Chapter 6

Bonds
 Course Structure
• Capital Budgeting
Valuation • Bond Valuation

Bonds are an important source of financing for firms. The

return that investors receive in the bonds is one factor that
determines the firm’s cost of capital.

We will apply valuation principles to value financial

securities including bonds and stocks.

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 Outline
Bond
Valuation

Dynamic Credit Risk

Yields Behavior of and
and Prices Bond Prices Bond Rating

Risk-free
Risk-free Time and Interest Rate Corporate
Zero Coupon
Coupon Bond Bond Prices Sensitivity Bond
Bond

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 Learning Objectives
1. Describe the bond terminology.
2. Identify the cash flows for zero-coupon bonds, and
calculate the yield to maturity and value.
3. Explain how prices of risk-free US treasury bonds are
used to determine the risk free interest rates and
produce the yield curve.
4. Identify the cash flows for coupon bonds, and
calculate the yield to maturity and value.
5. Interpret the meaning of yield to maturity for bonds.
6. Given coupon rate and yield to maturity, determine
whether a coupon bond will sell at a premium or a
discount.
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What are bonds?

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 Bond Terminology
 Bond
 fixed income securities
 a debt contract promising a stream of known future
cash payments to holders till the maturity date
 Bond Certificate
 stating the terms of the bond
 Maturity Date
 final repayment date
 Payments continue until this date.
 Term
 the time remaining until the repayment date
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 Bond Terminology
 Principal or Face / Par Value
 Maturity value/ principal
 Notional amount used to compute coupon payments
 Coupon Rate
 % of Par value; expressed as an APR
 fixed at issuance
 determines the amount of each coupon payment
 Coupon Payment
 promised interest payments
Coupon Rate × Face Value
CPN =
Number of Coupon Payments per Year
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 Outline
Bond
Valuation

Dynamic Credit Risk

Yields Behavior of and
and Prices Bond Prices Bond Rating

Risk-free
Risk-free Time and Interest Rate Corporate
Zero Coupon
Coupon Bond Bond Prices Sensitivity Bond
Bond

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 Zero-Coupon Bonds
 Does not make coupon payments
 Always sells at a discount (a price lower than face
value), so they are also called pure discount bonds
 Treasury Bills (t-bills) are U.S. government zero-
coupon bonds with a maturity of up to one year.
 Suppose that a one-year, risk-free, zero-coupon bond
with a $100,000 face value has an initial price of
$96,618.36. The cash flows would be:

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 Zero-Coupon Bonds
 Rate of return on the one-year zero coupon bond:
100,000  r1 = 3.5%
96,618.36 =
(1 + r1 )

 Yield to Maturity (YTM) on the one-year bond

 the discount rate that sets the present value of the
promised payment from the bond equal to the current
market price of the bond
 100,000
96,618.36 =
(1 + YTM 1 )
100,000
 1 + YTM= 1 = 1.035  YTM1 = 3.5%
96,618.36
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YTM and Price of Zero Coupon Bond
 Zero coupon bond
 single cash flow
 Yield to Maturity of an n-Year Zero-Coupon Bond
1/ n
 Face Value 
1 + YTM n =
 
 Price 
 the per-period rate of return for holding the bond
from today till maturity on date n
 Price of a zero-coupon bond
FV
P =
(1 + YTM n ) n

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 YTM for Different Maturities
Example 6.1

Solution:
Plan: 1/ n
 Face Value 
1 + YTM n =
 
 Price 
Face Value

YTM YTM YTM

Price
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 YTM for Different Maturities
Execute:

Evaluate:
 Solving for the YTM of a zero-coupon bond is the same
process we used to solve for the internal rate of return.
 YTM is the internal rate of return (IRR) of buying the bond.
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 PRS

Suppose a 4 year zero-coupon risk-free bond

is trading at $83.06 per $100 face value. Find
its yield to maturity.
1. 4.00%
2. 4.50%
3. 4.75%
4. 5.00%

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 Risk-Free Interest Rates
 In a competitive market, all risk free investments must
earn the same rate of return over the same time period.
 A default-free (risk free) zero-coupon bond that matures
on date n provides a risk-free return over this period.
 So the Law of One Price guarantees that the risk-free
interest rate equals the yield to maturity on such a bond.
i.e., YTM of risk free bond is a proxy for risk free rate.
 Spot Interest Rate
 Another term for a default-free, zero-coupon yield “on
the spot”
 Yield Curve (Term structure of interest rate)
 A plot of the yield of risk-free zero-coupon bonds as a
function of the bond’s maturity date
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Treasury Yield Curve

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 PRS

If the yield curve is downward sloping, longer maturity

bonds generally have _________ shorter maturity bonds.

