
“Information received since the Federal Open Market Committee met in January indicates that the economy continues to contract. Job losses, declining equity and housing wealth, and tight credit conditions have weighed on consumer sentiment and spending. Weaker sales prospects and difficulties in obtaining credit have led businesses to cut back on inventories and fixed investment. U.S. exports have slumped as a number of major
trading partners have also fallen into recession...”
FOMC Statement – March 18, 2009