Bonds

Valuing financial securities

• Whenever we value any financial asset, we

always find the present value of the
expected future cash flows.
• Our r or discount rate or required rate of
return will depend upon the security being
valued.
• Generally, the more likely it is that the
actual cash flows will not equal expected
cash flows, we as investors will demand a
higher rate of return, i.e. higher r for taking
more risk.
Bonds - I
 What we will cover:

- What is a bond?
- Bond valuation
- Bond prices and interest rates
- Perpetual bonds
- Interest rate sensitivity
- Bond coupons
 Objectives
By the end of this class, you should be able to:
• Develop the basic bond valuation formula.
• Explain the relation between bond prices and
interest rates.
• Calculate the price of a perpetual bond.
• Determine which bonds are more sensitive to
interest rate changes.
• Use the coupon rate to determine the dollar
coupons paid on a bond.
 What is a Bond?
• A bond is a financial security that obligates the
issuer (corporation or government) to make
specific payments to the buyer (bondholder)
• A typical bond is an interest only loan
• Bonds are often called “fixed income” securities
because they have strictly defined payments.
• Bonds are usually bought and sold “over the
counter” (OTC) in public debt markets
• Face Value: principal amount of the bond
that is repaid on the maturity date. Also called
‘par value’. Typically $1,000.
• Coupon Payment: interest payment paid
regularly to the bondholder. It does not
change over time.
• Coupon Rate: annual coupon payment
expressed s a percentage of face value. It is
fixed and it is an APR rate.
• Bond Covenant: specifies what the bond
issuer may and may not do over the life of the
bond. Intended to protect the rights of
bondholders.
 Cashflows on a Bond
A bond makes regular interest payments (I).
The principal (F), called the face value, is
repaid on the final date (n).
0 1 2 3 4 … n-1 n

I I I I … I I+F

Market price
of bond (P)
 Basic Bond Valuation
F= face value of bond
I = $ interest payments (coupons)
r = effective interest rate used to discount the bond’s
cash flows (a market rate - can change over time)
n = number of periods (i.e. payments) until the bond
matures
P = current price of the bond

1 − (1 + r ) −n
−n
P = I  + F (1 + r )
 r 
 1 − (1 + r ) − n  −n
Bond Pricing P = I  + F (1 + r )
 r 

a) Find the price of a bond with a face value

of $1,000 that pays 8% annual coupons and
has 25 years until maturity. The current
market rate of interest is 8% per year.
b) Suppose now that r = .06 instead of .08.
What is the price of the bond?

c) What if r = .10 instead of .08? What is the

price of the bond?
Summary of results from 8% coupon bond example
where we changed the market interest rate:

Price at 10%: Price at 8%: Price at 6%:

Key Point

Bond prices and market interest

rates are inversely related.
d) Suppose that after 5 years we sell the
bond. Thus, our bond has 20 years left
until it matures. If the market rate is 8%
(the same as the coupon rate), what is the
price of the bond at that time?
e) Instead, suppose that after 5 years we want to
sell the 8% coupon bond but the market rate of
interest is 10%. What is the bond’s price at that
time?

Q: How does the bond buyer earn money from

buying our bond and holding it to maturity?
1. Coupons: $80 per year
2. Capital Gain: $________
(Sales price or Face Value - Purchase price)
 Perpetual Bonds

Features of a perpetual (or consol) bond:

• level stream of interest payments
• beginning one period from now
• occurring at regular intervals
• never matures, so the bondholder never
receives the face value
The price of a perpetual bond is just the PV of
a perpetuity.

Formula for Price of a Perpetual Bond:

I
P=
r
 Example
Let r = .08. Three bonds, with $1,000 face value
and annual 10% coupon, have different maturities.
• Price of a perpetual bond:

• Price of a 30-year bond:

• Price of a one-year bond:

Now suppose r = .06. Price these three bonds.
• Price of a perpetual bond:

• Price of a 30-year bond:

• Price of a one-year bond:

When r fell from 8% to 6% …
• The price of the perpetual bond increased by:
(1666.67-1250)/1250 = 33.33%

• The price of the 30-year bond increased by:

(1550.59-1225.16)/1225.16 = 26.56%

• The price of the one-year bond increased by:

(1037.74-1018.52)/1018.52 = 1.88%
 Key Point

Bonds with different maturities have

different sensitivities to interest rate
changes (i.e. interest rate risk).

