Investments

Lesson 4: Bond
analysis
Cover image

Bond Prices and

Yields

Thanh Trúc – TCNH – ĐH KTL – ĐHQG HCM

 2

Bond Price and Yields

− Bond Characteristics
− Bond Pricing
− Bond Yields
− Bond Prices over time
− Default risk & Bond pricing

Cover
image
 3

Bond Characteristics

Pay a fixed amount of interest

periodically to the holder of record
Repay a fixed amount of principal at the
date of maturity)

Cover
image
 4

Bond Characteristics

 Intrinsic features
– Coupon rate
– Maturity
– Principal value: face value or par value
 Issuing features
– Secured (senior) bonds
– Unsecured bonds (debentures)
– Subordinated (junior) debentures

Cover
image
 5

Bond Characteristics
 Securing Indenture:
- Sinking funds
- Subordination of future debt
- Dividend restrictions
- Collateral
 Features affecting maturity
– Callable (call premium)
– Puttable
– Non-refunding provision
– Sinking Fund
– Convertible

Cover
image
 6

Call Provisions

Call Provisions :
- Allowing the issuer to repurchase the bond at
a specified call price before the maturity date
- Callable bonds typically come with a period
of call protection, an initial time during which
the bonds are not callable

Cover
image
 7

Puttable bonds

The puttable bond gives the bondholder

the option to extend or retire.
− If the bond’s coupon rate exceeds
current market yields, the bondholder
will choose to extend the bond’s life.
− If the bond’s coupon rate is too low, the
bondholder will reclaim principal, which
can be invested at current yields.

Cover
image
 8

Convertible bonds

Convertible bonds give bondholders an

option to exchange each bond for a
specified number of shares of common
stock of the firm. The conversion ratio is the
number of shares for which each bond may
be exchanged.
Convertible bondholders benefit from price
appreciation of the company’s stock.

Cover
image
 9

Floating rate bonds

Floating-rate bonds make interest

payments that are tied to some measure
of current market rates.
For example, the rate might be adjusted
annually to the current T-bill rate plus
2%.
If the 1-year T-bill rate at the adjustment
date is 4%, bond’s coupon rate over the
next year would be 6%.

Cover
image
 10

Sinking Fund
To help ensure the commitment does not create a cash
flow crisis, the firm agrees to establish a sinking fund
to spread the payment burden over several years. The
fund may operate in one of two ways:

1. The firm may repurchase a fraction of the outstanding

bonds in the open market each year.

2. The firm may purchase a fraction of the outstanding

bonds at a special call price associated with the sinking
fund provision. To allocate the burden of the sinking
fund call fairly among bondholders, the bonds chosen
for the call are selected at random based on serial
number.
Cover
image
 11

Issuers

Government
– Treasury Bill: less than 1 year
– Notes: from 1 to 10 years
– Bonds: from 10 to 30 years
Corporates
Local Government
Foreign corporates and governments

Cover
image
 12

Listing of Treasury Issues

Cover
image
 13

Corporate Bond Listings

Cover
image
 14
Principal and Interest Payments for Treasury
Inflation Protected Security

Cover
image
 15

Bonds listed on the HNX

Cover
image
 16

Bond Pricing

PB = Price of the bond

Ct = interest or coupon payments
T = number of periods to maturity
r = semi-annual discount rate or the semi-annual
yield to maturity

Cover
image
 17

Price: 10-yr, 8% Coupon, Face = $1,000

Ct = 40 (semiannually
P = 1000
T = 20 periods
r = 3% (semiannually)

Cover
image
 18

Bond price and yield

Bond price is inversely varied with the

required rate of return on the bond.
The bond price is very low at very high
required rate of return.
As the required rate of return approaches to
zero, the bond price approaches to the sum
of all expected cash flows.

