Situation 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 requested that Mutual of Seattle present an investment seminar to the mayors of the represented cities, and Strother and Tibbs, who will make the actual presentation, have asked you to help them by answering the following questions. Because the Boeing Company operates in one of the league's cities, you are to work Boeing into the presentation. a. What are the key features of a bond? Answer: See Chapter 4 Mini Case Show b. What are call provisions and sinking fund provisions? Do these provisions make bonds more or less risky? Call Provisions and Sinking Funds A call provision that allows the issuer to redeem the bond at a specified time before the maturity date. If interest rates fall, the issuer can refund the bonds and issue new bonds at a lower rate. Because of this, borrowers are willing to pay more and lenders require more on callable bonds. 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 4 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. 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 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 refers to the bond pricing formula above in B60). Select the range of cells that contains the formulas and values you want to substitute (A73:B78). Then click Data, What-If-Analysis, and then Data Table to get the menu. The input data are in a column, so put the cursor on "column input cell" and enter the cell with the value for r (B37), then Click OK to complete the operation and get the table. Bond Value Going rate, r: $1,000 0% $2,000.00 7% $1,210.71 10% $1,000.00 13% $837.21 20% $580.75 We can use the data table to construct a graph that shows the bond's sensitivity to changing rates. Put B37 here. (2.) What would happen to the value of the 10-year bond over time if the required rate of return remained at 13 percent, or if it remained at 7 percent? Would we now have a premium or a discount bond in either situation? You pick a rate. Value of Bond in Given Year: N 7% 10% 13% 0 $1,211 $1,000 $837 1 $1,195 $1,000 $846 2 $1,179 $1,000 $856 3 $1,162 $1,000 $867 4 $1,143 $1,000 $880 5 $1,123 $1,000 $894 6 $1,102 $1,000 $911 7 $1,079 $1,000 $929 8 $1,054 $1,000 $950 9 $1,028 $1,000 $973 10 $1,000 $1,000 $1,000 You pick the rate for a bond: Your choice: 20% Resulting bond prices $581 $597 $616 $640 $667 $701 $741 $789 $847 $917 $1,000 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: 10 Coupon rate: 9% Annual Pmt: $90.00 Going rate, r =YTM: 10.91% See RATE function at right. Current price: $887.00 Par value = FV: $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 $1,000.00 Coupon rate: 9% Current Yield = 10.15% Annual Pmt: $90.00 Current price: $887.00 YTM: 10.91% 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 = YTM - Current Yield Capital Gains Yield = 10.91% - 10.15% Capital Gains Yield = 0.76% 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 = 20 Coupon rate: 10% Semiannual pmt = $100/2 = $50.00 PV = $834.72 Future Value: $1,000.00 Periodic rate = 13%/2 = 6.5% Note that the bond is now more valuable, because interest payments come in faster. Excel Bond Functions Supose today's date is January 1, 2013, and the bond matures on December 31, 2022 Settlement (today) 1/1/2013 Maturity 12/31/2022 Coupon rate 10.00% Going rate, r 13.00% Redemption (par value) 100 Frequency (for semiannual) 2 Basis (360 or 365 day year) 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) 3/25/2013 Maturity 12/31/2022 Coupon rate 10.00% Going rate, r 13.00% Redemption (par value) 100 Frequency (for semiannual) 2 Basis (360 or 365 day year) 0 Value of bond = $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 1/1/2013 First interest date 6/30/2013 Settlement (today) 3/25/2013 Maturity 12/31/2022 Coupon rate 10.00% Going rate, r 13.00% Redemption (par value) 100 Frequency (for semiannual) 2 Basis (360 or 365 day year) 0 Accrued interest = $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 $1,150.00 Settlement (today) 1/1/2013 Maturity 12/31/2022 Coupon rate 10.00% Redemption (par value) 100 Frequency (for semiannual) 2 Basis (360 or 365 day year) 0 Yield 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: 10 