Intro to Financial Management

Bonds

Review

• Homework• Expected rate of return• Required rate of return• Risk-free rate of return• Market rate of return• Systemic and idiosyncratic risk• Beta?• CAPM

Review

• What is “the time value of money?”• How do you calculate and what do these mean?

– Compounding interest– PV, FV (incl. solving for n)– Different flows– Non-annual periods– Simple annuity (PV?)– Amortized loans– APR– Perpetuity

Bonds

• A bond is basically an IOU• Characteristics

– Coupon rate• Predetermined, fixed amount of interest

• Paid semi-annually

– Maturity date– Par Value

• Amount owed at maturity (normally $1000)

• Prices are given as a % of par (face) value

– E.g. bond at 125 can be bought at 125% of its par value

• May be callable (redeemable)• Claim on assets

Types of Bonds

• Corporate– Debenture – unsecured

– Subordinated debentures – comes after debentures if insolvent

– Secured

• Government– U.S Treasury Bonds

– Municipal Bonds (munis)• General obligation• Revenue

• Eurobonds

• Sovereign debt

• Convertible

• Mortgage bonds

Bond Ratings

• Companies rate the creditworthiness of bonds– Standard & Poor’s (S&P)– Moody’s– Fitch

• Typical ratings scale– AAA– AA– A– BBB– BB BB and below are “junk” bonds (also called “high yield”)– B– CCC– …– D in default

Value

• Book value – shown in the financial statements• Liquidation value – value if assets were sold• Market value• Intrinsic / economic value

– PV of future expected cash flows

• PV of future cash flows affected by• Amount and timing of payments• Riskiness of payments• Required rate of return

PV of Future Cash Flows

Ci is cash flow in period in = time to maturityr = required rate of return

Exercise - Compute value of example bonds.

Bond Yields

• Yield to maturity– Expected rate of return

• Use market price for PV

• Use par value for FV

• Use coupon interest rate for payments

• Current yield– Interest payment / price

• Use to compare to alternative investments

Bond Risk

• Default risk– Will affect your required rate of return to take on the risk

• Interest rate risk– If goes up, then required rate of return goes up– If retired rate of return goes up, price goes down

• Inflation risk– If goes up, then required rate of return goes up– If retired rate of return goes up, price goes down

• Maturity– The longer the maturity, the higher the risk– Why?

Bond Prices

• Price will be below par if required rate of return is above coupon interest rate– And vice versa

• Inverse relationships between bond prices and– Market interest rates– Inflation

Yield Curve