Fixed Income Securities

Bond Pricing
Relevant Sections from the textbook:
Chapter 14
Chapter 15: Section 15.1
Chapter 16: Section 16.1
1
 Fixed Income (Debt) Securities

• A debt security is a claim on a specified periodic

stream of income.
• Bonds
– The borrower issues (i.e. sells) a bond to the lender for
some amount of cash.
– When the bond matures, the issuer pays the face value
(par value) to the bondholder.
– The issuer also makes pre-specified payments to the
bondholder on specified dates.
• These payments are called “coupon payments” and are equal to
the par value times the coupon rate

2
 Basic Features of a Bond
• Bonds as fixed income securities
– Pay a fixed amount of interest periodically to the
holder of record
– Repay a fixed amount of principal at the date of
maturity
• Bond market is divided by maturity
– Money Market: Short-term issues that mature
within one year
– Notes: Intermediate-term issues that mature
between one and ten years
– Bonds: Long-term obligations with maturity
greater than ten years
 Bond Characteristics
• Intrinsic Features
– Coupon: Determine the periodic interest income
– Term to maturity: Term bond or a serial bond
– Principal value: Different from market value and
the common principal or par value is $1,000
– Type of ownership: Bearer vs. registered bonds
• Types of Issues
– Secured (senior) bonds
– Unsecured bonds (debentures)
– Subordinated (junior) debentures
 Bond Characteristics
• Indenture provisions
– The indenture is the contract between the issuer and
the bondholder specifying the issuer’s legal
requirements
• Features affecting a bond’s maturity
– Callable (call premium)
– Noncallable
– Deferred call
– Nonrefunding provision
– Sinking fund
 Rates of Return on Bonds
• The Computations of Bond Return
– Holding period return
Pi, t 1  Int i, t
HPR i, t 
Pi, t
where:
HPRi,t = the holding period return for bond i during period t
Pi,t+1 = the market price of bond i at the end of period t
Pi,t = the market price of bond i at the beginning of period t
Inti,t = the interest payments on bond i during period t

– The holding period yield (HPY) is

HPY = HPR - 1
 Bond Pricing
• The value of a bond is equal to the present value of
the cash flows from the bond.
T

PB   C t t  ParValue T
T

t 1 (1 r ) (1r )

– PB = Price of the bond

– Ct = Coupon payments
–T = Number of periods to maturity
–y = Semi-annual discount rate or the semi-
annual yield to maturity
7
 Discounting a Simple Cash Flow

• A simple cash flow is a single cash flow at a

specified time.
PV CFt

0 t

8
 Present Value of Annuities
• An annuity is a constant cash flow that occurs at
regular intervals for a fixed period of time.

$A $A $A $A

0 1 2 3 4

9
 Bond Pricing - Example
• 8% coupon rate, 30-year maturity, par value of $1000, semi-
annual coupons. Suppose that the interest rate is 8 %
annually:

• 8% coupon rate, 30-year maturity, par value of $1000, semi-

annual coupons. Suppose that the interest rate is 10 %
annually:

10
 Determinants of Bond Prices
• Market interest rates
• Credit ratings
• Maturity
 Bond Prices and Market Interest Rates

• Bonds are very sensitive to market interest rates.

• If you sell a bond in the secondary market before it matures, the value
of the bond will be affected by current market interest rates.

– When current interest rates are greater than a bond’s coupon rate,
the bond will sell at a discount (a price less than its face value),

– When current interest rates are less than a bond’s coupon rate, the
bond will sell at a premium (a price more than its face value).
What Determines Interest Rates
• Inverse relationship with bond prices
• Forecasting interest rates
• Fundamental determinants of interest rates
i = RFR + I + RP
where:
RFR = real risk-free rate of interest
I = expected rate of inflation
RP = risk premium
– Conceptually
i = f (Economic Forces + Issue Characteristics)
What Determines Interest Rates
• Effect of Economic Factors
– Real growth rate
– Tightness or ease of capital market
– Expected inflation
– Supply and demand of loanable funds
• Impact of Bond Characteristics
– Credit quality
– Term to maturity
– Indenture provisions
– Foreign bond risk including exchange rate risk
and country risk
 Bond Pricing
• Interest Rates and Bond Prices
– At a higher interest rate, the present value of the payments received
by the bondholders is lower.
– Bond price falls as the market interest rates rise.

15
 Premium and Discount Bonds
• A premium bond is any bond that is currently trading at a
price above par.
• A discount bond is a bond trading at a price lower than par.
• Note: Bonds mature at a par value.

