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buying Treasury bonds that protect you against inflation
seems as crazy as preparing for a communist takeover.
Less Volatile
But guess what? Treasury Inflation-Indexed Securities
are actually a great deal right now. Even if the consumer
But if inflation spikes up, TIPS would outshine conven-
price index rises only 1.7% annually over the next three
tional bonds. For example, a $1,000, 30-year TIPS with
decades”a mere tenth of a percentage point above the
a 4% coupon would yield $40 in its first year. If inflation
current rate”buy-and-hold investors will be better off
rises by three points, your principal would be worth
with 30-year inflation-protected securities, commonly
$1,030. The $30 gain plus the interest would translate
known as TIPS, than with conventional Treasuries.
into a 7% total return.
TIPS have yet to catch on with individual investors,
TIPS are attractive for another reason: They™re one-
who have bought only a fraction of the $75 billion is-
quarter to one-third as volatile as conventional Trea-
sued so far, says Dan Bernstein, research director at
suries because of their built-in inflation protection. So
Bridgewater Associates, a Westport (Conn.) money
investors who use them are less exposed to risk, says
manager. Individuals have shied away from TIPS be-
Christopher Kinney, a manager at Brown Brothers Har-
cause they™re hard to understand and less liquid than
riman. As a result, a portfolio containing TIPS can have
ordinary Treasuries.
a higher percentage of its assets invested in stocks, po-
Slowing inflation has also given people a reason to
tentially boosting returns without taking on more risk.
stay. If you buy a conventional $1,000, 30-year bond at
Even so, the price of TIPS can change. If the Federal
today™s 5.5% rate, you are guaranteed $55 in interest
Reserve hikes interest rates, they™ll fall. If it lowers rates,
payments each year, no matter what the inflation rate is,
they™ll rise. That won™t be a concern if you hold the TIPS
until you get your principal back in 2029. Let™s say you
until maturity, of course.
buy TIPS, now yielding 3.9% plus an adjustment for the
consumer price index, and inflation falls to 0.5% from
the current 1.6%. Because of the lower inflation rate, Source: Reprinted from April 5, 1999 issue of Business Week by spe-
you™ll get only $44 annually. Nevertheless, even if the cial permission, copyright © 1999 by the McGraw-Hill Companies.




yield on a U.S. Treasury bond with the same coupon and maturity is called the default
DEFAULT PREMIUM
The additional yield on a premium. The greater the chance that the company will get into trouble, the higher the
bond investors require for default premium demanded by investors.
bearing credit risk. The safety of most corporate bonds can be judged from bond ratings provided by
Moody™s, Standard & Poor™s, or other bond-rating firms. Table 3.1 lists the possible
bond ratings in declining order of quality. For example, the bonds that receive the high-
est Moody™s rating are known as Aaa (or “triple A”) bonds. Then come Aa (“double A”),
INVESTMENT GRADE A, Baa bonds, and so on. Bonds rated Baa and above are called investment grade,
Bonds rated Baa or above by while those with a rating of Ba or below are referred to as speculative grade, high-yield,
Moody™s or BBB or above by or junk bonds.
Standard & Poor™s. It is rare for highly rated bonds to default. For example, since 1971 fewer than one
in a thousand triple-A bonds have defaulted within 10 years of issue. On the other hand,
Bond with
JUNK BOND almost half of the bonds that were rated CCC by Standard & Poor™s at issue have de-
a rating below Baa or BBB. faulted within 10 years. Of course, bonds rarely fall suddenly from grace. As time
passes and the company becomes progressively more shaky, the agencies revise the
bond™s rating downward to reflect the increasing probability of default.
As you would expect, the yield on corporate bonds varies with the bond rating. Fig-
ure 3.9 presents the yields on default-free long-term U.S. Treasury bonds, Aaa-rated

271
272 SECTION THREE


TABLE 3.1
Standard
Key to Moody™s and Standard
Moody™s & Poor™s Safety
& Poor™s bond ratings. The
Aaa AAA
highest quality bonds are The strongest rating; ability to repay interest and principal is
very strong.
rated triple A, then come
Aa AA Very strong likelihood that interest and principal will be repaid.
double-A bonds, and so on.
A A Strong ability to repay, but some vulnerability to changes in
circumstances.
Baa BBB Adequate capacity to repay; more vulnerability to changes in
economic circumstances.
Ba BB Considerable uncertainty about ability to repay.
B B Likelihood of interest and principal payments over sustained
periods is questionable.
Caa CCC Bonds in the Caa/CCC and Ca/CC classes may already be in
default or in danger of imminent default.
Ca CC
Little prospect for interest or principal on the debt ever to be
C C
repaid.


FIGURE 3.9
Yields on long-term bonds. 20
Bonds with greater credit
18
risk promise higher yields to
Junk bonds
maturity. 16
Baa-rated
Aaa-rated
14
Yield to maturity (%)




Treasury bonds
12

10

8

6

4

2

0
1954 1958 1962 1966 1970 1974 1978 1982 1986 1990 1994 1998
Year




corporate bonds, and Baa-rated bonds since 1954. It also shows junk bond yields start-
ing in November 1984. You can see that yields on the four groups of bonds track each
other closely. However, promised yields go up as safety falls off.


