Bond Prices and Yield

Investment

Week 7, Chap 10
10.1 Bond Characteristics (1 of 10)

Bond
• Security that obligates issuer to make payments to holder
over time

Face Value, Par Value

• Payment to bondholder at maturity of bond

Coupon Rate
• Bond’s annual interest payment per dollar of par value

Zero-Coupon Bond
• Pays no coupons, sells at discount, provides only payment
of par value at maturity
Prices/Yields of U.S. Treasury Bonds

FIGURE 10.1
Prices and yields of U.S. Treasury bonds, February 15, 2017
Source: The Wall Street Journal Online, April 22, 2017.

Maturity Coupon Bid Ask Chg Ask yield to maturity

15-Feb-2018 3.500 102.5000 102.5156 −0.0547 0.959
31-Dec-2020 1.750 99.7188 99.7344 −0.1406 1.821
15-Nov-2022 1.625 97.0938 97.1094 −0.2188 2.163
15-Feb-2026 1.625 92.9141 92.9297 −0.2734 2.508
15-Feb-2026 6.000 128.4922 128.5078 −0.3438 2.450
15-May-2030 6.250 140.5547 140.6172 −0.4453 2.604
15-Nov-2043 3.750 112.3984 112.4297 −0.7734 3.065
15-Feb-2047 3.000 98.2500 98.2813 −0.5703 3.088
10.1 Bond Characteristics (2 of 10)

Treasury Bonds and Notes

• Accrued interest and quoted bond prices
– Quoted prices do not include interest accruing between payment
dates

Accrued interest
Annual coupon payment Days since last coupon payment
= ×
2 Days separating coupon payments
Example: Consider a bond with the following characteristics: Semi-annu
al payments, coupon rate of 6%, $1,000 par value. If 45 days have passe
d since the last coupon payment, what is the accrued interest?

45
A. I. = × $30 = $7.42
182
 Figure 10.2 Listing of Corporate Bonds

Source: FINRA (Financial Industry Regulatory Authority), May 30, 2017.

Moody’s®
Issuer Name Symbol Coupon Maturity High Low Last Change Yield%
/S&P
NORTHWESTERN U NWUA4062616 4.643% 12/01/2044 /AAA 118.50400 118.30400 118.50400 2.245000 3.579884
NIV
SANOFIS A SNY3990861 1.250% 04/10/2018 A1/ 99.94500 99.82800 99.91960 0.143600 1.344026
MORGAN STANLEY MS4190343 1.875% 01/05/2018 A3/BBB+ 100.38300 100.12700 100.30600 −0.060733 1.355591
WESTPAC BKG CO WBK4461873 2.150% 03/06/2020 Aa2/ 100.38400 100.27000 100.38400 0.075000 2.005983
RP
ROYAL BK CDA RY4207609 1.875% 02/05/2020 Aaa/ 99.89200 99.81200 99.81200 0.079000 1.946994
CREDIT SUISSE AG CS4237858 1.700% 04/27/2018 A1/A 100.09500 100.03600 100.07600 0.053000 1.614536
NEW YORK BRH ME
DIUM TER
PACCAR FINL CORP PCAR4361418 1.300% 05/10/2019 A1/A+ 99.18213 99.05900 99.11600 0.050000 1.764976
MEDIUM TERM SR
NTS BOOK
HSBC USA INC HBC4217868 2.350% 03/05/2020 A2/A 100.76200 100.56400 100.56400 −0.214000 2.137972
10.1 Bond Characteristics (3 of 10)

Corporate Bonds

• Call provisions on corporate bonds

– Callable bonds: May be repurchased by issuer at
specified call price during call period

• Convertible bonds
– Allow bondholder to exchange bond for specified
number of common stock shares
10.1 Bond Characteristics (4 of 10)

Corporate Bonds

• Puttable bonds
– Holder may choose to exchange for par value or to
extend for given number of years

• Floating-rate bonds
– Coupon rates periodically reset according to specified
market date
10.1 Bond Characteristics (5 of 10)

