Bond Investment

• Loan borrowed by business.

• Investor receive principal and interest:
• Standard Par = $1000
• When bond matures, the investor gets
$1000 from issuer.
 Example:
3 Year 10% Coupon Bond.
Bondholders receive annual coupon
interest ($100 per year) for next 3
years,
plus $1000 par (maturity value ) at the
end of Year 3.
Bond was originally issued 7 years ago
as a 10 year bond.
 Coupon Rate
• Fixed for life

Coupon Interest = Coupon Rate x par

$100 = 10% x $1000
(Par Value is always $1000)
 Cash Flows for
3 year 10% Coupon Bond

Now 1000
100 100 100

1 2 3
 Price of Bond
• You can sell the bond for as much as the
next person is willing to pay. To the next
person, the bond is worth the present value
of its future cash flows. That is why :
Price today = PV of future cash flows.
 3 Year Bond
• Par (Maturity Value) = $1000
• rc = coupon rate = .10 (fixed for life)
• coupon interest = rc x par
• = .10 x $1000 = $100
• rm = market rate = .12 (changeable)
• rc = rm on the original issuance date
 Yield
• Yield is market interest rate
Changes with market conditions from day to day
• Used for calculating market price of bond
The coupon rate is the market rate on the first date,
but no longer. It is outdated and should not be
used for calculating current price.
Yield is the true interest rate
 When to use which?
• Use coupon rate to get coupon payment
• Use market rate to get market price (present
value of future cash flow).
 Present Value of Coupon Pmts
• Present value of $1 annuity (PVA) =
1 – PV of $1
r

1 1

r r (1  r ) n

• Present Value of interest pmt @12%

= PVA x 100
= 2.402 x 100
= $240
 Present Value of Par
Present Value of $1000
= 1000 x 1/ (1+ r)n
= 1000 x 1/(1.12)3
= $712
 Value of Bond
Present value of interest = $240
Present Value of par = $712
Bond value today = $952
 Discount
• Discount = par – price
• $48 = $1000 - $952
 Why did the price drop?
• New Bond issued today pays ____ (dollars)
coupon interest.
• Why did the price drop?
• Why did the price drop by $48?
 Discount means higher yield
• Discount adds to the interest you earn
• Investors buying bonds at discount earn
higher yield than coupon rate
• Yield = coupon rate + discount rate
• 12% = 10% + ?
 What if market rate declines to
8%?
• Re-calculate the bond price if yield drops to
8%.
• Why did the price rise?
 One-to-one correspondence
between
Yield and Price
Yield (market rate) Price (market price)

8% 1051

10% 1000

12% 952
 Discount vs Premium
• If market rate > coupon rate,
then price <1000, and the bond is sold at
discount
• If market rate < coupon rate,
then price > 1000, and the bond is sold at
premium.
Next File:Interest Rate Risk