Seminannual coupon rate: 5% Semiannual Rate = I = YTC = 3.77% Seminannual Pmt: $50.00 Annual nominal rate = 7.53% Current price: $1,135.90 Call price = FV $1,050.00 Par value $1,000.00 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 4 Mini Case Show. j. Define the nominal risk-free rate (rRF). What security can be used as an estimate of rRF? Answer: See Chapter 4 Mini Case Show. k. Describe a way to estimate the inflation premium (IP) for a T-Year bond. Answer: See Chapter 4 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 4 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 30-year 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. Your Choice of Maturity 10-Yr Maturity 1-Yr Maturity Years to Mat: 10 Rate Price Rate Price Rate Price Coupon rate: 9% $929.60 $887.63 $982.87 Annual Pmt: $90.00 5.0% 1,173.18 5.0% $1,308.87 5.0% $1,038.10 Current price: $887.63 7.0% 1,082.00 7.0% $1,140.47 7.0% $1,018.69 Par value = FV: $1,000.00 9.0% 1,000.00 9.0% $1,000.00 9.0% $1,000.00 YTM = 10.9% 11.0% 926.08 11.0% $882.22 11.0% $981.98 13.0% 859.31 13.0% $782.95 13.0% $964.60 Years to Mat: 1 Scratch sheet for Your Choice Coupon rate: 9% Years to Mat: 5 Annual Pmt: $90.00 Coupon rate: 9% Current price: $982.87 Annual Pmt: $90.00 Par value = FV: $1,000.00 Current price: $929.60 YTM = 10.9% Par value = FV: $1,000.00 YTM = 10.9% Enter your choice for years to maturity: 5 n. What is reinvestment rate risk? Which has more reinvestment rate risk, a 1-year bond or a 10-year bond? Answer: See Chapter 4 Mini Case Show. o. How are interest rate risk and reinvestment rate risk related to the maturity risk premium? Answer: See Chapter 4 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. Hypothetical Inputs See to right for actual date used in graph. Suppose most investors expect the inflation rate to be 5 percent next year, 6 percent the following year, and 8 percent thereafter. The real risk-free rate is 3 percent. The maturity risk premium is zero for securities that mature in 1 year or less, 0.1 percent for 2-year securities, and then the MRP increases by 0.1 percent per year thereafter for 20 years, after which it is stable. What is the interest rate on 1-year, 10-year, and 20-year Treasury securities? Draw a yield curve with these data. What factors can explain why this constructed yield curve is upward sloping? Real risk free rate 3.00% Expected inflation of 5% for the next 1 years. Expected inflation of 6% for the next 1 years. Expected inflation of 8% thereafter. Now, we want to set up a table that encompasses all of the information for our yield curve. INPUT DATA Real risk free rate 3.00% Expected inflation of 5% for the next 1 years. Expected inflation of 6% for the next 1 years. Expected inflation of 8% thereafter. Years to Real risk-free Inflation Maturity Risk Treasury Maturity rate (r*) Premium (IP) Premium (MRP) Yield 1 3.00% 5.00% 0.00% 8.00% 2 3.00% 5.50% 0.10% 8.60% 3 3.00% 6.33% 0.20% 9.53% 4 3.00% 6.75% 0.30% 10.05% 5 3.00% 7.00% 0.40% 10.40% 6 3.00% 7.17% 0.50% 10.67% 7 3.00% 7.29% 0.60% 10.89% 8 3.00% 7.38% 0.70% 11.08% 9 3.00% 7.44% 0.80% 11.24% 10 3.00% 7.50% 0.90% 11.40% 11 3.00% 7.55% 1.00% 11.55% 12 3.00% 7.58% 1.10% 11.68% 13 3.00% 7.62% 1.20% 11.82% The yield is upward sloping due to increasing expected inflation and an increasing maturity risk premium 14 3.00% 7.64% 1.30% 11.94% 15 3.00% 7.67% 1.40% 12.07% 16 3.00% 7.69% 1.50% 12.19% 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 4 Mini Case Show. 17 3.00% 7.71% 1.60% 12.31% 18 3.00% 7.72% 1.70% 12.42% 19 3.00% 7.74% 1.80% 12.54% 20 3.00% 7.75% 1.90% 12.65% 21 3.00% 7.76% 2.00% 12.76% 22 3.00% 7.77% 2.10% 12.87% 23 3.00% 7.78% 2.20% 12.98% 24 3.00% 7.79% 2.30% 13.09% 25 3.00% 7.80% 2.40% 13.20% 26 3.00% 7.81% 2.50% 13.31% 27 3.00% 7.81% 2.60% 13.41% 28 3.00% 7.82% 2.70% 13.52% 29 3.00% 7.83% 2.80% 13.63% 30 3.00% 7.83% 2.90% 13.73% The table above gives us all of the components for our Treasury yield curve. Recall, we have said that Treasury securities are subject to two kinds of risk premiums, the inflation premium and the maturity risk premium. Just as we "built" Treasury yields in the table, we can "build" a yield curve based upon these expectations.