All things equal, longer maturity bonds

are more sensitive to interest rate
changes than shorter maturity bonds.
 Coupons and Face Value
• The coupon rate is quoted in APR terms,
based on the bond’s face value.
• Coupons are normally paid semi-annually,
but could be paid at some other frequency.
• A bond’s face value is normally $1,000 but
could be some other amount.
 Calculating Coupon Payments
• Bonds’ coupons are quoted using a coupon rate.
• Coupons are calculated using:
CR
I = F×
where: k

– I is the coupon (or interest) payment in $

– F is the face value of the bond (often $1000)
– CR is the coupon rate
– k is the number of coupon payments per year (often
semi-annual or 2 payments per year)
 Example
• A Government of Canada bond has a face
value of $1000, semi-annual coupon payments
and a coupon rate of 6%.What is the coupon
paid each period?
• Solution:
F = $1,000
CR = 6%
k=2
I=
Bonds - II
 What we will cover:

- Yield to maturity
- Effective periodic yield
- Current yield
- Default risk and
- Default premium
 Objectives
By the end of this class, you should be able to:
• Find the market price of a bond given its yield
to maturity (YTM).
• Set up the equation to solve for a bond’s
effective periodic yield and, by extension, its
YTM.
• Distinguish between coupon rate and YTM.
• Use “current yield” to get a clue about YTM.
• Interpret bond quotations.
• Describe default risk and default premium.
 What is the Yield to Maturity – YTM?

• The total return anticipated on a bond if the bond is

held until the end of its lifetime.
• It is the internal rate of return of an investment in a
bond if the investor holds the bond
until maturity and if all coupon payments are made
as scheduled.
• The YTM is not the same as the coupon rate!
The coupon rate determines the bond cash flows
and the YTM determines the discount rate we use
to value the bond.
7-27
 Yield to Maturity
• Bond quotations usually report the bond’s yield
to maturity (YTM).
• A YTM is quoted in APR terms (just like the
coupon rate).
• The relationship between a bond’s YTM and its
effective periodic yield, r, is:
YTM = r × k
where k is the number of coupon payments per year.
 Semi-annual bond example
An 8–year GOC bond with a $1,000 face value
has semi-annual coupon payments, a 12%
coupon rate, and a YTM of 10%. What is the
bond valued at today?

Solution:
1. Determine the $ amount of the coupons.
2. Determine r, the effective periodic yield.
3. Use the bond valuation formula.
 Semi-annual bond example
1. Determine the $ amount of the coupons:

2. Determine r, the effective periodic yield:

 Semi-annual bond example
3. Use the bond valuation formula:
1 − (1 + r ) − n  −n
P = I  + F (1 + r )
 r 
 Calculating a Bond’s YTM

• If we know all the other relevant variables,

we can determine a bond’s effective
periodic yield (r) and, by extension, its
YTM.
• The difficulty: we don’t have a closed form
solution for doing this. You need to do this
by trial and error or with a financial
calculator or spreadsheet.
 The solution technique to use is:
1. Enter the bond’s price on the left side of the
bond pricing equation and enter all your
inputs on the right hand side.
2. Use trial and error until you find the correct r
that makes the LHS = RHS.
3. Use YTM = r × k to obtain the YTM.
 YTM Example 1
A 4-year $1,000 bond with a coupon rate of
6%, paying coupons semi-annually, is priced
at $1035.85. We wish to determine its YTM.
First: set up the equation to determine r.
 Shortcuts
Trial and error is time-consuming and tedious.
There are a couple of shortcuts:
1. Many financial calculators and software
packages such as Excel calculate YTM.
2. Choose your initial estimate for r more
accurately, by remembering the following
relationship between YTM and the coupon
rate …
• Note that a bond’s YTM and its coupon rate
are both quoted in APR terms.
• This leads to the following relationships:
If… then… and the bond trades at

YTM < CR P > F a premium

YTM = CR P = F par
YTM > CR P < F a discount
Don’t confuse coupon rate with yield to maturity!