Preferred Stock

• Commonly pays fixed dividend

– Floating-rate preferred stock becoming more popular

• Dividends not normally tax-deductible

– Corporations that purchase other corporations’
preferred stock are taxed on only 50% of dividends
received. (tax deduction ratio can be changed)
10.1 Bond Characteristics (6 of 10)

Other Domestic Issuers

• State, local governments (municipal bonds)

• Federal Home Loan Bank Board
• Farm Credit agencies
• Ginnie Mae, Fannie Mae, Freddie Mac
10.1 Bond Characteristics (7 of 10)

International Bonds

• Foreign bonds
– Issued by borrower in different country than where
bond sold
– Denominated in currency of market country

• Eurobonds
– Denominated in currency (usually that of issuing
country) different than that of market
10.1 Bond Characteristics (8 of 10)

Innovation in the Bond Market

• Inverse floaters
– Coupon rate falls when interest rates rise

• Asset-backed bonds
– Income from specified assets used to service debt
10.1 Bond Characteristics (9 of 10)

Innovation in the Bond Market

• Pay-in-kind bonds
– Issuers can pay interest in cash or additional bonds

• Catastrophe bonds
– Higher coupon rates to investors for taking on risk
10.1 Bond Characteristics (10 of 10)

Innovation in the Bond Market

• Indexed bonds
– Payments tied to general price index/price of particular
commodity
– Treasury Inflation Protected Securities (TIPS): Par value
of bond increases with consumer price index

Interest + Price appreciation

Nominalreturn=
Initial price
1+ Nominal return
Realreturn = −1
1+ Inflation
Table 10.1 TIPS, Principal and Interest
Payments

Principal and interest payments for a Treasury Inflation

Protected Security

Tim Inflation in Year Par Coupon Principal Total

+ =
e Just Ended Value Payment Repayment Payment
0 $1,000.00
1 2% 1,020.00 $40.80 0 $ 40.80
2 3 1,050.60 42.02 0 42.02
3 1 1,061.11 42.44 $1,061.11 1,103.55
10.2 Bond Pricing (1 of 3)

Bond value = Present value of coupons + Present par value

Coupon Par value

Bondvalue=  t =1
T
+
(1+ r ) (1+ r )
t T

T = Maturity date
r = discount rate

1 1 1
Bondprice = Coupon × 1 − + Parvalue ×
r 1+r T 1+r T

= Coupon × Annuityfactor r, T + Parvalue × PVfactor r, T

10.2 Bond Pricing: Example

What is the price of the following two bonds:

Bond A Bond B
Maturity (T) 4 Years 30 Years
Coupon Rate (C) 5% 5%
Discount Rate (r) 8% 8%
Par Value (FV) $1,000 $1,000

BondA BondB
1 − 1 + r −T 1 − 1 + r −T
PV = C × + FV × 1 + r −T PV = C × + FV × 1 + r −T
r r
1 − 1.08 −4 1 − 1.08 −30
= $50 × + $1,000 × 1.08 −4 = $50 × + $1,000 × 1.08 −30
.08 .08
= $165.61 + $735.03 = $900.64 = $562.89 + $99.38 = $662.27

Present Value of Coupons: $165.61, $562.89

Present Par Value: $735.03, $99.38
10.2 Bond Pricing (2 of 3)

• Prices fall as market interest rate rises

• Interest rate fluctuations are primary source of

bond market risk

• Bonds with longer maturities more sensitive to

fluctuations in interest rate
Figure 10.3 Inverse Relationship between
Bond Prices and Yields
Table 10.2 Bond Prices at Different Interest
Rates

Bond Price Bond Price

Bond Price at Bond Price at Bond Price at
at Given at Given
Time to Given Market Given Market Given Market
Market Market
Maturity Interest Rate: Interest Rate: Interest Rate:
Interest Interest
2% 4% 10%
Rate: 6% Rate: 8%