Cover
image
 19
Figure 14.3 The Inverse Relationship Between
Bond Prices and Yields

Cover
image
 20
Table 14.2 Bond Prices at Different Interest Rates (8%
Coupon Bond, Coupons Paid Semiannually

Cover
image
 Accrued Interest and Quoted Bond Prices 21

The bond prices that you see quoted in the

financial pages are not actually the prices that
investors pay for the bond.
This is because the quoted price does not include
the interest that accrues between coupon payment
dates.

Invoice Price = Flat Price + Accrued interest

Cover
image
 22

Bond Yields

Nominal Yield (Coupon rate)

Current Yield

Yield To Maturity IRR based

Yield To Call Yield

Cover 5/11/2022 22
image
 23

Yield to Maturity (YTM)

 Is defined as the interest rate that makes the
present value of bond’s payments equal to its
price.
 Is often interpreted as a measure of the
average rate of return that will be earned on a
bond if it is bought now and held until maturity.
 To calculate YTM we solve the bond price
equation for the interest rate given the bond’s
price

Cover
image
 24

Example: calculate YTM

Cover
image
 25

Calculate YTM for semiannual bond

 For bond that interests are paid semiannually

YTM = 2 × semiannual IRR

Cover
image
 26

Example: semiannual bond

A semiannually interest paid bond with a

maturity of 10 years and coupon rate of 7%
are selling at $950.

10 yr Maturity Coupon Rate = 7%

Price = $950
Solve for r = semiannual rate r = 3.8635%
Cover
image
 27

Calculate YTM for semiannual bond

 A semiannually interest paid bond with a maturity
of 10 years and coupon rate of 7% are selling at
$950.
N = 20 PMT = 35 FV = 1000 PV = –950
=> CPT I/Y = 3.86%
Bond Equivalent Yield To Maturity:
YTM = 2 × 3.86% = 7.72%
Effective Annual Yield
(1.0386)2 - 1 = 7.88%
 YTM of semiannual bond is called Bond
Equivalent Yield (BEY)
Cover
image
 28

Current Yield

A semiannually interest paid bond with a

maturity of 10 years and coupon rate of 7% are
selling at $950.
Current Yield = $70 / $950 = 7.37 %
Cover
image
 29

Bond yields

Coupon rate, Current yield, Yield to Maturity:

 Bond Price > Face value (Premium Bond):
Coupon rate > Current yield > Yield to Maturity.
 Bond price < Face value (Discount Bond):
Coupon rate < Current yield < Yield to Maturity

Cover
image
 30

Yield to Call

 Very similar to Yield to Maturity, face value is

replaced with call price, time to maturity is
replaced with time to call.
Example: Consider a 10-year, 5% bond priced
at $1,028

Cover
image
 31
Figure 14.4 Bond Prices: Callable and Straight
Debt

Cover
image
 32

Example 14.4 Yield to Call

Yield to Maturity: 6.82% (3.41% X 2)

Yield to Call: 6.64% (3.32% x 2)

Cover
image
 33

Limitations of the conventional yields

1. Assume that the bond is hold until maturity

2. Assume no default risk
3. Assume all coupon interests are reinvested
at an interest rate equal to the bond’s YTM
or YTC
3. Assume the term structure is flat.

Cover
image
 34

Realized Yield versus YTM

Reinvestment Assumptions
Holding Period Return
– Changes in rates affects returns
– Reinvestment of coupon payments
– Change in price of the bond

Cover
image
 35

Realized yield versus YTM

Yield to maturity will equal the rate of return

realized over the life of the bond if all
coupons are reinvested at an interest rate
equal to the bond’s yield to maturity.

− If the coupon can be invested at more than

YTM, the realized compound return will
exceed YTM
− If the reinvestment rate is less than YTM, so
will be the realized compound return.

