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 Summary of chapter 25 : Bonds
The price of a bond does not reflect its actual cost. The yield to maturity (which cancels out the bond's NPV~-- that is the difference between the issue price and the present value of future flows) - is the only criterion allowing investors to evaluate the various investment opportunities, (according to risk and length of investment). On the secondary market, the yield to maturity is merely an opportunity cost for the issuer, i.e. the cost of refunding today.
The basic parameters for bonds are as follows:
• Nominal or face value.
• Issue price, with a possible premium on the nominal value.
• Redemption: redemption at maturity (known as a bullet repayment), constant amortisation or fixed instalments. The terms of the issue may also include provisions for early redemption (call options) or retraction (put options).
• Average life of bond: where the bond is redeemed in several instalments, the average life of the bond corresponds to the average of each of the repayment periods.
• Nominal rate: also known as the coupon rate and used to calculate interest\break payable.
• Issue/redemption premium/discount: the difference between the issue premium/ discount and the nominal value and the difference between the redemption premium/discount and the nominal value.
• Periodic coupon payments: frequency at which coupon payments are made. We talk of zero coupon bonds when total compounded interest earned is paid only upon redemption.
The diversity of these parameters explains why the yield to maturity may differ from the coupon rate.
Floating-rate debt securities are exposed to the risk of interest rate fluctuations: the value of a fixed rate debt security increases when interest rates fall, and vice versa. This fluctuation is measured by:
• the modified duration, which measures the percentage change in the price of a bond for a small change in interest rates. Modified duration is a function of the maturity date, the nominal rate and the market rate;
• convexity, the second derivative of price with respect to interest rates, which expresses the speed of appreciation or the sluggishness
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