9-4b Yield To Call: Price of Bond

9-4b YIELD TO CALL
Allied’s 10% coupon bonds were callable and if interest rates fell from 10% to 5%, the
company could call in the 10% bonds, replace them with 5% bonds, and save $100-$50=$50
interest bond per year. This would be beneficial to the company, but not its bondholders.
If current interest rates are well below an outstanding bond’s coupon rate, a callable bond is
likely to be called, and investors will estimate its most likely rate of return as the yield to call
(YTC) rather than the yield to maturity. To calculate YTC here is the formula using years to call
N and the call price rather than the maturity value as the ending payment:
N
∫¿
price of bond=∑ ¿ ¿ ¿ ¿
t=1
Here N is the number of years until the company can call the bond; call piece is the price the
company must pay to call the bond; and r d is the YTC.
To illustrate, suppose Allied’s bonds had a deferred call provision that permitted the company, if
it desired, to call them 10 years after their issue date at a price of $1,100. Suppose further that
interest rates had fallen and that 1 year after issuance, the going interest rate had declined,
causing their price to rise $1,494.93. here is the timeline and the setup for finding the bonds’
YTC with financial calculator:
The YTC is 4.21%---- this is the return you would earn if you bought Allied bond at a price of
$1,494.93 and it was called 9 years from today (one year has gone by, so there are 9 years left
until the first call date).
A company is more likely to call its bonds if they can replace their current high-coupon debt
with cheaper financing. Broadly speaking, a bond is more likely to be called if its price is above
par because a price above par means that the going market interest rate (the yield to maturity) is
less than the coupon rate. So, do you think Allied will call its 10% bonds when they become
callable? Allied’s action will depend on what the going interest rate is when they become
callable. If the going rate remains at r d = 5%, Allied could save 5% or $50 per bond per year; so
it would call the 10% bonds and replace them with new 5% issue. There would be some cost to
the company to refund the bonds; but because the interest savings would most likely be worth the
cost, Allied would probably refund them. therefore, you should expect earn the YTC= 4.21%
rather than the YTM=5% if you purchased the bond under the indicate conditions. In this chapter
We assume that bonds are not callable unless otherwise noted.
9-5 CHANGES IN BOND VALUES OVER TIME
When a coupon bond is issued, the coupon is generally set at a level that causes the bond’s
market price to equal its par value.
- If a lower coupon were set, investors would be willing to pay $1000 for the bond
- If a higher coupon were set, investors would clamor for it and bid its price up over $1000.
A bond that has just been issued is known as a New Issue. Once it has been issued, it is an
Outstanding Bond, also called Seasoned Issue.
- Generally, Newly Issued bond is sold at prices very close to par. Except for Floating-Rate
Bonds where coupon payments are constant.
TABLE 9.1 Calculation of Current Yields and Total Revenues for 7%, 10% and 13% Coupon
Bonds when the Market Rate Remains Constant at 10%
Table 9.1 demonstrates how the prices of each of these bonds will change over time if market
interest rates remain at 10%. One year from now each bond will have a maturity of 14 years–that
is, N=14. With a financial calculator, override N=15 with N=14, and press the PV key; that gives
you the value of each bond 1 year from now. Continuing, set N=13, N=12, and so forth, to see
how the prices change over time. It also shows the current yield (coupon interest divided by
bond’s price), the capital gains yield and the total return over time. For any given year, the
capital gains yield is calculated as the bond’s annual change in price divided by the beginning-
of-year price.
FIGURE 9.2 Time Paths of 7%, 10% and 13% Coupon Bonds when the Market Rates Remains
Constant at 10%
Figure 9.2 plots the three bonds’ predicted prices as calculated in Table 9.1. Here are some
points about the prices of the bonds over time.
 The price of the 10% coupon bond trading at par will remain at $1000 if the market
interest rate remains at 10%. Therefore, its current yield will remain at 10%, and its
capital gains yield will be zero each year.
 The 7% bond trades at a discount; but at maturity, it must sell at par because that is the
amount the company will pay its bondholders. Therefore, its price must rise over time.
 The 13% coupon bond trades at a premium. However, its price must be equal to its par
value at maturity; so the price must decline over time.
9-6 BONDS WITH SEMIANNUAL COUPONS

