Chapter 17: Bonds

Equity = Ownership, Stocks

Debt = Borrower/ender, bonds
o Corner stone: 1! year "#S# $reasury, and $%Bi&&
're risk (ree rates and used as C')*
Bond Price Movement
o Discounted cash +ows o( in+ows
Coupon/,nterest
o 's prices -oes up, the yie&d -oes down and .ice .ersa#
o /hy does it ha.e a price 0o.e0ent1
Because i( so0eone buys a bond at a discount, the
.a&ue o( the bond wi&& decrease#
'nd the yie&ds wi&& -o up
o *onday:
2ohn buys a 1! year "S $reasury at a yie&d o( 34# ,t
pays 51!! at par .a&ue#
o $uesday:
6ie&d -oes up to 74# 2ohn -ets upset#
8ow do you bui&d yie&ds1
o 9isk :ree Bonds:
;o0ina& 9ate= 9ea& ,nterest < ,n+ation
9ea& interest is the nu0ber you=d -o (ro0
consu0in- .s# spendin-#
8i-her interest rate: sa.e
o 9isky Bonds:
;o0ina& 9ate = 9ea& ,nterest < ,n+ation < 9isk
pre0iu0
6ou take 0ore risk when in.estin- in co0panies
.s# the -o.ern0ent
/hat kind o( risk pre0iu0s do we ha.e1
$i0e
>ua&ity/Credit/De(au&t risk
6ie&d Spread
o *easure o( return between co0panies or -o.ern0ent#
6ie&d Cur.e
o ;or0a&
o :&at
o ,n.erted
?arious 6ie&d *easures
o 6ie&d to *aturity @6$*A: $he discount rate that equates the
cash +ows and the current price o( the bond#
o 6$* has two assu0ptions that are questionab&e:
'ssu0es that you are -oin- to ho&d the security ti&& it
0atures#
'ssu0es that current interest rates ne.er chan-es
$his is ca&&ed rein.est0ent risk
Diference between stocks and bonds:
Stocks:
o :or -rowth dri.ers
o e.era-e B:1
Buy B stocks, on&y spend 51
Bonds:
o Steady inco0e (or conser.ati.e
o $o reduce the risk
o )rice appreciation (or short%ter0 specu&ators
o e.era-e @1!:1A
Buy 1! bonds, on&y spend 51
Bond Yields
6ie&d to *aturity
o Ca&cu&ated before you purchase the bond
o *ost do0inant yie&d
Current yie&d: current coupon you recei.e/current price o( the bond
o Error: Doesn=t inc&ude price appreciation
9ea&iCed co0pound yie&d
o Ca&cu&ated yie&d after the bond 0atures
8oriCon yie&d
o *ake assu0ptions &ike: chan-in- interest rates
Types of Bonds
'cti.e:
o EDpensi.e eDpense ratio
o 8a.e to &ook (or where the interest rates are -oin-
)assi.e
o Cheaper eDpense ratio
o ,ndeD
o E$:
Bond buyers:
8ate in+ation
o.e econo0ic weakness
o.e Enancia& crises
o $he +i-ht to sa(ety: peop&e rush to the sa(ety o( the
-o.ern0ent when there are Enancia& crises in the 0arket
Bond Path:
)u&&ed to par: $he prices near the end are pu&&ed to the par .a&ue
Cash +ows:
o Coupon
o )rincipa&
o ,nterest on interest
/e -et 0ost o( our 0oney (ro0 the co0poundin-
Duration: a bond=s price sensiti.ity to chan-es in interest rates