• Coupon rate: remains unchanged over the life of

the bond. It determines the $ coupon payments.
• YTM: changes because market interest rates
change and the bond’s risk can changed, which
cause the bond price to change.

The YTM measures the average annual (APR)

rate of return on the bond you would earn if you
were to buy the bond today and hold it until
maturity.
Bond valuation seen in reverse…
 “Current Yield ”
• A bond’s “current yield” gives us a clue as to
the correct YTM for a bond.
• Current Yield = Annual $Coupon /Current Price
• Example:
A bond with a $1,000 face value has an 8%
coupon rate and is trading at $953.80.
Current Yield = $80 / $953.80 = 8.39%
 YTM Example 2
A ten-year $1,000 bond has a coupon rate of
5%, semi-annual coupons, and a price of $926.
Set up any equations necessary to determine
YTM.

1 − (1 + r ) − n  −n
P = I  + F (1 + r )
 r 
YTM Example 2
 Bond Selling at a Discount?
• In Example 2, the bond (with a price of $926)
was selling at a discount. Why?
• Answer:
 Bond Price Quotations
• Newspapers and online sources quote prices
of government and corporate bonds.

• The bid price is the price that a bond dealer

is prepared to bid (i.e. pay) for the bond. The
ask price is the price that a bond dealer is
asking for a bond (i.e. willing to sell at).
• Bond prices are quoted as a percent of a
$1,000 face value. The price of a bond
trading at $1,045.90 would be quoted as
104.59 .

• Quotes also provide coupon rate, maturity

date, and YTM information.
 Default Risk
• Default (or credit) risk: risk that a bond
issuer will be unable to make promised
payments of coupons or principal.
• Investors expect to be compensated for
default risk.
• Other things being equal, a bond with higher
default risk will have to offer a higher yield
to attract investors.
• Note: This is our first look at risk! Generally
risk is a major consideration in finance
 Default Risk
Consider two zero coupon bond that promises to
pay face value $1000 in one year. Bond A has a
price of $980, Bond B $920. Bond A is a U.S.
treasury bill which is considered to be risk free
by the market.

• Why does B have a lower price?

• What is the probability of default on Bond B if
the market is risk neutral?
 Default Risk
• If an investor invests in $1 of Bond A, she will receive
a return of 1000/980-1= 2.04%
• If an investor invests in $1 of Bond B, she will receive
a return of 1000/920-1= 8.7%
• If the expected return on Bond B is higher than on A,
all investors would buy Bond B. The expected return
on the two must be the same. (This is called the No
Arbitrage principle)
• Therefore, the 8.7% is not the expected return due to
the riskiness of the bond and the possibility of default
(p).
 Default Risk
We know that Bond B is riskier than Bond A and has a
higher probability of default (p). If we set Bond B’s
expected return equal to that of Bond A, we can
determine the probability of default (p) priced into the
Bond B.
• Set the expected return on Bond B as 2.04%:
(1000/920)*(1-p) =1.0204
Probability of no default (1-p) = 93.8768%
Probability of default (p) = 0.0612 = 6.12%
• The probability of default is 6.12%, assuming a
recovery rate on Bond B of zero
 Default Risk
• The YTM on risky bonds includes a default
premium to cover expected default losses.
• Default premium: difference between the
YTM on a risky bond and a government
bond of similar maturity and coupon.
• Bond rating firms rate the default risk of
risky bonds. High investment grades are
in the range from BBB to AAA. Junk (or
speculative) bonds are rated below BBB.
 To do:
Bonds Practice Problems – I
Bonds - III
 What we will cover:

- Realized rates of return (ROR)