1. higher yields than

2. lower yields than
3. same yields as

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 Outline
Bond
Valuation

Dynamic Credit Risk

Yields Behavior of and
and Prices Bond Prices Bond Rating

Risk-free
Risk-free Time and Interest Rate Corporate
Zero Coupon
Coupon Bond Bond Prices Sensitivity Bond
Bond

18
 Cash Flows of Coupon Bonds
Coupon Bonds
 Pay regular coupon interest payments based on the
coupon rate
 Pay value or face value at maturity

0 1 2 3 4 n

Purchase Coupon Coupon Coupon Coupon Coupon +

Price Face Value

Cash Outflows Cash Inflows

to the Investor to the Investor
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 Coupon Bonds
 Treasury Securities
 U.S. Treasury coupon securities with original maturities as
follows:

 Coupon Bond Price Quotes

 Prices and yields are often used interchangeably.
 Bond traders generally quote bond yields rather than bond
prices.
 The coupon rates of most bonds are set equal to the prevailing
yields at issuance.
 To yield the same risk-free rate of return to investors, bonds with
different coupons will sell at different prices. 20
 Computing YTM of Coupon Bonds
Example 6.4
Problem:
 Consider a five-year, $1000 bond with a 2.2% coupon rate and
semiannual coupons. If this bond is currently trading for a price of
$963.11, what is the bond’s yield to maturity?

Solution:
Plan:
 Cash Flows of the Coupon Bond:

 coupons + face value

0 1 2 3 …… 10

 an annuity + a lump sum 21

 Computing YTM of Coupon Bonds
Execute:
 PV as outflow; PMT and FV with same sign as inflows

Given: 10 -963.11 11 1,000

Solve for: 1.50
Excel Formula: =RATE(NPER,PMT,PV,FV)=
RATE(10,11,-963.11,1000)

 y = 1.5%; this yield is for a six-month period

 convert it to annual rate of 3% (stated as APR)
Evaluate:
 The yield to maturity is the discount rate that equates the
present value of the bond’s cash flows with its price.
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 YTM of Coupon Bonds
 the single discount rate that equates the present value
of the bond’s remaining cash flows to its current price.

 a promised yield assuming:

 investor buys the bond and holds until maturity
 interim cash flows can be reinvested at YTM
 no default of coupon or maturity value
 the rate of return implied by the current bond price
 if we buy the bond at the market price, we will earn
the YTM
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 Breakout Exercise

A 5-year 10% semiannual coupon bond with face

value of $1000 is being sold at a price of $950.

1. What is its yield to maturity?

2. What is the expected rate of return if you buy it
at the market price?

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 Computing Price of Coupon Bonds
Example 6.5

Problem:
Consider again the five-year, $1000 bond with a 2.2% coupon rate and
semiannual coupons. Suppose interest rates drop and investors now
only demand a yield to maturity of 2% (expressed as an APR with
semiannual compounding). What price will the bond be trading for?

Solution:
Plan: PV = ?
0 1 2 3 …… 10

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Computing Price of Coupon Bonds
Execute:

Given: 10 1.0 11 1,000

Solve for: -1,009.47

Excel Formula: = PV(RATE,NPER,PMT,FV)=PV(.01,10,11,1000)

Evaluate:
 Given that investors have lowered the required rate of return from
investing in it from 1.5% to 1% per 6-month period, the bond’s price
will rise to $1009.47.
 Market interest rates have dropped, the bond’s yield will fall so that it
is in line with the lower competitive rates being offered for similar
risk and maturity elsewhere in the market.
 Since the cash flows from investing in the bond remain the same, its
PV will be higher at a lower discount rate.
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 Price of Coupon Bonds

Annuity Factor using the YTM (y )

  
1 1  FV
P= CPN × 1 − N 
+
y (1 + y )  (1 + y ) N
    
Present Value of all of the periodic coupon payments Present Value of the
Face Value repayment
using the YTM (y )

 The Purchase Price or Market Price of a bond is simply

the present value of the cash inflows, discounted at the
bond’s yield-to-maturity.
Note: Ignore clean price and dirty price. (with accumulated
coupon before payment due date)
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 Breakout Exercise

A 5-year 10% semiannual coupon bond with face

value of $1000 is being sold with a yield of 9%.
What is its market price?

