Chapter 6 Notes

Bonds and the Bond Market

• Governments and corporations borrow money for long-term investments by selling
bonds to investors
• The interest payment paid to the bondholders is called the coupon. This is fixed when
the bond is issued
• The payment at the maturity of the bond is called the face value, maturity value, or par
value
• Most bonds have a face value of $1,000 (you can assume this if no face value is given)
• The date on which the loan will be paid off is the maturity date
• The coupon rate is the annual interest payment as a percentage of the face value of the
bond
• Most bonds pay coupons semi-annually – half the payment is made on the anniversary
of the maturity date, and the other half is paid six months from that date (i.e., if the
maturity date is January 15, 2035, then the coupons are paid each year on January 15
and July 15)
• Bonds are traded by a network of bond dealers
• Prices for some government and corporate bonds are reported on the Web sites of
major newspapers
• Bond price listings will have a bid price (the price you can sell your bond for) and an ask
price (the price you pay to buy a bond). The difference is the spread that goes to the
dealer
• Bond prices are listed as a percentage of face value, so a price of 112 means the price is
112% of face value and if the face value is $1,000, then the price is $1,120
• When you buy a bond you will pay more than the ask price unless you buy it on a
coupon payment date. The extra you pay represents the accrued interest – coupon
interest earned from the last coupon payment to the purchase date of the bond
• Clean price: Bond price excluding accrued interest (quoted ask price)
• Dirty price: Bond price including accrued interest (price you actually pay)
• Example: Suppose you purchase a 407 International Inc 5.96% bond maturing on
December 3, 2035 with a settlement date January 28 for an ask price of 131.651. What
is the total cost that you will pay for this bond, i.e., what is the dirty price?
o Coupon payment = .0596 x 1,000/2 = $29.80 (semi-annual coupons)
o Accrued interest:
▪ Number of days from coupon to settlement = Dec. 3 to Jan. 28
• = 28 + 28 = 56 days
▪ Number of days in coupon period (Dec. 3 to June 3)
• = 28 + 31 + 28 + 31 + 30 + 31 + 3 = 182 days
▪ Accrued interest = 29.80 x (56/182) = $9.17
o Clean price = 131.651% x 1,000 = $1,316.51
o Total Cost (Dirty price) = 1,316.51 + 9.17 = $1,325.68
Interest Rates and Bond Prices
• The value of a bond is the present value of the bond’s future cash flows – coupon
payments and face value
• The rate at which the cash flows from the bond are discounted to determine its present
value is known as the interest rate or the market interest rate, or the yield. This is the
discount rate
• The discount rate must capture the bond’s opportunity cost of capital – the current rate
of interest on similar risk investments
• The coupon rate and the discount rate are NOT necessarily the same. When they are
not, the price of the bond is not the same as its face value
• Don’t confuse the interest (coupon) payment on the bond with the interest rate – the
return investors require
• Coupon payments are fixed when the bond is issued, but the market interest rate
changes from day to day
• Changes in the market rate affect the PV of the coupon payments (but not the payments
themselves) which causes changes in the bond price
• Example: Calculate the current price of a 7.0% annual coupon bond with a $1,000 face
value which matures in 3 years. Assume a required return of 5.0%.
o Coupon payment is 7% x $1,000 = $70 each year
o Coupon payments occur at times 1, 2, and 3
o Face value is repaid at time 3
o Price of the bond equals the present value of the cash flows
70 70 1,070
o 𝑃𝑟𝑖𝑐𝑒 = 1.05 + 1.052 + 1.053 = $1,054
o The bond is selling at a Premium (Price > Face Value)
• Example: What is the price of the bond if the interest rate is 7%?
o Note: The bond is an annuity of coupon payments plus the repayment of the
face value at maturity
o Price of Bond = PV(Coupons) + PV(Face)
1 1 1,000
o 𝑃𝑟𝑖𝑐𝑒 = 70 [.07 − .07(1.07)3] + 1.073 = $1,000
o The bond is selling at Par (Price = Face Value)
• Example: What is the price of the bond if the interest rate is 10%?
1 1 1,000
o 𝑃𝑟𝑖𝑐𝑒 = 70 [.10 − .10(1.10)3] + 1.103 = $925
o The bond is selling at a Discount (Price < Face Value)
• Notice from the three examples how bond prices vary with interest rates. When
interest rates go up, the bond price decreases
• When the market interest rate (discount rate) is higher than the coupon rate, bonds sell
for less than face value (at a discount)
• When the market interest rate is less than the coupon rate, bonds sell for more than
face value (at a premium)
• When the market interest rate equals the coupon rate, bonds sell at face value (at par)
• Semi-Annual Payments: Most bonds make coupon payments semi-annually
 • The annual coupon payment is paid in two equal installments, every six months
• When calculating the price of a bond with semi-annual coupon payments, you need to
adjust the payment amount (divide the annual coupon by 2), the number of payments
(multiply the years to maturity by 2), and the discount rate (divide the discount rate by
2)
• Example: Calculate the current price of a 7.0% semi-annual coupon bond with a $1,000
face value which matures in 3 years. Assume a required return of 8%
o Ask yourself whether this bond will sell at a discount, a premium, or at par
o Annual coupons paid = 7% x $1,000 = $70
o -annual coupons = ($70/year)/(2 payments per year) = $35
o Total number of coupons paid = (3 years) x (2 payments per year) = 6
o Discount rate = (8%/year)/(2 Payments per year) = 4% per 6-month period
1 1 1,000
o 𝑃𝑟𝑖𝑐𝑒 = 35 [.04 − .04(1.04)6] + 1.046 = $974