To evaluate semiannual bonds, we must modify the valuation model (Equation 9.1):
1. Divide the annual coupon interest payment by 2 to determine the dollars of interest paid
each six months.
2. Multiply the years to maturity, N, by 2 to determine of semiannual periods.
3. Divide the nominal (quoted) interest rate, rd, by 2 to determine the periodic (semiannual)
interest rate.
There would be twice as many payments on a time line, but each would be half the size
of an annual payment bond. Making the indicated changes results in the following
equation for finding a semiannual bond’s value:
9.1a
2n
VB= ∑ INT/2 + M
T=1 (1 + rd/2) t (1 + rd/ 2)2N
9-7 ASSESSING A BONDS’ RISKINESS

In this section, we identify and explain the two key factors that impact a bond’s riskiness.
Once those factors are identified, we differentiate between them and discuss how you can
minimize these risks.
9-7a PRICE RISK
Interest rates fluctuates over time, and when they rise the value of outstanding bonds
decline. Price Risk (interest rate risk) is the risk of a decline in bond values due to an increase
in interest rates. Price risk is higher on bonds that have long maturities than on bonds that will
mature in the near future. This follows because the longer the maturity, the longer before the
bond will be paid off and the bondholder can replace it with another value of a 1-year bond with
a 10% annual coupon fluctuates with changes in r, and then comparing those changes with
changes on a 15-year bond. The 1-year bond’s values at different interest rates are shown below.
Value of a 1-year bond at:
rd=5 % : 1 5 100 1000

N 1/YR PV PMT FV
=-1,047.62
An immediate increase in rate s from 10% to 15% would be quite unusual, and it would occur
only if something quite bad were revealed about the company or happened in the economy.
Smaller but still significant rate increase that adversely affect bondholders do occur fairly often.
You would have an accounting loss if you sold the bond; if you held it to maturity, you would
not have such a loss. However, even if you did not sell, you would still have suffered a real
economic loss in an opportunity cost sense because you would have lost the opportunity to invest
at 15% and would be stuck with a 10% bond in a 15% market. In an economic sense, “paper
losses” are just bad as realized accounting losses.
Bond’s maturity and coupon rate both affect price risk. Low coupon mean that most of the
bond’s return will come from repayment of principal, whereas on a high-coupon with the same
maturity, more of the cash flows will come in during the early years due to the relatively coupon
payments.
rd=10 % : 1 5 100 1000

