A 1 2 3 4 5 Situation 6 7

Chapter 5. Mini Case

Sam Strother and Shawna Tibbs are vice-presidents of Mutual of Seattle Insurance Company and co-directors of the company's pension fund management division. A major new client, the Northwestern Municipal Alliance, has 8 requested that Mutual of Seattle present an investment seminar to the mayors of the represented cities, and Strother 9 and Tibbs, who will make the actual presentation, have asked you to help them by answering the following questions. 10 Because the Boeing Company operates in one of the league's cities, you are to work Boeing into the presentation. 11 12 a. What are the key features of a bond? Answer: See Chapter 5 Mini Case Show 13 14 b. What are call provisions and sinking fund provisions? Do these provisions make bonds more or less risky? 15 16 Call Provisions and Sinking Funds 17 A call provision that allows the issuer to redeem the bond at a specified time before the maturity date. If interest rates 18 fall, the issuer can refund the bonds and issue new bonds at a lower rate. Because of this, borrowers are willing to 19 pay more and lenders require more on callable bonds. 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41 42 43 44 45 46 47 48 49 50 In a sinking fund provision, the issuer pays off the loan over its life rather than all at the maturity date. A sinking fund reduces the risk to the investor and shortens the maturity. This is not good for investors if rates fall after issuance. c. How is the value of any asset whose value is based on expected future cash flows determined? Answer: See Chapter 5 Mini Case Show d. How is the value of a bond determined? What is the value of a 10-year, $1,000 par value bond with a 10 percent annual coupon if its required rate of return is 10 percent? Finding the "Fair Value" of a Bond First, we list the key features of the bond as "model inputs": Years to Mat: 10 Coupon rate: 10% Annual Pmt: $100 Par value = FV: $1,000 Going rate, rd: 10% The easiest way to solve this problem is to use Excel's PV function. Click fx, then financial, then PV. Then fill in the menu items as shown in our snapshot in the screen shown just below.

A 51 52 53 54 55 56 57 58 59 60 61 62 63 64 65 66 67 68 69 70 71 72

Value of bond =

$1,000.00 Thus, this bond sells at its par value. That situation always exists if the going rate is equal to the coupon rate.

The PV function can only be used if the payments are constant, but that is normally the case for bonds. e. (1.) What would be the value of the bond described in Part d if, just after it had been issued, the expected inflation rate rose by 3 percentage points, causing investors to require a 13 percent return? Would we now have a discount or a premium bond? We could simply go to the input data section shown above, change the value for r from 10% to 13%. You can set up a data table to show the bond's value at a range of rates, i.e., to show the bond's sensitivity to changes in interest rates. This is done below. To make the data table, first type the headings, then type the rates in cells in the left column. Since the input values are listed down a column, type Bond Value the formula in the row above the first value and one cell to the right of the column of values (this is B73; note that the formula in B73 actually just Going rate, r: $1,000 refers to the bond pricing formula above in B60). Select the range of cells 0% $2,000.00 that contains the formulas and values you want to substitute (A73:B78). 7% $1,210.71 Then click Data, What-If-Analysis, and then Data Table to get the menu. 10% $1,000.00 The input data are in a column, so put the cursor on "column input cell" 13% $837.21 and enter the cell with the value for r (B37), then Click OK to complete the 20% $580.75 operation and get the table. We can use the data table to construct a graph that shows the bond's sensitivity to changing rates.

73 74 75 76 77 78 79 80 81 82 83 Interest Rate Sensitivity of a 10-Year Bond 84 85 Value at 7% Value at 13% $2,500 86 $2,000 87 $1,500 88 $1,000 89 $500 90 $0 91 Put B37 here. 0% 5% 10% 15% 20% 92 93 94 95 (2.) What would happen to the value of the 10-year bond over time if the required rate of return remained at 13 96 97 percent, or if it remained at 7 percent? Would we now have a premium or a discount bond in either situation? You 98

A 99 100 101 102 103 104 105 106 107 108 109 110 111 112 113 114 115 116 117 118 119 120 121 122 123 124 125 126 127 128 129 130 131 132 133 134 135 136 137 138 139 140 141 142 143 144 145 146 147 148 149 150 N 0 1 2 3 4 5 6 7 8 9 10

B C D Value of Bond in Given Year: 7% 10% 13% $1,211 $1,000 $837 $1,195 $1,000 $846 $1,179 $1,000 $856 $1,162 $1,000 $867 $1,143 $1,000 $880 $1,123 $1,000 $894 $1,102 $1,000 $911 $1,079 $1,000 $929 $1,054 $1,000 $950 $1,028 $1,000 $973 $1,000 $1,000 $1,000

Value of the bond over time

Rates fall to 7%
Rates stay the same

You pick the rate for a bond: Your choice:

Rates increase to 13%

$1,400

Your choice

Resulting bond prices

$1,200
$1,000 Price $800 $600 $400 $200

$0
1 3 5 7 9 Years to maturity 11

If rates fall, the bond goes to a premium, but it moves towards par as maturity approaches. The reverse hold if rates rise and the bond sells at a discount. If the going rate remains equal to the coupon rate, the bond will continue to sell at par. Note that the above graph assumes that interest rates stay constant after the initial change. That is most unlikely--interest rates fluctuate, and so do the prices of outstanding bonds. Yield to Maturity (YTM) f. (1.) What is the yield to maturity on a 10-year, 9 percent annual coupon, $1,000 par value bond that sells for $887.00? That sells for $1,134.20? What does the fact that a bond sells at a discount or at a premium tell you about the relationship between rd and the bond's coupon rate? What is the yield-to-maturity of the bond? Use the Rate function to solve the problem. Years to Mat: Coupon rate: Annual Pmt: Current price: 10 9% $90.00 $887.00

Going rate, r =YTM:

10.91%

See RATE function at right.