- ROR vs YTM
- Key determinants of bond yields
- Term structure of interest rates
- Nominal and real interest rates
- Inflation
 Objectives
By the end of this class, you should be able to:
• Calculate the realized rate of return after
holding a bond and reinvesting the coupons.
• Explain why the realized rate of return on a
bond may differ from the bond’s YTM.
• Identify the key determinants of default-free
government bond yields.
• Define the term structure of interest rates.
• Distinguish between nominal and real interest
rates and know which rate to use.
• Solve problems involving inflation.
 Expected vs Realized
Rate of Return
• The expected rate of return is the return that an
investor expects, or hopes to get, for an
investment of a certain type of risk, when they
consider making an investment
• The realized rate of return (ROR) is the return
that the investor actually obtained over the life of
the investment when they finally sell the bond.
 Realized Rate of Return
• Realized rate of return (ROR): the annual rate
of return that an investor actually earned during
the time period that they owned an asset.
• ROR is typically expressed in effective annual
terms, so it is in fact a realized annual rate of
return.
• ROR should be distinguished from the total
return or the holding period return which
measures the return for the period of the
investment and is not annualized.
 ROR Example
• You buy a painting for $4,000 and 5 years
later sell it for $5,200.
• What is your Realized Rate of Return?
• You earned $1,200 over the 5 year period on
an investment of $4,000.
• The ROR is the rate that you earned and is
expressed in effective annual terms.
 ROR Example Continued
0 1 2 3 4 5

$4,000 $5,200

PV ( 1 + r ) n = FV
$4,000 (1 + r ) 5 = $5,200
(1 + r ) 5 = $5,200/$4,000
(1 + r ) = ($5,200/$4,000) 1/5
r = ($5,200/$4,000) 1/5 - 1
r = 0.05387 or 5.387% is the annualized ROR
*Note: r = ($5,200/$4,000) – 1 = 30% is the total 5 year HPR
 Gross vs Net Returns
• Invest $4,000 today and receive $5,200 in 5 years
• Gross return: R = 5,200/4,000 = 1.30 (includes original
4,000 investment!)
• Net return: r = R – 1 = (5,200/4,000) – 1 = 0.30 or 30%,
excludes the original investment
• Gross and net returns are two different ways to represent
the same information. Do not confuse the two!
• Gross return answers the question – what is your
investment worth?
• Net return answers the question – how much money did
you make on your investment?
 ROR for Bonds
• A painting provides no intermediate cash
flows (to be reinvested), whereas a bond does.
• To calculate the ROR for a bond, we must
also determine the future value of any
reinvested coupons.
• A bond’s ROR is:
1
 (selling price + FVRC )  n
ROR =   −1
 purchase price 
where:
– FVRC (future value of reinvested coupons) carries
coupons forward to their future value at the point the
bond is sold, at the specified reinvestment interest
rate. This is an annuity, and we find the FV.
– n is the number of years the investor held the bond
• Note: ROR is expressed in effective annual terms
 ROR Example: Bonds 1
• You pay $679.12 to buy a 5-year, $1,000
face, 8% coupon, semi-annual payments
bond with a YTM of 18%.
• You hold the bond until maturity, and you
reinvest the coupons in a savings account
that pays 4% per year, compounded semi-
annually.
• What is your ROR?
• Timeline:

• Inputs to the ROR formula …

– n = 5 (number of years you hold the bond)
– purchase price = $679.12
• What is the selling price? $1,000
– The “selling” action in this case is holding the bond
until maturity and receiving the $1,000.
• What if you sold the bond before maturity?
– Then use the actual selling price iso face value of
$1,000 (also adjust n to reflect your holding period!)
• What is the relevant interest rate to use to
calculate the FV of reinvested coupons?
• What is the future value of the reinvested
coupons?

