FINA5533 – Finance Essentials

Week 3
Valuing Debt Instruments
Learning Objectives

1. Identify the cash flows for both coupon bonds and zero-
coupon bonds, and calculate the value for each type of bond.
2. Calculate the yield to maturity for both coupon and zero-
coupon bonds, and interpret its meaning for each.
3. Given coupon rate and yield to maturity, determine whether a
coupon bond will sell at a premium or a discount.
4. Illustrate the change in bond price that will occur as a result of
changes in interest rates; differentiate between the effect of
such a change on long-term versus short-term bonds.
5. Discuss the effect of coupon rate to the sensitivity of a bond
price to changes in interest rates.

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Learning Objectives (cont'd)

6. Assess the creditworthiness of a corporate bond using its

bond rating; define default risk.
.

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Bond Terminology

 Bond – a debt instrument sold by the borrower to the lender.

Promises periodic interest payments and repayment of principal
at maturity.
• Bond Certificate - states the terms of the bond
Which term is
• Face Value – the principal to be repaid for the “interest
• Maturity Date – when face value is to be repaid rate”?
• Term - time remaining until the maturity date
• Coupon - promised interest payments
• Coupon Rate - the amount of each coupon payment expressed as an
APR
• Coupon Payment Coupon Rate  Face Value
CPN 
Number of Coupon Payments per Year

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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
 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:

 Although the bond pays no “interest”, your compensation is the

difference between the initial price and the face value.

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Zero-Coupon Bonds YTM is the for
the “interest
 Price of a Zero-Coupon bond rate”!

FV 100,000
P  96,618.36 
(1  YTM n ) n (1  YTM 1 )

 Yield to Maturity (YTM)

• The return earned from investing in the Bond
• The discount rate (interest rate) that sets the present value of the
promised bond payments equal to the current market price of the bond.
1
 FV  n 100,000
• YTM n     1 so 1  YTM 1   1.035
 P  96,618.36

• Thus, the YTM is 3.5% (EAR)

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Yield to Maturity and Internal Rate of Return

 Internal Rate of Return (IRR):

• The interest rate that sets the net present value of the cash
flows equal to zero.

 The IRR of an investment in a bond is given a special name, the

Yield to Maturity (YTM), or yield.

 In most cases that dealing with investments with multiple (non-

regular) cash flows, it is not possible to solve for IRR using
simple algebra.
• Use Excel spreadsheet or a financial calculator!

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Example

Suppose a risk-free zero-coupon bond with $1000 FV, which

matures in 1.5 years, is trading for $940.
• What is its YTM expressed as an EAR and as a 6 month APR?
• What is the value (price) of the bond 2 months prior to maturity
assuming the same YTM?
1 1
 FV   1000 
n 1 .5
YTM     1     1  YTM  4.21%( EAR )
 P   940 
1
 1000  3
YTM (6 _ month )     1  YTM  2.08%  APR  4.16%
 940 
1000
P  $993.15
1
(1.0421) 6

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Coupon Bonds

 Coupon Bonds
• Pay face value at maturity
• Pay regular coupon interest payments (annuity)

 Yield to Maturity
• The YTM is the single discount rate that equates the present value of
the bond’s remaining cash flows to its current price.

1  1  FV
P  CPN  1  N 

y  (1  y )  (1  y ) N
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Example

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Computing YTM or Price

 We know the cash flows (face value and coupons) so:

• If we know YTM we can calculate price
• If we know price we can calculate YTM

 Consider the following semi-annual bond:

– $1000 face value
– 7 years until maturity
– 9% coupon rate
– Price is $1,080.55.
• What is the bond’s yield to maturity?
• Suppose its yield to maturity has increased to 10% APR. What is the
bond’s new price?

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Annuity calculator inputs for solutions, or Excel

 Or Excel Demonstration in Class.

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Dynamic Behavior of Bond Prices

 Price is not the same thing as face value

• A bond is selling at a discount if the price is less than the
face value.
• A bond is selling at par if the price is equal to the
face value.
• A bond is selling at a premium if the price is greater than
the face value.
 Why does this happen?
• Coupon rate is not necessarily the same as YTM.

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An Intuitive Explanation

 Think about the interest rate only loans (from week 5):
• Borrower makes periodic interest payment and the principal is repaid at
termination of loan.
• If the borrower just made sufficient payment to cover all interest generated in
that period, then the outstanding loan balance would be the same as the
principal to be paid at the end.
 Then think about coupon bond scenario:
• If coupon rate is less than YTM (the interest rate), it means the issuer of the
bond (borrower) does not make “sufficient” payment to repay the interest in
each period.
• Because the borrower does not pay the lender (buyer of the bond) enough
interest generated from the principal in that period, it does not make sense
for the lender to lend out (i.e. buy bond) the entire amount of principal (i.e.
face value).
• As a lender, the amount of money you are willing to lend out (price) will be
less than the face value.

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Discounts and Premiums
 An increase in the required YTM will decrease the present value of the cash
flows and cause the bond to trade at a discount
 A decrease in the required YTM will increase the present value of the cash
flows and cause the bond to trade at a premium.
 Most coupon bonds have a coupon rate so that the bonds will initially trade
at, or very close to, par.