151 152 153 154 155 156 157 158 159 160 161 162 163 164 165 166 167 168 169 170 171 172 173 174 175 176 177 178 179 180 181 182 183 184 185 186 187 188 189 190 191 192 193 194 195 196 197 198 199 200 201 202 203

A Par value = FV:

B $1,000.00

(2.) What are the total return, the current yield, and the capital gains yield for the discount bond? (Assume the bond is held to maturity and the company does not default on the bond.) Current and Capital Gains Yields The current yield is the annual interest payment divided by the bond's current price. The current yield provides information regarding the amount of cash income that a bond will generate in a given year. However, it does not account for any capital gains or losses that will be realized if the bond is held to maturity or call. Simply divide the annual interest payment by the price of the bond. Even if the bond made semiannual payments, we would still use the annual interest. Par value Coupon rate: Annual Pmt: Current price: YTM: $1,000.00 9% $90.00 $887.00 10.91%

Current Yield = 10.15%

The current yield provides information on a bond's cash return, but it gives no indication of the bond's total return. To see this, consider a zero coupon bond. Since zeros pay no coupon, the current yield is zero because there is no interest income. However, the zero appreciates through time, and its total return clearly exceeds zero. YTM = Current Yield + Capital Gains Yield

Capital Gains Yield = Capital Gains Yield = Capital Gains Yield =

YTM 10.91% 0.76% -

Current Yield 10.15%

g. How does the equation for valuing a bond change if semiannual payments are made? Find the value of a 10-year, semiannual payment, 10 percent coupon bond if nominal rd = 13%. Bonds with Semiannual Coupons Since most bonds pay interest semiannually, we now look at the valuation of semiannual bonds. We must make three modifications to our original valuation model: (1) divide the coupon payment by 2, (2) multiply the years to maturity by 2, and (3) divide the nominal interest rate by 2. Use the Rate function with adjusted data to solve the problem. Periods to maturity = 10*2 = Coupon rate: Semiannual pmt = $100/2 = Future Value: Periodic rate = 13%/2 = 20 10% $50.00 $1,000.00 6.5%

PV =

$834.72

Note that the bond is now more valuable, because interest payments come in faster.

Excel Bond Functions

204 205 206 207 208 209 210 211 212 213 214 215 216 217 218 219 220 221 222 223 224 225 226 227 228 229 230 231 232 233 234 235 236 237 238 239 240 241 242 243 244 245 246 247 248 249 250 251 252 253 254 255

A B C D E F G Suppose today's date is January 1, 2014, and the bond matures on December 31, 2023 Settlement (today) Maturity Coupon rate Going rate, r Redemption (par value) Frequency (for semiannual) Basis (360 or 365 day year) 1/1/2014 12/31/2023 10.00% 13.00% 100 2 0

Value of bond =

$83.4737

or

$834.74

Notice that you could choose a current date that is between coupon payments, and the PRICE function will calculate the correct price. See the example below.

Settlement (today) Maturity Coupon rate Going rate, r Redemption (par value) Frequency (for semiannual) Basis (360 or 365 day year) Value of bond =

3/25/2014 12/31/2023 10.00% 13.00% 100 2 0 $83.6307 or $836.31

This is the value of the bond, but it does not include the accrued interest you would pay. The ACCRINT function will calculate accrued interest, as shown below. Issue date First interest date Settlement (today) Maturity Coupon rate Going rate, r Redemption (par value) Frequency (for semiannual) Basis (360 or 365 day year) Accrued interest = 1/1/2014 6/30/2014 3/25/2014 12/31/2023 10.00% 13.00% 100 2 0 $2.3333 or $23.33

Suppose the bond's price is $1,150. You can also calculate the yield using the YIELD function, as shown below. Curent price Settlement (today) Maturity Coupon rate Redemption (par value) Frequency (for semiannual) Basis (360 or 365 day year) $ 1,150.00 1/1/2014 12/31/2023 10.00% 100 2 0

A 256 257 Yield 258 259 260 261 262 263 264 265 266 267 268 269 270 271 272 273 274 275 276 277 278 279 280 281 282 283 284 285 286 287 288 289 290 291 292 293 294 295 296 297 298 299 300 301 302 303 304 305 306