16
 Credit Rating
• If a bond issuer is at risk for default, it will be
assigned a low credit rating.
• Models used to predict the default risk.
– Coverage ratios
– Leverage ratios
– Liquidity ratios
– Profitability ratios
– Cash flow to debt
18
 Default Premium
• To compensate for the probability of default,
corporate bonds must offer a “default premium”
• The default premium is the difference between the
promised yield on a corporate bond and yield on a
similar-maturity government bonds.
• Default premiums are larger during recessions.
– Flight-to-quality : Investors move their bonds into
safer bonds unless they receive larger premiums
on lower-rated bonds.
 Maturity and Prices

• Changing interest rates affect bonds with

varying maturities differently.
– When interest rates rise:
• The longer the bond’s maturity, the more discounted
bond’s price will be.
• Example:
– When interest rates fall:
• Bonds with longer maturities will have higher
premiums.
 Table 14.2 Bond Prices at
Different Interest Rates

Maturity and Bond Prices

Keeping all other factors the same, the longer the
maturity of a bond, the greater the sensitivity of prices
to the market interest rate.
 Bond Yields

• Yield to maturity: Average rate of return that will be

earned on a bond if it is bought now and held up to
maturity.
– Defined as: The interest rate that makes the present value
of the bond’s payments equal to its price.
– To calculate the yield-to-maturity, we need to solve the
bond pricing formula for r
T
ParValue T
PB   (1C
t 1r)
t
t

(1 r )
T

22
 Bond Yields - Example
• Suppose an 8% coupon (semiannual payments),
$1000 par value, 30-year bond is selling at $1276.76.
What is its yield to maturity?
T
ParValue T
PB   (1C
t 1r)
t
t

(1 r )
T

23
 Yield to Maturity Example

10 yr Maturity
Coupon Rate = 7%
Price = $950
20
35 1000
950    T
(1r )
t
t 1 (1 r )

r = 3.8635%
 Yield Measures
1. Bond Equivalent Yield
7.72% = 3.86% x 2
2. Effective Annual Yield
(1.0386)2 - 1 = 7.88%
3. Current Yield
Annual Interest / Market Price
$70 / $950 = 7.37 %
Note: Current yield ignores capital gain/loss.
 Yield Curve
• The yield curve is a graph that displays the
relationship between yield and maturity.
• Pure yield curve
– Curve for zero-coupon treasury bonds (strips)
• On-the-run yield curve
– Yield for recently issued coupon bonds selling at par value

26
 Term Structure of Interest Rates

• It is a static function that relates the term to

maturity to the yield to maturity for a sample of
bonds at a given point in time
• The following slide shows yield curves for a
sample of U.S. Treasury obligations
Yields on U.S. Treasury Securities with
Alternative Maturities at Different times
Types of Yield Curves
 Shape of the Yield Curve
• A upward-sloping yield curve is one in which longer
maturity bonds have a higher yield compared to shorter-
term bonds due to the risks associated with time.
• An inverted yield curve is one in which the shorter-term yields
are higher than the longer-term yields, which can be a sign of
upcoming recession.
• A flat, or humped yield curve is one in which the shorter- and
longer-term yields are very close to each other, which is also a
predictor of an economic transition.
• The slope of the yield curve is also seen as important: the
greater the slope, the greater the gap between short- and
long-term rates.

30
 Duration
• Definition: The weighted average of the times
until each payment is received, with the weights
proportional to the present value of the
payment.
• Duration is a measure of a bond’s interest rate
risk
• Duration is expressed as years from a bond’s
purchase date.
• Duration can be used to compare bonds with
different issue and maturity dates, coupon rates
and yields to maturity.
Macaulay’s Duration: Calculation
t
wt  CF t (1  y ) Price

CFt Cash Flow for period t

T
D  t wt
t 1

By definition, duration measures the number of years

required to recover the true cost of a bond, considering
the present value of all coupon and principal payment
received in the future.
Spreadsheet 16.1 Calculating the Duration of
Two Bonds
 Macaulay’s Duration Example
• The duration of a par value bond with a
coupon rate of 8% and a remaining time to
maturity of 5 years is
 Duration/Price Relationship
Price change is proportional to duration and not to
maturity

Note that =

D* = modified duration =

∆𝑃 ∗
=− 𝐷 ∗ ∆ 𝑦
𝑃
• A 9%, 16-year bond has a yield to maturity of
11% and duration of 9.25 years. If the market
yield changes by 32 basis points, how much
change will there be in the bond's price?
 Interest Rate Risk
• What Determines Duration?
– Rule 1
• The duration of a zero-coupon bond equals its time to
maturity
– Rule 2
• Holding maturity constant, a bond’s duration is higher
when the coupon rate is lower
– Rule 3
• Holding the coupon rate constant, a bond’s duration
generally increases with its time to maturity
Figure 16.2 Bond Duration versus
Bond Maturity
 Interest Rate Risk
• What Determines Duration?
– Rule 4
• Holding other factors constant, the duration of a
coupon bond is higher when the bond’s yield to
maturity is lower
– Rules 5
• The duration of a level perpetuity is equal to:
(1 + y) / y