? How do we determine the rate of return on a bond?
? What is the difference between a real and a nominal interest rate?
FEATURES OF A BOND
A BOND is:
? A financial asset that acknowledges debt;
? It entitles the owner to specified periodic interest payments; and,
? The repayment of the principal (the face value) at the stated date of maturity.
FACE VALUE OR PAR VALUE:
? The principal amount of a bond that is repaid at maturity (the end of the term of the bond).
COUPON:
? The interest payments paid to the bondholder.
COUPON RATE:
? The annual interest as a percentage of face value.
MATURITY:
? Specified date at which the principal amount of a bond is paid.
Example: a $1,000 bond with a 6% coupon maturing in 10 years.
? This bond will pay $60 in interest at the end of each year for 10 years and will then repay the $1,000 face value at the end of the 10th year.
(Note: most bonds pay interest semi-annually. This is a simple complication that we will deal with after understanding the basic valuation techniques)
BOND VALUES
How much would you pay for the $1,000 bond, maturing in 10 years with a 6% annual coupon, if the current market rate of interest were 6%?
In other words, what is the Present Value of this bond?
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The Bond has two parts:
i. A 10-year stream of interest payments of $60 per year; and,
ii. The repayment of the face value of the bond, the $1,000, at the end of 10
years.
BOND = Present Value + Present Value VALUE of the Coupons of the Principal
PVbond = C * PVIFA6%,10 + P * PVIF6%,10
In our example, then:
PVbond = 60*( 1 – 1/(1.06)10) +1,000 * 1/(1.06)10 .06
= ( 60 * 7.3601) + (1,000 * .55839)
= 441.61 + 558.39
PVbond = $1,000
You would be prepared to pay $1,000 for the bond.
BUT:
What if the market rate of interest for that type of bond was really 7%? Why would you pay $1,000 and earn only 6%?
a YIELD TO MATURITY equal to the market rate of interest.
That price is easily calculated:
PVbond = C * PVIFA7%,10 + 1,000 * PVIF 7%,10
=60 * 1 – (1/(1.07)10 + 1,000 * 1/(1.07)10 .07
= ( 60 * 7.02358) + (1,000 * .50835)
= 421.41 + 508.35
PVbond = $ 929.76
YIELD TO MATURITY OR INTERNAL RATE OF RETURN OF THE BOND:
? The discount rate that equates a bond’s present value of interest payments and principal repayment with its price.
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