C 7.81%

h. Suppose a 10-year, 10 percent, semiannual coupon bond with a par value of $1,000 is currently selling for $1,135.90, producing a nominal yield to maturity of 8 percent. However, the bond can be called after 5 years for a price of $1,050. (1.) What is the bond's nominal yield to call (YTC)? (2.) If you bought this bond, do you think you would be more likely to earn the YTM or the YTC? Why? Yield to Call The yield to call is the rate of return investors will receive if their bonds are called. If the issuer has the right to call the bonds, and if interest rates fall, then it would be logical for the issuer to call the bonds and replace them with new bonds that carry a lower coupon. The yield to call (YTC) is found similarly to the YTM. The same formula is used, but years to maturity is replaced with years to call, and the maturity value is replaced with the call price. Use the Rate function to solve the problem. Number of semiannual periods to call: Seminannual coupon rate: Seminannual Pmt: Current price: Call price = FV Par value 10 5% $50.00 $1,135.90 $1,050.00 $1,000.00

Semiannual Rate = I = YTC = Annual nominal rate =

i. Write a general expression for the yield on any debt security (rd) and define these terms: real risk-free rate of interest (r*), inflation premium (IP), default risk premium (DRP), liquidity premium (LP), and maturity risk premium (MRP). Answer: See Chapter 5 Mini Case Show.

j. Define the nominal risk-free rate (rRF). What security can be used as an estimate of rRF? Answer: See Chapter 5 Mini Case Show.

k. Describe a way to estimate the inflation premium (IP) for a T-Year bond. Answer: See Chapter 5 Mini Case Show.

l. What is a bond spread and how is it related to the default risk premium? How are bond ratings related to default risk? What factors affect a companys bond rating? Answer: See Chapter 5 Mini Case Show.

m. What is interest rate (or price) risk? Which bond has more interest rate risk, an annual payment 1-year bond or a 10year bond? Why?

Interest Rate Risk is the risk of a decline in a bond's price due to an increase in interest rates. Price sensitivity to interest rates is greater (1) the longer the maturity and (2) the smaller the coupon payment. Thus, if two bonds have the same coupon, the bond with the longer maturity will have more interest rate sensitivity, and if two bonds have the same maturity, the one with the smaller coupon payment will have more interest rate sensitivity.

A 307 308 309 310 311 312 313 314 315 316 317 318 319 320 321 322 323 324 325 326 327 328 329 330 331 332 333 334 335 336 337 338 339 340 341 342 343 344 345 346 347 348 349 350 351 352 353 354 355 356 357 358

Years to Mat: Coupon rate: Annual Pmt: Current price: Par value = FV: YTM = Years to Mat: Coupon rate: Annual Pmt: Current price: Par value = FV: YTM =

10 10% $100.00 $946.77 $1,000.00 10.9% 1 10% $100.00 $991.88 $1,000.00 10.9%

Your Choice of Maturity Price Rate $966.65 5.0% 1,216.47 7.0% 1,123.01 10.0% 1,000.00 13.0% 894.48 15.0% 832.39

10-Yr Maturity Price Rate $946.77 5.0% $1,386.09 7.0% $1,210.71 10.0% $1,000.00 13.0% $837.21 15.0% $749.06

10 Yr. versus 1 Yr.

$1,500.00 $1,400.00 $1,300.00 $1,200.00

Enter your choice for years to maturity:

$1,100.00 $1,000.00

$900.00 $800.00 $700.00

5.0%

7.0%

10.0%
YTM

13.0%

As the interst rate goes from 5% to 15%, the price changes are bigger for the 10-year bond.

rd 5.0% 10.0% 15.0%

10-Year P Change $1,048 4.8% $1,000 4.5% $957

1-Year P Change $1,386 38.6% $1,000 33.5% $749

n. What is reinvestment rate risk? Which has more reinvestment rate risk, a 1-year bond or a 10-year bond? Answer: See Chapter 5 Mini Case Show.

o. How are interest rate risk and reinvestment rate risk related to the maturity risk premium? Answer: See Chapter 5 Mini Case Show.

p. What is the term structure of interest rates? What is a yield curve? The term structure describes the relationship between long-term and short-term interest rates. Graphically, this relationship can be shown in what is known as the yield curve. See the hypothetical curve below.

A 359 360 361 362 363 364 365 366 367 368 369 370 371 372 373 374 375 376 377 378 379 380 381 382 383 384 385 386 387 388 389 390 391 392 393 394 395 Hypothetical Inputs Real risk free rate Expected inflation of Expected inflation of Expected inflation of

G See to right for actual date used in graph.

3.00% 5% 6% 8%

for the next for the next thereafter.

1 1

years. years.

Hypothetical Treasury Yield Curve 14.00% 12.00% Interest Rate

MRP

10.00%
8.00% 6.00% 4.00% 2.00% 0.00% 1 2 3 4 5 6 7 8 9 1011121314151617181920 Maturity
Real Risk Free Rate
Inflation Premium

The yield is upward sloping due to increasing expected inflation and an increasing maturity risk premium

q. Briefly describe bankruptcy law. If a firm were to default on the bonds, would the company be immediately liquidated? Would the bondholders be assured of receiving all of their promised payments? Answer: See Chapter 5 Mini Case Show.