FV of Annuity inputs:
amount of each coupon = $40
number of coupons you receive = 10
FVRC =
• Using the realized rate of return formula…
1
 ($1,000 + $437.99 ) 
5
ROR =   − 1 = .161882
 $679.12 
• This is less than your expected YTM when
you bought the bond. Why?
 YTM assumes that:
1. You hold the bond until maturity.
2. You reinvest the coupons at that YTM.
 • Using the realized rate of return formula…
1
 ($1,000 + $437.99 ) 
5
ROR =   − 1 = .161882
 $679.12 
• Can you adjust the above to calculate your
net HPR over 5 years?

 ($1, 000 + $437.99 ) 

=
HPR5y  = − 1 1.11743
= 111.74%
$679.12 
 ROR Example: Bonds 2
Roberta purchased a newly-issued Province of
Ontario $1,000 face value bond with a coupon rate
of 6% and semi-annual coupons. The bond, which
had a 20-year maturity, had a price equal to its par
value. Three years later, Roberta sold the bond. At
the time of sale, the bond market required a YTM
on the bond of 8%. Over her three year holding
period Roberta was able to reinvest the coupons at
the bond’s original YTM.
Timeline:
1. Calculate the price at which Roberta sold the bond:

2. Calculate the FVRC:

 3. Calculate Roberta’s ROR on this bond
investment. How does it compare to the
bond’s original YTM?
1
 (selling price + FVRC ) n
ROR   −1
 purchase price 

1
 (815.89 + 194.05 ) 
3
ROR   −1
 1000 
= = 0.33% pa
ROR 0.0033
 Bond Yields
Bond yields are affected by:
1. The real rate of interest
2. A premium for expected future inflation
3. An interest rate risk premium
4. A default risk premium
5. A liquidity premium
 Term Structure
• The term structure is a plot of yields on
default-free government bonds of different
maturities.
• Default-free government bond yields represent
the combined effect of:
1. The real rate of interest
2. A premium for expected future inflation
3. An interest rate risk premium
Term Structure Diagrams
Term Structure Diagrams
 Inflation and the
Time Value of Money
• Nominal returns: returns measured in
dollar terms.
• Real returns: returns measured in terms of
purchasing power.
• Investors should be concerned about the
real investment rate of return.
 Inflation
• Inflation is the rate of the increase in the price of goods
– If the price of apples rises from $1.00/lb to $1.50/lb in 1
year, the inflation rate on apples was 50%
• Investors should not care about the price of apples per se,
but about how many apples they can buy
– If your salary rose by 50% in year, you can still buy the
same quantity of apples
• Investors should not care about nominal wealth, but many
seem to nevertheless: Money Illusion is a theory that some
investors make financial decisions based on nominal rather
than real quantities
 Inflation
The Fisher Equation relates the real rate of
return to the nominal rate of return and the rate
of inflation:
1 + nominal rate
1 + real rate =
1 + inflation rate

You can rewrite this approximately as:

real rate = nominal rate – inflation rate

Note: The approximation is closer to the actual for rates that are low
 Inflation illustration
How do you like them apples? You have $5…
Option 1: You can buy 5 apples today, lend them
to a friend with the agreement that she returns 6
apples to you in 1 year.
Option 2: You invest your money at a 25%
nominal rate in a bank, and then buy 6 apples, but
you expect the price of apples to rise by 7% in 1
year.
– Which of the two do you prefer? Which
nominal rate would make you indifferent?
 Inflation illustration
Option 1:
6/5-1 = 20% real return in ‘purchasing power’ terms
(or 1 apple for 5).

Option 2:
If, instead you invest your original $5 at 25% and
have $5x1.25 = $6.25 at the end of the year, can you
buy 6 apples with $6.25 after a year?

=>No, 6 apples will cost 6 x $1.07 = 6.42, so you are

better off receiving apples!
 Inflation illustration
At what nominal rate would you be indifferent?
=>At the rate that fully compensates you for the
loss in purchasing power:
(new cost of apples/original cost) – 1
= $6.42/$5 – 1 = 0.284 = 28.4% nominal rate, but
the current rate nominal rate is 25%. I.e. if you
earned 28.4%, you would have $6.42 => enough
for 6 apples!
At a nominal rate of 28.4% and with 7% inflation,
your real rate would be 20%, which is the same as
if we chose Option 1. (1.284/1.07 = 1.20)
 Valuing Real Cash Payments
Discounting nominal future cash flows by
nominal rates will give the same answer as
discounting real cash flows by the real interest
rate!
 Inflation Example 1
You want to do an MBA 8 years from now.
MBA tuition is currently at $36,000 per year
and is expected to increase by 3% per year. If
you earn 5% per year on investments, how
much must you invest today to pay the first
year’s tuition?

