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Agenda
The Bond Market
Types of Bonds Present Value and the Time-Value of Money Valuing a Bond and its Cash Flows Zero-Coupon Bonds
Bonds
Remember back to when we had the option of issuing debt or equity to finance our T-shirt company? Equity was sold to investors as stocks Debt was either issued in the form of bonds or loans (the difference is bonds are publiclytraded)
Remembering bonds
Each bond has a face-value, coupon rate, and maturity date. Face value is the amount of money the issuer (typically a company or government) will pay the person holding the bond at the specified maturity date. Coupon rate is essentially the interest rate specified by the bond to be paid out at regular intervals. Zero-coupon means there are no interest payments
BOND
$1000 to be paid at maturity Matures in 1 year on Jan 1 Pays out 2.5% of par value semiannually
In order to make 8% on the investment, the investor can pay less for the bond than its face-value, effectively increasing the return the investor will make.
If we were only to pay $9,900 for the bond issue, we would still receive a total of $10,700 in payout, but we would effectively yield 800 dollars beyond what we paid for the investment, or 8%. This is also referred to as pricing to yield an effective interest rate.
Since investors can now get MFST bonds that yield 6%, 5% bonds need to reduce their price to effectively yield 6%.
Bond Trading
Traders can buy bonds during times of high interest rates when bonds are yielding a lot, then sell them for more than they paid when interest rates decrease and drive down yields.
Less Risk
Types of Bonds
Government
-AKA Treasuries -Least risky because governments are typically the most stable institutions in the world -Debt of developing countries is significantly more risky Municipal -AKA Munis -City governments arent likely to go bankrupt often, but it can happen -Free from government taxation Corporate -Much more risk than government or municipal bonds, depending on the company and its financial situation. -Higher risk, but also higher returns (in the form of higher yields) More Risk
Credit Ratings
Bonds and their issuing institutions are rated by major credit agencies like S&P, Moodys, and Fitch to designate how likely the institution is to pay the interest and principal back.
Investment Grade
AAA and AA are considered risk-free investments
Speculative
Would you rather have $100 today or $110 dollars a year from now?
We have a choice
Today $100 1-Year from Now $110
5% InterestWhat if there was a way to figure out how much money in the future is worth in Rate todays terms Future Value = Present Value(1+Interest Rate)^(Number of Years) FV= PV*(1+i)^n FV= 100*(1+.05)^(1) FV= $105
= PV
So
A dollar today is worth more than a dollar in the future because we can invest the dollar today and get interest by the time the future comes around. We refer to this as the time-value of money.
But Parker
When will a stranger ever offer me the choice of having $100 now or $105 later? What use do I have for this stuff? We use present value to find the value of a bond, calculate terminal value and cash flow value of a company in order to form a DCF, and can use it to calculate internal rate of return.
$1336.60
PV(Interest Payments)
= $1336.60
$ 9732.79
Zero-Coupon Bonds
Sometimes bonds do not pay interest, why would investors be interested in this kind of investment? Remember, bonds can be sold for less than their face-value when first auctioned off. If the PV of the face-value is greater than what you paid for the bond, you will make money
AAA: Average 5% Interest Rate AA: Average 7% interest Rate A: Average 9% Interest Rate BBB: Average 12% Interest Rate What is the most you would be willing to pay for this investment?
PV(Interest Payments)
= $0
$ 8162.98 You should pay no more than $8162.98 for this bond.
= 85,000 * (1 + .08) ^ 5
= $124,892.89
We can invest 85,000 at 8% and make turn it into $125,000 in 5 years, so we should not take the bonds.