Promised versus Expected Yield to Maturity
EXAMPLE 5
Bad Bet Inc. issued bonds several years ago with a coupon rate (paid annually) of 10
percent and face value of $1,000. The bonds are due to mature in 6 years. However, the
firm is currently in bankruptcy proceedings, the firm has ceased to pay interest, and the
Valuing Bonds 273


bonds sell for only $200. Based on promised cash flow, the yield to maturity on the
bond is 63.9 percent. (On your calculator, set PV = “200, FV = 1,000, PMT = 100, n =
6, and compute i.) But this calculation is based on the very unlikely possibility that the
firm will resume paying interest and come out of bankruptcy. Suppose that the most
likely outcome is that after 3 years of litigation, during which no interest will be paid,
debtholders will receive 27 cents on the dollar”that is, they will receive $270 for each
bond with $1,000 face value. In this case the expected return on the bond is 10.5 per-
cent. (On your calculator, set PV = “200, FV = 270, PMT = 0, n = 3, and compute i.)
When default is a real possibility, the promised yield can depart considerably from the
expected return. In this example, the default premium is greater than 50 percent.


VARIATIONS IN CORPORATE BONDS
Most corporate bonds are similar to the 6 percent Treasury bonds that we examined ear-
lier in the material. In other words, they promise to make a fixed nominal coupon pay-
ment for each year until maturity, at which point they also promise to repay the face
value. However, you will find that there is greater variety in the design of corporate
bonds. We will return to this issue, but here are a few types of corporate bonds that you
may encounter.

Zero-Coupon Bonds. Corporations sometimes issue zero-coupon bonds. In this case,
investors receive $1,000 face value at the maturity date but do not receive a regular
coupon payment. In other words, the bond has a coupon rate of zero. You learned how
to value such bonds earlier. These bonds are issued at prices considerably below face
value, and the investor™s return comes from the difference between the purchase price
and the payment of face value at maturity.

Floating-Rate Bonds. Sometimes the coupon rate can change over time. For exam-
ple, floating-rate bonds make coupon payments that are tied to some measure of current
market rates. The rate might be reset once a year to the current Treasury bill rate plus 2
percent. So if the Treasury bill rate at the start of the year is 6 percent, the bond™s coupon
rate over the next year would set at 8 percent. This arrangement means that the bond™s
coupon rate always approximates current market interest rates.

Convertible Bonds. If you buy a convertible bond, you can choose later to exchange
it for a specified number of shares of common stock. For example, a convertible bond
that is issued at par value of $1,000 may be convertible into 50 shares of the firm™s
stock. Because convertible bonds offer the opportunity to participate in any price ap-
preciation of the company™s stock, investors will accept lower interest rates on convert-
ible bonds.



Summary
What are the differences between the bond™s coupon rate, current yield, and yield
to maturity?
A bond is a long-term debt of a government or corporation. When you own a bond, you
receive a fixed interest payment each year until the bond matures. This payment is known as
274 SECTION THREE


the coupon. The coupon rate is the annual coupon payment expressed as a fraction of the
bond™s face value. At maturity the bond™s face value is repaid. In the United States most
bonds have a face value of $1,000. The current yield is the annual coupon payment
expressed as a fraction of the bond™s price. The yield to maturity measures the average rate
of return to an investor who purchases the bond and holds it until maturity, accounting for
coupon income as well as the difference between purchase price and face value.

How can one find the market price of a bond given its yield to maturity and find
a bond™s yield given its price? Why do prices and yields vary inversely?
Bonds are valued by discounting the coupon payments and the final repayment by the yield
to maturity on comparable bonds. The bond payments discounted at the bond™s yield to
maturity equal the bond price. You may also start with the bond price and ask what interest
rate the bond offers. This interest rate that equates the present value of bond payments to the
bond price is the yield to maturity. Because present values are lower when discount rates are
higher, price and yield to maturity vary inversely.

Why do bonds exhibit interest rate risk?
Bond prices are subject to interest rate risk, rising when market interest rates fall and falling
when market rates rise. Long-term bonds exhibit greater interest rate risk than short-term
bonds.

Why do investors pay attention to bond ratings and demand a higher interest rate
for bonds with low ratings?
Investors demand higher promised yields if there is a high probability that the borrower will
run into trouble and default. Credit risk implies that the promised yield to maturity on the
bond is higher than the expected yield. The additional yield investors require for bearing
credit risk is called the default premium. Bond ratings measure the bond™s credit risk.



www.finpipe.com/ The Financial Pipeline is an Internet site dedicated to financial education; see
Related Web the page on Bonds
Links www.investinginbonds.com/ All about bond pricing
www.bloomberg.com/markets/C13.html A look at the yield curve, updated daily
www.bondmarkets.com/publications/IGCORP/what.htm A guide to corporate bonds
www.moodys.com The Web site of the bond rating agency
www.standardandpoors.com/ratings/ Standard & Poor™s Corporation provides information on
how it rates securities

bond yield to maturity junk bond
Key Terms coupon rate of return credit risk
face value, par value, maturity value yield curve default risk
coupon rate default premium interest rate risk
current yield investment grade

1. Bond Yields. A 30-year Treasury bond is issued with par value of $1,000, paying interest of
Quiz $80 per year. If market yields increase shortly after the T-bond is issued, what happens to the
bond™s:

a. coupon rate
b. price
Valuing Bonds 275


c. yield to maturity
d. current yield

2. Bond Yields. If a bond with par value of $1,000 and a coupon rate of 8 percent is selling at
a price of $970, is the bond™s yield to maturity more or less than 8 percent? What about the
current yield?
3. Bond Yields. A bond with par value $1,000 has a current yield of 7.5 percent and a coupon
rate of 8 percent. What is the bond™s price?
4. Bond Pricing. A 6-year Circular File bond pays interest of $80 annually and sells for $950.
What is its coupon rate, current yield, and yield to maturity?
5. Bond Pricing. If Circular File (see question 4) wants to issue a new 6-year bond at face
value, what coupon rate must the bond offer?
6. Bond Yields. An AT&T bond has 10 years until maturity, a coupon rate of 8 percent, and
sells for $1,050.
a. What is the current yield on the bond?
b. What is the yield to maturity?

7. Coupon Rate. General Matter™s outstanding bond issue has a coupon rate of 10 percent and

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