Timeline:
 Inflation Example 1
Step 1: Calculate FV of $36,000 at 3% inflation to see what
the first year’s tuition will be:
FV = $36,000(1.03)8 = $45,603.72

Step 2: Calculate the PV of the above at a 5% discount rate

(the rate of return that your investments is estimated to earn)
PV = 45,603.72/(1.05)8=$30.866.39
OR:
Step 1: Calculate the real rate: 1.05/1.03 – 1 =

Step 2: Discount real cash flow at real discount rate:

36,000/(1+__________)8=$
 Inflation example 2

A business owner is considering a five year advertising

campaign. Currently the annual advertising will cost
$3,500 every year for five years, starting today.
Advertising costs are expected to increase with the rate of
inflation, which is expected to average 6% per year. In
addition, signage with a one-time cost of $2,000, will be
incurred immediately. The business owner estimates that
his cost of capital is a (nominal) rate of 10% per year.

What is the cost of the advertising campaign in present

value terms?
 Inflation Example 2: (nominal rates)

Year 0: -$3,500 − $2, 000 =

−$5,500
Year 1: -$3,500(1.06)1 = −$
Year 2 : -$3,500(1.06) 2 = −$
Year 3: -$3,500(1.06)3 = −$
Year 4: -$3,500(1.06) 4 = −$

PV0 =
−$5,500 − $ ________/ (1.10)1 − $ ________/ (1.10) 2
− $ ________/ (1.10)3 − $ _________/ (1.10) 4
PV0 = −$ ______________
Or, we can use real cashflows and a real discount
rate:

Year 0: - $3,500 − $2, 000 =−$5,500

Year 1: - $3,500
Year 2 : - $3,500
Year 3: - $3,500
Year 4: - $3,500
(1 + 0.1) / (1 + 0.06) =
1+ r
r = 0.037736
PV0 =
−$5,500 − $3,500 / (1.037736)1 − $3,500 / (1.037736) 2
− $3,500 / (1.037736)3 − $3,500 / (1.037736) 4
PV0 =
 Excel solution (check work):
Nominal cash flow Nominal cash flow
year Cash flow (real) at 6% inflation at 10% discount rate
0 -5500.00 -5500.00 -5500.00
1 -3500.00 -3710.00 -3372.73
2 -3500.00 -3932.60 -3250.08
3 -3500.00 -4168.56 -3131.90
4 -3500.00 -4418.67 -3018.01
-18272.72
Real cash flow
real rate year Cash flow (real) at real discount rate
0.037736 0 -5500 -5500
1 -3500 -3372.73
2 -3500 -3250.08
3 -3500 -3131.90
4 -3500 -3018.01
-18272.72
 Important Rule
Discount nominal cash flows using the
nominal interest rate

and

Discount real cash flows using the real

interest rate.
 Real or Nominal?
• Most analysis we will do will assume
nominal rates and will discount nominal
cash flows. (Assume this unless otherwise
indicated!)
• When one set of cash flows is presented in
real terms, then other nominal cash flows
and rates must be adjusted in order to
compare, add or subtract the cash flows.
• As noted earlier, do not mix nominal and real
or you will have garbage results!
 Providing for Retirement
• Expected inflation is a significant variable in
retirement planning, tuition savings plans,
choice of vocation, or any long term financial
planning. Even a low rate of inflation can have
a major negative effect on people who will
receive relatively fixed nominal income or
returns.
• From the Fisher equation, we see that with high
inflation, the realized real rate may be negative!
 To do:
Bonds Practice Problems – II