Current Yield and Yield to Maturity

• Current Yield: Annual coupon payment divided by current bond price
o Current yield focuses only on current income so is not the same as total return,
which consists of interest income and any capital gains or losses on the sale of
the bond
• Example: You are buying a $1,000 face value bond with coupon rate of 8% per year for a
price of $1,053.46. What is the current yield?
o Coupon = .08 x $1,000 = $80
o Current Yield = Coupon/Price = 80/1,053.46 = .076 or 7.6%
• For a bond selling at a premium:
o Current Yield = Coupon/Price and Coupon Rate = Coupon/Face
o For a bond selling at a premium, Price > Coupon, so therefore:
o Current Yield < Coupon Rate
• For a bond selling at a discount:
o Current Yield > Coupon Rate
• Yield to Maturity (YTM): The discount rate that equates the present value of the bond’s
cash flows (both coupon income and repayment of face value) with its price
o It measures the rate of return that you will earn if you buy the bond today and
hold it to maturity
• Example: A bond has 3 years to maturity, an 8% annual coupon rate and a face value of
$1,000. If the price of the bond is $1,053.46, what is its yield to maturity?
o Price = PV(Coupons) + PV(Face)
1 1 1,000
o 1,053.46 = 80 [𝑟 − 𝑟(1+𝑟)3 + (1+𝑟)3 ]
o Find r = YTM
o We cannot solve this equation, so we must use trial and error
o The bond is selling at a premium, so YTM < Coupon = 8%
o Try r = 5%
1 1 1,000
o 𝑃𝑉 𝑜𝑓 𝐵𝑜𝑛𝑑 𝑎𝑡 5% = 80 [.05 − .05(1.05)3 ] + 1.053 = $1,082
 o $1,082 > Price = $1,053.46, so YTM > 5%
o Try r = 6%
1 1 1,000
o 𝑃𝑉 𝑜𝑓 𝐵𝑜𝑛𝑑 𝑎𝑡 6% = 80 [.06 − .06(1.06)3 ] + 1.063 = $1,053.46
o YTM = 6%
• The yield to maturity can also be found using a financial calculator or a spreadsheet
program
• You will not be asked to find yield to maturity on an exam since not everyone will have a
financial calculator, but you should understand how the trial and error process works
• One thing you can do to help with the trial and error process is to create a present value
profile – a graph showing the price of the bond given different discount rates

Bond Rates of Return

• Rate of Return: Total income per period per dollar invested
• Rate of Return = (Coupon income + Price Change)/Investment
• Example: You buy a $1,000 face value, 3-year, 8% annual coupon bond for $1,053.46.
One year later, you sell it for $1,100. What is your rate of return?
o Rate of Return = [80 + (1,100 – 1,053.46)]/1,053.46 = .120 or 12.0%
• Note that the rate of return equation can also be written as:
• Rate of Return = (Coupon/Investment) + (Price Change/Investment)
= Current Yield + Capital Gain Yield
• Example: You buy a $1,000 face value, 3-year, 8% annual coupon bond for $1,053.46
(YTM = 6%). Suppose the YTM stays at 6% and you sell the bond one year later. What is
the rate of return on your investment?
o What is the price of the bond in one year?
o It now has 2 years to maturity, and the YTM is 6%
1 1 1,000
o 𝑃𝑟𝑖𝑐𝑒 = 80 [.06 − .06(1.06)2] + 1.062 = $1,036.67
o Rate of Return = (80/1,053.46) + (1,036.67 – 1,053.46)/1,053.46 = 7.6% + (-1.6%)
= 6.0% (same as the YTM)
• Over time, if discount rates do not change, the price of a bond that is selling at a
premium will fall, until at maturity the price is equal to the face value
o Thus, the capital gain yield will be negative
o Current Yield > Yield to Maturity
• Similarly, the price of a bond selling at a discount will increase over time
o Thus, the capital gain yield will be positive
o Current Yield < Yield to Maturity
• Taxes and Rate of Return
• Taxes reduce the rate of return on an investment
• To calculate the after-tax rate of return on the investment, convert the cash flows to
their after-tax values
• Example: You bought an 8% annual coupon bond for $1,000 (par value - $1,000) and
sold it one year later for $1,047. If your marginal tax rate is 35%, what is the after-tax
rate of return?
 o Before-Tax Rate of Return = [80 + (1,047 – 1,000)]/1,000 = .127 or 12.7%
o After-Tax Rate of Return:
▪ Interest (Coupon) = $80
▪ Tax = .35 x 80 = $28
▪ After-tax income from coupon = 80 – 28 = $52
▪ Capital Gain = 1,047 – 1,000 = $47
▪ Taxable amount of gain = .50 x 47 = $23.50 (only 50% of gains are
taxable)
▪ Tax = .35 x 23.50 = $8.22
▪ After-tax income from gain = 47 – 8.22 = $38.78
▪ After-Tax Return = (52 + 38.78)/1,000 = .0908 or 9.08%

