|Corporate Bond Ratings
Corporate Bond Ratings
Moody's and Standard and Poor's are probably the best-known issuers of bond ratings. The following table shows their bond rating codes (summarized from Mishkin, Frederic S. 1986. "The Economics of Money, Banking, and Financial Markets." Boston, Little, Brown & Co., Table 7.1)
The risk (and corresponding opportunity for gain) rises with time to maturity. If we have a 7% bond and the prevailing rate is 8%, but the bond matures in a year, it's not a big problem. We need only wait a year, collect the interest and principal, and reinvest them. It's another matter if we're stuck with 7% for thirty years. (If prevailing rates drop to 6%, though, a 30 year 7% bond will command a premium price in the market.)
A bond's yield to maturity is its lifetime rate of return. Suppose this bond, which sells for $1200, matures in thirty years. When it matures, its issuer pays back the face value, which is only $1000. The yield to maturity is the rate of return that makes the transaction's net present value equal to $1200. This will be less than 7.5 percent, since we had to pay a premium for the bond. (When we redeem it in thirty years, we will take a $200 loss.) Here is the formula for computing the yield to maturity (i, expressed as a fraction) of a bond that sells for P dollars, whose annual coupon payment is C, and which matures in N years. Solve for i (an iterative solution is required: once I learn Java, I will provide an interactive formula for this.)
Example: a bond that matures in 9 years sells at 80 and 5/16, or $803.1. Its coupon rate is 4.5%, or $45 a year. Solution of the following equation for i shows the yield to maturity to be 7.6%.
The net present worth of nine annual payments of $45, when the rate of return is 7.6%, is $285.85. The net present worth of $1000 received nine years from now is $517.24. The net present worth is therefore $803.09, ~$803.1.
* Nothing on this page is to be construed as investment advice, or endorsements for a particular financial instrument or fund.
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