1 year $1,059.11 $1,038.83 $1,019.1 3 $1,000.00 $981.41

10 years 1,541.37 1,327.03 1,148.77 1,000.00 875.38
20 years 1,985.04 1,547.11 1,231.15 1,000.00 828.41
30 years 2,348.65 1,695.22 1,276.76 1,000.00 810.71
10.2 Bond Pricing (3 of 3)

Bond Pricing between Coupon Dates

• Invoice price = Flat price + Accrued interest

Bond Pricing in Excel

• =PRICE (settlement date, maturity date, annual coupon
rate, yield to maturity, redemption value as percent of par
value, number of coupon payments per year)
Spreadsheet 10.1 Valuing Bonds
10.3 Bond Yields (1 of 3)

Yield to Maturity
• Discount rate that makes present value of bond’s
payments equal to price.

Current Yield
• Annual coupon divided by bond price

Premium Bonds
• Bonds selling above par value

Discount Bonds
• Bonds selling below par value
Spreadsheet 10.2 Finding Yield to Maturity

Semiannual Annual
coupons coupons
Settlement date 1/1/2000 1/2/2000
Maturity date 1/1/2030 1/2/2030
Annual coupon rate 0.08 0.08
Bond price (flat) 127.676 127.676
Redemption value 100 100
(% of face value)
Coupon payments per year 2 1
Yield to maturity (decimal) 0.0600 (YIELD) 0.0599
The formula entered here is
=YIELD(B3,B4,B5,B6,B7,B8)
10.3 Bond Yields (2 of 3)

Yield to Call

• Calculated like yield to maturity

• Time until call replaces time until maturity; call price
replaces par value
• Premium bonds more likely to be called than discount
bonds
Figure 10.4 Bond Prices: Callable and
Straight Debt
10.3 Bond Yields (3 of 3)

Realized Compound Returns versus Yield to Maturity

• Realized compound return

– Compound rate of return on bond with all coupons
reinvested until maturity
• Horizon analysis
– Analysis of bond returns over multiyear horizon
– Based on forecasts of bond’s YTM and investment
options
• Reinvestment rate risk
– Uncertainty surrounding cumulative future value of
reinvested coupon payments
Figure 10.5 Growth of Invested Funds
10.4 Bond Prices Over Time (1 of 3)

Yield to Maturity versus Holding Period Return (HPR)

• Yield to maturity measures average RoR if investment held

until bond matures

• HPR is RoR over particular investment period; depends on

market price at end of period
Figure 10.6 Price Paths of Coupon Bonds in
Case of Constant Market Interest Rates

Price path of two 30-year maturity bonds each selling at a

yield to maturity of 8%. Bond price approaches par value as
maturity date approaches.
10.4 Bond Prices Over Time (2 of 3)

Zero-Coupon Bonds and Treasury STRIPS

• Zero-coupon bond: Carries no coupons, provides all return

in form of price appreciation
• Separate Trading of Registered Interest and Principal of
Securities (STRIPS): Oversees creation of zero-coupon
bonds from coupon-bearing notes and bonds
Figure 10.7 Price of 30-Year Zero-Coupon
Bond over Time at Yield to Maturity of 10%
10.4 Bond Prices Over Time (3 of 3)

After-Tax Returns

• Built-in price appreciation on original-issue discount bonds

constitutes implicit interest payment to holder

• IRS calculates price appreciation schedule to determine

taxable interest income for built-in appreciation
10.5 Default Risk and Bond Pricing (1 of 7)

Investment grade bond

• Rated BBB and above by S&P or Baa and above by
Moody’s

Speculative grade or junk bond

• Rated BB or lower by S&P, Ba or lower by Moody’s, or
unrated
Figure 10.8 Bond Rating Classes
10.5 Default Risk and Bond Pricing (2 of 7)

Determinants of Bond Safety

• Coverage ratios: Company earnings to fixed costs

• Leverage ratio: Debt to equity

• Liquidity ratios
– Current: Current assets to current liabilities
– Quick: Assets excluding inventories to liabilities
10.5 Default Risk and Bond Pricing (3 of 7)