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 Discount and Premium Bonds
Example 6.6

Solution:
Plan:
 They are all priced to yield 5%, meaning that 5% is the
discount rate that equates the present value of the cash
flows to the price of the bond.

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 Discount and Premium Bonds
Execute:
1  1  100
P(10% coupon) =
10 ×  1 − 30 
+ =
$176.86 (trades at a premium)
0.05  1.05  1.05 30

1  1  100
P(5% coupon) =
5×  1 − 30 
+ =
$100.00 (trades at par)
0.05  1.05  1.05 30

1  1  100
P(3% coupon) =
3×  1 − 30 
+ =
$69.26 (trades at a discount)
0.05  1.05  1.05 30

30 N 30 N
30 N

5 I/YR 5 I/YR 5 I/YR

10 PMT 5 PMT 3 PMT

100 100 FV 100 FV

FV

CPT PV -176.86
CPT PV -100 CPT PV -69.26

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 Discount and Premium Bonds
Evaluate:

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 Your questions are
welcome!

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 PRS

When a bond trades at a discount, what is its yield

compared to its coupon rate?

1. higher than
2. lower than
3. same as

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 PRS

A $1000 par value 5% bond is trading to yield 4%.

Which of the following is likely to be the bond’s
market price?

1. $900
2. $1000
3. $1100

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 Outline
Bond
Valuation

Dynamic Credit Risk

Yields Behavior of and
and Prices Bond Prices Bond Rating

Risk-free
Risk-free Time and Interest Rate Corporate
Zero Coupon
Coupon Bond Bond Prices Sensitivity Bond
Bond

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 Bond Price and Interest Rate
$P $1,200.00
 4 year 6% coupon bond

$1,100.00

$1,035.46

$1,000.00 $1,000.00

$966.13

$900.00

$800.00
0% 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 11% 12%
r%

 Bond prices are inversely related to interest rates

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Example: Bond’s Price vs. Its Yield to Maturity
Suppose an 8% semi-annual coupon US treasury bond
was just sold at par at issuance. However, the Federal
Reserve Bank’s fed fund rate suddenly rises to 9%.
1. What will be the rate of return on the bond now?
 The current YTM of the bond must be the same as
the current interest rate in the market.
 i.e., 9%
2. What will be the current price of the bond?
 The current price will equal to the present value of
the future cash flows discounted at the going market
interest rate.
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Example: Bond’s Price vs. Its Yield to Maturity

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 Bond Pricing Principle
 Basic principle in valuing PV of known cash flows
 A change in market interest rates causes a change in
the opposite direction in the market values of fixed
income securities
 An inverse relationship between $P and r%
 Implication:
 Because interest rate changes are unpredictable,
prices of fixed income securities are uncertain up to
the time they mature.
 Bonds do not “guarantee” a fixed return.
 Fixed income ≠ Fixed return
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 Why Bond Price Changes?
 Level of market interest rate has changed, but the
promised future cash flows from the bond do not.
A higher YTM implies a higher discount rate for a bond’s
remaining cash flows, reducing their PV and hence the
bond’s price.
 price will fall to the point where it equals the PV of future
cash flows discounted at the prevailing interest rate
 Bond prices are subject to the effects of both the
passage of time and changes in interest rate.
 Capital gain (loss) yield = ∆ Price / Original Price
= (new price – original price) / original price
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 Yield Fluctuations Over Time
 a 30-year zero-coupon bond
 the changes in the bond’s yield to maturity over its life

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 Bond Price Fluctuations Over Time
 Because the yield to maturity does not remain constant over the
bond’s life, the bond’s price fluctuates as it converges to the face
value over time.

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 Outline
Bond
Valuation

Credit Risk
Yields Dynamic
and
and Prices Behavior of
Bond Rating
Bond Prices

Risk-free Corporate
Risk-free Time and Interest Rate
Zero Coupon Bond
Coupon Bond Bond Prices Sensitivity
Bond

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 Prep for Next Class
1. Complete HW5 before 5pm on Nov 3 (Tue)
2. Read Ch 6 (Bonds)
3. Practice HW6 on Study Plan and complete HW6
before 5pm on Nov 10 (Tue).
4. Attend tutorials (online and f2f).
 Sign up link for F2F tutorials on canvas (updated
weekly)
5. Midterm result summary stat is posted on canvas.

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Next Lecture:

Ch. 6 (Cont’d)
Bonds

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