The Yield Curve

• Yield Curve or Term Structure of Interest Rates: Graph of the relationship between time
to maturity and yield to maturity, for bonds that differ only in their maturity dates
• To properly assess this relationship bonds must have the same coupon rate and same
risk
• Usually government bills and bonds are used to graph this relationship
• Generally, the yield curve is upward-sloping with long-term rates higher than short-
term, but the curve is sometimes downward-sloping or humped. Why do long-term and
short-term rates differ?
• Expectations Theory: A major factor determining the shape of the yield curve is
expected future interest rates. An upward-sloping yield curve tells you that investors
expect short-term interest rates to rise; downward sloping, that short-term rates will fall
• Interest Rate Risk: The risk in bond prices due to fluctuations in interest rates. An
increase in rates causes a decrease in bond prices and vice versa
• Different bonds are affected differently by interest rate changes:
o Longer term bonds are more sensitive to changes in interest rates than shorter
term bonds (greater interest rate risk)
o Lower coupon bonds are more sensitive to changes in interest rates than higher
coupon bonds (greater interest rate risk)
• Liquidity Premium or Liquidity Preference Theory: The yield curve will tend to be
upward sloping because of the liquidity premium needed to induce investors to buy the
riskier longer-term bonds
• Example: On January 8, 2020, the return on a 1-year, Government of Canada bond
(called the 1-year spot rate) was r1 = 1.73%. The return on a 2-year, Government of
Canada bond (called the 2-year spot rate) was r2 = 1.66%.
o Forward Rate = f2 = extra return you earn in the second year for investing for 2
years rather than 1
o (1 + r1)(1 + f2) = (1 + r2)2
o (1.0173)(1 + f2) = (1.0166)2
o F2 = (1.0166)2/(1.0173) – 1 = .0159 or 1.59%
o 1r2 = Expected 1-year spot rate for year 2
 o Expectations Theory – shape of yield curve determined by expectations about
future spot rates: 1r2 = f2 = 1.59%
o Liquidity Preference Theory – Long-term bonds are riskier than short-term
bonds, so offer a risk premium: 1r2 < f2, so 1r2 < 1.59%

Corporate Bonds and the Risk of Default

• Both corporations and the Government of Canada borrow money by issuing bonds
o Corporate borrowers can run out of cash and default on their borrowings
o Typically, national governments don’t go bankrupt if they can print5 more
money or raise taxes to cover debts. If they have borrowed in a foreign currency
(sovereign debt) and have a financial crisis, they may be unable to repay the
debt. This concern shows up in the yield that investors demand on such debt
• Default risk (or credit risk) is the risk that a bond issuer may default on its bonds
• The default premium or credit spread is the difference between the promised yield on a
corporate bond and the yield on a Canada bond with the same coupon and maturity. It
is the additional yield investors require for bearing credit risk
• Example: On January 23, 2019, a British Columbia Ferry Services Inc., 5.021% coupon
bond with a maturity of March , 20, 2037, had a price of $1193.14 and a yield to
maturity of 3.566. A Government of Canada 5.000% coupon bond with a maturity of
June 1, 2037, had a price of $1432.31 and a yield to maturity of 2.138
o Default premium for the BC Ferry services bond:
o 3.566 – 2.138 = 1.428%
• The safety of most corporate bonds can be judged from their bond ratings
• Bond ratings are provided by companies such as:
o Dominion Bond Rating Service (DBRS)
o Moody’s
o Standard and Poor’s (S&P)
o Fitch
• High investment grades are in the range from A++ to B++
• Speculative grade or Junk Bonds are rated below B+