Lecture 2

Fixed Income Valuation

Introduction
Globally, the fixed-income market is a key source of financing for businesses and governments. In fact,
the total market value outstanding of corporate and government bonds is significantly larger than that
of equity securities. Similarly, the fixed-income market, which is also called the debt market or bond
market, represents a significant investing opportunity for institutions as well as individuals. Pension
funds, mutual funds, insurance companies, and sovereign wealth funds, among others, are major
fixed-income investors. Retirees who desire a relatively stable income stream often hold fixed-income
securities. Clearly, understanding how to value fixed-income securities is important to investors,
issuers, and financial analysts.

Bond prices and the time value of money

Bond Pricing with a Market Discount Rate

Bond pricing is an application of discounted cash flow analysis. The general approach to bond valuation
is to use a series of spot rates that correspond to the timing of the future cash flows.

Bond Pricing with a Market Discount Rate

On a traditional fixed-rate bond, the promised future cash flows are a series of coupon interest
payments and repayment of the full principal at maturity. The coupon payments occur on regularly
scheduled dates; for example, an annual payment bond might pay interest on 15 June of each year for
five years. The final coupon typically is paid together with the full principal on the maturity date. The
price of the bond at issuance is the present value of the promised cash flows. The market discount rate
is used in the time-value-of-money calculation to obtain the present value. The market discount rate
is the rate of return required by investors given the risk of the investment in the bond. It is also called
the required yield, or the required rate of return.

For example, suppose the coupon rate on a bond is 4% and the payment is made once a year. If the
time-to-maturity is five years and the market discount rate is 6%, the price of the bond is 91.575 per
100 of par value. The par value is the amount of principal on the bond.

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The final cash flow of 104 is the redemption of principal (100) plus the coupon payment for that date
(4). The price of the bond is the sum of the present values of the five cash flows. The price per 100 of
par value may be interpreted as the percentage of par value. If the par value is USD100,000, the
coupon payments are USD4,000 each year and the price of the bond is USD91,575. Its price is 91.575%
of par value. This bond is described as trading at a discount because the price is below par value.

Suppose that another five-year bond has a coupon rate of 8% paid annually. If the market discount
rate is again 6%, the price of the bond is 108.425.

This bond is trading at a premium because its price is above par value.

If another five-year bond pays a 6% annual coupon and the market discount rate still is 6%, the bond
would trade at par value.

■ When the coupon rate is less than the market discount rate, the bond is priced at a discount below
par value.

■ When the coupon rate is greater than the market discount rate, the bond is priced at a premium
above par value.

■ When the coupon rate is equal to the market discount rate, the bond is priced at par value.

Equation 1 below is a general formula for calculating a bond price given the market discount rate:

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Example:

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Yield to Maturity
If the market price of a bond is known, Equation 1 can be used to calculate its yield-to-maturity (YTM).
The yield-to-maturity is the internal rate of return on the cash flows—the uniform interest rate such
that when the future cash flows are discounted at that rate, the sum of the present values equals the
price of the bond. It is the implied market discount rate.

The yield-to-maturity is the rate of return on the bond to an investor given three critical assumptions:

1 The investor holds the bond to maturity.

2 The issuer makes all the coupon and principal payments in the full amount on the scheduled dates.
Therefore, the yield-to-maturity is the promised yield—the yield assuming the issuer does not default
on any of the payments.

3 The investor is able to reinvest coupon payments at that same yield. This is a characteristic of an
internal rate of return.

For example, suppose that a four-year, 5% annual coupon payment bond is priced at 105 per 100 of
par value. The yield-to-maturity is the solution for the rate, r, in this equation:

Solving by trial-and-error search or using the time-value-of-money keys on a financial calculator

obtains the result that r = 0.03634. The bond trades at a premium because its coupon rate (5%) is
greater than the yield that is required by investors (3.634%). The yield is implied by the market price.

Example

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Pricing bonds using spot rates
When a fixed-rate bond is priced using the market discount rate, the same discount rate is used for
each cash flow. A more fundamental approach to calculate the price of a bond is to use a sequence of
market discount rates that correspond to the cash flow dates. These market discount rates are called
spot rates. Spot rates are yields-to-maturity on zero-coupon bonds maturing at the date of each cash
flow.

Suppose that the one-year spot rate is 2%, the two-year spot rate is 3%, and the three-year spot rate
is 4%. Then, the price of a three-year bond that makes a 5% annual coupon payment is 102.960.

This three-year bond is priced at a premium above par value, so its yield-to-maturity must be less than
5%. Using Equation 1, the yield-to-maturity is 3.935%.

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When the coupon and principal cash flows are discounted using the yield-to-maturity, the same price
is obtained.

Equation 2 is a general formula for calculating a bond price given the sequence of spot rates:

Example

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Flat price, accrued interest and the full price
When a bond is between coupon payment dates, its price has two parts: the flat price (PVFlat) and the
accrued interest (AI). The sum of the parts is the full price (PVFull), which also is called the invoice or
“dirty” price. The flat price, which is the full price minus the accrued interest, is also called the quoted
or “clean” price.

PVFull = PVFlat + AI.

The flat price usually is quoted by bond dealers. If a trade takes place, the accrued interest is added to
the flat price to obtain the full price paid by the buyer and received by the seller on the settlement
date. The settlement date is when the bond buyer makes cash payment and the seller delivers the
security. The reason for using the flat price for quotation is to avoid misleading investors about the
market price trend for the bond. If the full price were to be quoted by dealers, investors would see the
price rise day after day even if the yield-to-maturity did not change. That is because the amount of
accrued interest increases each day. Then, after the coupon payment is made, the quoted price would
drop dramatically. Using the flat price for quotation avoids that misrepresentation.

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Accrued interest is the proportional share of the next coupon payment.

Notice that the accrued interest part of the full price does not depend on the yield-to maturity.
Therefore, it is the flat price that is affected by a market discount rate change.

For example, consider a 5% semiannual coupon payment government bond that matures on 15
February 2028. Accrued interest on this bond uses the actual/actual day-count convention. The
coupon payments are made on 15 February and 15 August of each year. The bond is to be priced for
settlement on 14 May 2019. The annual yield-to-maturity is stated to be 4.80%. Calculate PVFull, PVFlat
and AI.

PMT = 2.5, N=18, FV=100 and r = 0.0240