N 1/YR PV PMT FV
=-1,000
rd=15 % : 1 5 100 1000

N 1/YR PV PMT FV
=-956.52
You would obtain the first value with a financial calculator by entering N=1, 1/YR=5,
PMT=100, and FV=1,000 and then pressing PV to get $1,047.62. With all the data still in your
calculator, enter 1/YR=10 to override the old 1/YR =5 and press PV to find the bond’s value at a
10% rate; it drops to 1,000. Then enter 1/YR=15, and press the PV key to find the last bond
value, $956.52.
Compared to the 1year bond, the 15-year bond is far more sensitive to changes in rates. At a 10%
interest rate, both the 15-year bond and 1-year bond are valued $1,000. When rates rise to 15%,
the 15-year bond falls to $707.63 but the 1-year bond falls only to $956.52. The price decline for
the 1-year bond only 4.35%, while that for the 15-year bond is 29.24%
For bonds with similar coupons, this differential interest rate sensitivity always holds true-the
longer a bond’s maturity, the more its price changes in response to a given change in interest
rates. Thus, even if the risk of default on two bonds is exactly the rise in interest rates.
The logical explanation for this difference in price risk is simple. Suppose you bought a 15-year
bond that yielded 10%, or $100 a year. Now suppose interest rates on comparable risk bonds rose
to 15%. You would be stuck receiving only $100 of interest for the next 15 years. On the other
hand, had you bought a 1-year bond, you would have earned a low return for only 1 year. At the
end of the year, you would have received your $1,000 back, then you could have reinvested it
and earned 15%, or $150 per year, for the next 14 years.
9-7b RISK OF INVESTMENT
Another risk inherent in the bond market is called to as reinvestment risk. In essence, a bond
exposes investors to reinvestment risk if the bond's revenues or future cash flows must be
reinvested in a security that offers a lower yield than the bond originally offered. Reinvestment
risk is also a possibility with callable bonds—investments that the issuer may redeem prior to the
maturity date.
Reinvestment risk is the danger that an investor may be unable to reinvest cash flows from an
investment, such as coupon payments or interest, at a rate competitive with their existing rate of
return. This new interest rate is called to as the reinvestment rate.
Reinvestment risk is the possibility that the cash flows from an investment would yield less in a
new security, resulting in an opportunity cost. It is the possibility that the investor will be unable
to reinvest cash flows at a comparable rate of return to their existing rate of return.
Callable bonds, in particular, are prone to reinvestment risk. This is because callable bonds are
frequently redeemed as interest rates decline. When the bonds are redeemed, the investor
receives their face value, and the issuer gains access to a new source of funding at a lower rate. If
the investor is willing to reinvest, they will do so at a lower rate of interest.
By investing in non-callable securities, investors can mitigate reinvestment risk. Additionally, Z-
bonds may be purchased because they do not pay interest on a regular basis. Investing in longer-
term securities is also a possibility, as cash is accessible less frequently and does not require
frequent reinvestment.
Example of Reinvestment Risk
Company A issues callable bonds with an 8% interest rate. Interest rates subsequently drop to
4%, presenting the company with an opportunity to borrow at a much lower rate.
As a result, the company calls the bonds, pays each investor their share of principal and a small
call premium, and issues new callable bonds with a 4% interest rate. Investors may reinvest at
the lower rate or seek other securities with higher interest rates.
9-7c COMPARING PRICE RISK AND REINVESTMENT RISK

Price Risk relates to current market value of the bond portfolio
o (Long-term): The value of your portfolio will decline if interest rates rise
o (Short-term): Bonds will be less risk
Reinvestment Risk relates to income the portfolio produces
o (Long-term): Bond is stable because income is stable
o (Short-term): Bonds will be in significant risk
Bond Level of Price Risk Level of Reinvestment Risk

Long-term AND/OR Low
High Low
coupon bonds
Short-term AND/OR High
Low High
coupon bonds
o Interest rate is a big concern in low interest environment, and reinvestment risk is a big
concern in high interest environment.
Investment Horizon – the period of time an investor plans to hold a particular investment.
 Investor with shorter investment horizons should view long-term bonds as being more
risky than short-term bonds.
 Long-term investors should be especially concerned about the reinvestment risk inherent
in short-term bonds.
To account for the effects related to both a bond’s maturity and coupon, many analyst focus on a
measure called duration – the weighted average of the time it takes to receive each of the bond’s
cash flow.
 One ways to minimize both price and reinvestment risk is to buy a zero coupon Treasury
bond with a duration equal to the investor’s investment horizon because when the
investment horizon is equal to the duration of the bond, coupon reinvestment risk offsets
price risk.
o For example: assume your investment horizon is 10 years. If you buy a 10-
year zero, you will received a guaranteed payment in ten years equal to the
bond’s face value. Moreover, as there is no coupons to reinvest, there is no
reinvestment risk. This explains why investors with specific goals often invest
in zero coupon bonds.

9-4b Yield To Call: Price of Bond

Uploaded by

Copyright:

Available Formats

9-4b Yield To Call: Price of Bond

Uploaded by

Document Information

Original Description:

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

9-4b Yield To Call: Price of Bond

Uploaded by

Copyright:

Available Formats

9-4b YIELD TO CALL

9-6 BONDS WITH SEMIANNUAL COUPONS

9-7 ASSESSING A BONDS’ RISKINESS

rd=5 % : 1 5 100 1000

rd=10 % : 1 5 100 1000

rd=15 % : 1 5 100 1000

9-7c COMPARING PRICE RISK AND REINVESTMENT RISK

Bond Level of Price Risk Level of Reinvestment Risk

You might also like