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Example

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Time and Bond Prices

 Assume YTM does not change:

 Does a bond always have the same price if yield to maturity does
not change?
• No. Money has a time value and cash flows become more valuable as the
time to receiving them decreases.
• Up until now we have been assuming that the next payment is in one
periods time but we need to be able to value at any point in time (i.e. ‘N’
is not always an integer)

 Holding all other things constant, the price of a bond will move
towards par value over time.

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Example

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Solution

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Solution (cont’d)

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The Effect of Time on Bond Prices

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Duration

 There is an inverse relationship between interest rates and bond prices.

• As interest rates and bond yields rise, bond prices fall.
• As interest rates and bond yields fall, bond prices rise.

 The sensitivity of a bond’s price to changes in interest rates is measured by

the bond’s duration.
• Bonds with high durations are highly sensitive to interest rate changes.
• Bonds with low durations are less sensitive to interest rate changes.
• Duration is related to both coupon rate and maturity date.

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Example - The interest rate sensitivity of bonds -
Maturity
 Consider a 10-year coupon bond and a 30-year coupon bond,
both with 10% annual coupons. By what percentage will the
price of each bond change if its yield to maturity increases from
5% to 6%?

• The price of the 10-year bond changes by:

(129.44 − 138.61) / 138.61 = − 6.6% if its yield to
maturity increases from 5% to 6%.
• For the 30-year bond, the price change is
(155.06 − 176.86) / 176.86 = − 12.3%.

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Example - The interest rate sensitivity of bonds –
Coupon rates
 Consider two bonds, each pays semi-annual coupons and five
years left until maturity. One has a coupon rate of 5% and the
other has a coupon rate of 10%, but both currently have a yield
to maturity of 8%. How much will the price of each bond
change if its yield to maturity decreases from 8% to 7%?

• The 5% coupon bond’s price changed from

$87.83 to $91.68, or 4.4%;
• The 10% coupon bond’s price changed from
$108.11 to $112.47, or 4.0%.

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Corporate Bonds

 Corporate Bonds
• Issued by corporations
 Credit Risk
• Risk of default
 Investors pay less for bonds with credit risk
than they would for an otherwise identical
default-free bond.
 The yield of bonds with credit risk will be higher than that of
otherwise identical default-free bonds

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Bond Ratings

 Several companies rate the creditworthiness of bonds and make

this information available to investors.

 By consulting these ratings, investors can assess the

creditworthiness of a particular bond issue. The ratings therefore
encourage widespread investor participation and relatively liquid
markets.

 Two best-known bond rating companies are:

• Standard & Poor’s
• Moody’s.

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Bond Ratings

 Bonds in the top four categories are often referred to as

investment-grade bonds because of their low default risk.
 Bonds in the bottom five categories are often called speculative
bonds, junk bonds or high-yield bonds because their likelihood
of default.
 The rating depends on:
• the risk of bankruptcy
• bondholder’s claim to assets in the event of bankruptcy.

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Bond Ratings

 Credit Spread
• Also known as Default Spread
• The difference between the yields of the corporate bonds
and the yields of Treasury bonds is the credit spread.
• Credit spreads fluctuate as perceptions regarding the
probability of default change.

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Bond Ratings

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Example - Credit Spreads and Bond Prices

 Your firm has a credit rating of AA. You notice that the credit
spread for 10-year maturity debt is 90 basis points (0.90%). Your
firm’s 10-year debt has a coupon rate of 5%. You see that new
10-year Treasury bonds are being issued at par with a coupon
rate of 4.5%. What should be the price of your outstanding 10-
year bonds?

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Solution

 If the credit spread is 90 basis points, then the yield to maturity

on your debt should be the yield to maturity on similar Treasury
bonds plus 0.9%.
 The fact that new 10-year Treasury bonds are being issued at
par with coupons of 4.5% means that with a coupon rate of
4.5%, these notes are selling for $100 per $100 face value.
 Thus, their yield to maturity is 4.5% and your debt’s yield to
maturity should be: 4.5% + 0.9% = 5.4%.

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Solution

 The cash flows on your bonds are $5 per year for every $100
face value, paid as $2.50 every six months.
 The six-month rate corresponding to a 5.4% yield is
5.4% / 2 = 2.7%.

1  1  100
2.50  1    $96.94
0.027  1.027 20  1.027 20

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Solution

 Your bonds offer a higher coupon (5% vs. 4.5%) than Treasury
bonds of the same maturity, but sell for a lower price ($96.94 vs.
$100). The reason is the credit spread. Your firm’s higher
probability of default leads investors to demand a higher yield to
maturity on your debt.
 To provide a higher yield to maturity, the purchase price for the
debt must be lower. If your debt paid 5.4% coupons, it would
sell at $100, the same as the Treasury bonds.
 But to get that price, you would have to offer coupons that are
90 basis points higher than those on the Treasury bonds—
exactly enough to offset the credit spread.

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