Determinants of Bond Safety

• Profitability ratios: Measures of RoR on assets or equity

• Cash flow-to-debt ratio: Total cash flow to outstanding

debt
 Financial Ratios and Default Risk

TABLE 10.3 Financial ratios by rating class

Aaa Aa A Baa Ba B C
EBITA/Assets (%) 20.9% 15.6% 13.8% 10.9% 9.1% 7.1% 4.0%
Operating profit margin (%) 22.0% 17.1% 17.6% 14.1% 11.2% 8.9% 4.1%
EBITA to interest coverage (multiple) 28.9 15.1 9.7 5.9 3.5 1.7 0.6

Debt/EBITDA (multiple) 0.58 2.03 1.83 2.58 3.41 5.26 8.35

Debt/(Debt + Equity) 19.3% 50.2% 38.6% 46.2% 51.7% 72.0% 98.0%
Funds from operations/Total debt ( 1.335 0.385 0.425 0.296 0.206 0. 120 0.031
multiple)
Retained cash flow/Net debt (multip 1.3 0.3 0.4 0.3 0.2 0. 1 0.0
le)
10.5 Default Risk and Bond Pricing (4 of 7)

Bond Indentures

• Indenture
– Defines contract between issuer and holder

• Sinking fund
– Indenture calling for issuer to periodically repurchase
some proportion of outstanding bonds before maturity
10.5 Default Risk and Bond Pricing (5 of 7)

Bond Indentures

• Subordination clause
– Restrictions on additional borrowing stipulating senior
bondholders paid first in event of bankruptcy

• Collateral
– Specific asset pledged against possible default

• Debenture
– Bond not backed by specific collateral
Figure 10.9 Callable Bond: Apple
10.5 Default Risk and Bond Pricing (6 of 7)

Yield to Maturity and Default Risk

• Stated yield is maximum possible yield to maturity of bond

• Default premium
– Increment to promised yield that compensates investor
for default risk
10.5 Default Risk and Bond Pricing (7 of 7)

Credit Default Swaps (CDS)

• Insurance policy on default risk of corporate bond or loan

• Designed to allow lenders to buy protection against losses
on large loans
– Later used to speculate on financial health of
companies
Yield Spreads among Corporate Bonds

Figure 10.10
Yield spreads between corporate and 10-year Treasury bonds
Source: Federal Reserve Bank of St. Louis.
Prices of CDS, Greece

Figure 10.11
Prices of five-year credit default swaps
Source: Bloomberg, August 1, 2012, www.bloomberg.com/quote
CDBR1U5:IND/chart
10.6 The Yield Curve (1 of 3)

Yield Curve
• Graph of yield to maturity as function of term to maturity

Term Structure of Interest Rates

• Relationship between yields to maturity and terms to
maturity across bonds

Expectations Hypothesis
• Yields to maturity determined solely by expectations of
future short-term interest rates
Figure 10.12 Treasury Yield Curve

Source: Various editions of The Wall Street Journal.

Figure 10.13 Returns to Two 2-Year
Investment Strategies
10.6 The Yield Curve (2 of 3)

Forward Rate
Inferred short-term ROI for future period, makes expected t
otal return of long-term bond equal to that of rolling over
short-term bonds

(1+ y n ) = (1+ y n -1 ) (1+ fn )

n n -1
10.6 The Yield Curve (3 of 3)

Liquidity Preference Theory

• Investors demand risk premium on long-term bonds

• Liquidity premium
– Extra expected return demanded by investors as
compensation for greater risk of long-term bonds
• Spread between forward ROI and expected short sale
– fn = E(rn) + Liquidity premium
Illustrative Yield Curves

FIGURE 10.14
Illustrative yield curves
Panel A: Increasing expected short
rates combined with increasing
liquidity premium. The result is a
sharply rising yield curve.
Panel B: Declining expected short
rates combined with constant
liquidity premium. The result is a
hump-shaped yield curve.
Figure 10.15 Term Spread: Yields on 10-
Year versus 90-day Treasuries
Thank You