Bond 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. An important new client, The North-Western 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.
1) What are the key features of a bond?
Par value - face amount, paid at maturity
Coupon interest rate - Stated interest rate
Maturity length - years until bond must be repaid
Issue date - Date when bond is issued
Default risk - Risk that issuer will not make interest payments
Call provisions - provisions that allow the original issuer to repurchase and retire the
bonds, usually within a time window or on a specific date, which the bond can be called,
and a specific price to be paid to bondholders.

2) What are call provisions and sinking fund provisions? Do these provisions make
bonds more or less risky?
Call provisions give the issuing corporation the right to call the bonds for redemption.
The call provision generally states that if the bonds are called, then the company must
pay the bondholders an amount greater than the par value, or a call premium. Sinking
funds are provisions to pay off a loan over its life rather than all at maturity. These
provisions make bonds less risky to both the corporation and the investors.

3) How does one determine the value of any asset whose value is based on
expected future cash flows?
The value of such an asset is determined by calculating the net present value (NPV) of
all future expected cash flows. NPV measures the increase of an investment based on
the present value of future expected cash flows against the cost of the initial investment.
NPV is calculated by totalling the result of multiplying each year’s expected cash flow by
the discount rate, and subtracting the initial investment.

4) How is the value of a bond determined? What is the value of a 10-year, $1,000
par value bond with a 10% annual coupon if its required rate of return is 10%?
The value of a bond is determined by multiplying the coupon rate by the par value/face
value of the bond and dividing it by the number of periods per year. The result is then
multiplied by the number of periods and added to the original face value of the bond to
reach the total value of the bond. In this example the formula would be (10% * $1,000) /
1 = $100 per period → $100 * 10 = $1,000 + $1,000 = $2,000
5) What would be the value of the bond described in part 4 if, just after it had been
issued, the expected inflation rate rose by 3 percentage points, causing investors to
require a 13% return? Would we now have a discount or a premium bond?
a. What would happen to the bond’s value if inflation fell and the rd declined to 7%?
Would we now have a premium or a discount bond?
b. What would happen to the value of the 10-year bond over time if the required
rate of return remained at 13%? If it remained at 7%?
6) What is the yield to maturity on a 10-year, 9% 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?
a. 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.)
7) Write a general expression for the yield on any debt security (rd) and define these
terms: real risk-free rate of interest, inflation premium, default risk premium, and
maturity risk premium.
8) Define the nominal risk-free rate. What security can be used as an estimate of
rRF?
9) What is interest rate (or price) risk? Which bond has more interest rate risk: an
annual payment 1-year bond or a 10-year bond? Why?

Interest rate risk is the risk that arises for bond owners from fluctuating interest rates. As
interest rates rise, bond prices fall and vice versa. Suppose you buy a 10-year bond that
yielded 10% per year. Now suppose that interest rates on comparable-risk bonds
increased to 12%. We would be stuck with $100 of interest for the next 10 years. But if
you buy a 1-year bond, at the end of the year we would receive $1,000 back and we
could re-invest it and receive 12%. Interest rate risk reflects the length of time one is
committed to a given investment. Thus, 10-year bond has more interest rate risk.

10) What is reinvestment rate risk? Which has more reinvestment rate risk: a 1-year
bond or a 10-year bond?

Reinvestment rate risk is the risk that cash flows will have to be reinvested in the future
at rates lower than today’s rate. For example, suppose you win a $50,000 lottery and
plan to invest the money. You buy a 1-year bond with a yield-to-maturity of 10%. For the
1st year your income will be $5,000. Then after 1 year you will receive $50,000 when the
bond matures, which you will reinvest. If rates have fallen to 3% then your income will
fall from $5,000 to $1,500. Alternatively, if you had bought a 10-year bond that yielded
10%, your income would have remained constant at $5,000 per year. Thus, buying
bonds with short maturities carries reinvestment rate risk.