Cover
image
 36

Figure 14.5 Growth of Invested Funds

Cover
image
 37

Realized compound return versus YTM

Example:
suppose you buy a 30-year, 7.5% (annual payment)
coupon bond for 980$ (YTM 7.67%) and plan to
hold it for 20 years. Your forecast is that
- Bond’s YTM is 8% when it is sold in 20 years.
- Reinvestment rate of the coupons will be at 6
- The forecast sales price in 20 years will be 966,45$
The 20 coupon payments will grow with compound
interest to 2,758.92$ at the end of year 20.
Your $980 investment will grow in 20 years to
$966.45 + $2,758.92 = $3,725.37.
This corresponds to an annualized compound return
of 6.90%:
Cover
image
 38

Factors affecting reinvestment risk

Others held constant, reinvestment risk

increases with
 Higher coupon interest— larger reinvested
cash flows
 Longer maturity: — the fraction of value that
comes from the coupon interests and the
return on these reinvested interests is larger.

Cover 5/11/2022 38
image
 39

Holding-Period Return: Single Period

HPR = [ I + ( P0 - P1 )] / P0
where
I = interest payment
P1 = price in one period
P0 = purchase price

Cover
image
 40

Holding-Period Example

CR = 8% YTM = 8% N=10 years

Semiannual Compounding P0 = $1000
In six months the rate falls to 7%
P1 = $1068.55
HPR = [40 + ( 1068.55 - 1000)] / 1000
HPR = 10.85% (semiannual)

Cover
image
 41

HPR versus YTM

When the yield to maturity is unchanged over the
period, the rate of return on the bond will equal that
yield.

When yields fluctuate, a bond’s holding-period return

can be better or worse than the yield at which it initially
sells.

An increase in the bond’s yield acts to reduce its price,

In this event, the holding-period return is likely to be
less than the initial yield to maturity.

Conversely, a decline in yield will result in a holding-

period return greater than the initial yield.
Cover
image
 42

Example: Holding-Period

Coupon Rate = 8% ,YTM = 8% N=10 năm, P0 = $1000

- 1 year later the YTM is still 8%
P1 = $1000
HPR = [80 + ( 1000 - 1000)] / 1000
HPR = 8%
- 1 year later the YTM is only 7%
P1 = $1065.15
HPR = [80 + ( 1065.15 - 1000)] / 1000
HPR = 14.51%
- - 1 year later the YTM increases to 9%
P1 = $940.05
HPR = [80 + ( 940.05 - 1000)] / 1000
HPR = 2%
Cover
image
 43

Bond prices over time

A bond will sell at par value when its

coupon rate equals the market interest
rate
When the coupon rate is lower than the
market interest rate, the bond will sell at a
price that less than par value.
When the coupon rate is higher than the
market interest rate, the bond will sell at a
price that more than par value.

Cover
image
 44

Bond prices over time

If the market interest rate is unchanged,

over time, the bond price will approach
par value as the bond comes to mature.
The low-coupon bond enjoys capital
gains as price steadily approaches par
value, whereas the high-coupon bond
suffers capital losses.

Cover
image
 45
Figure 14.6 Prices over Time of 30-Year
Maturity, 6.5% Coupon Bonds

Cover
image
 46

Bond price over time

Bonds with different coupon rates but the

same risk must offer the same HPR.
 A low coupon bond, bought at a low price
will compensate investors with capital
gains.
A high coupon bond suffers capital
losses. Capital losses is offset with higher
coupon interests.

Cover
image
 47

Example Holding-Period Return: Single Period

A 5 year, coupon rate of 8% bond A and a 4 year, coupon

rate of 7% bond A’. Both bonds’ YTM is 7,5%. Calculate
HPR of the two bonds, the holding period is 1 year, the
market rate is unchanged.

Current Coupon Year end HPR

price interest price
Bond A 1,020.23 80 1,016.75 7.5%

Bond A’ 983.25 70 987.00 7.5%

Cover
image
 48

Price of zero-coupon bond

 The price of a zero-coupon bond increases

over time, and reaches the par value as the bond
matures.
 The fraction of the increase in value that is
correspondent to YTM is interest
 The changes in price that are caused by
changes in market interest, which exceed the
changes corresponding to YTM, are considered
capital gains or losses.

Cover
image
 49
Figure 14.7 The Price of a 30-Year Zero-Coupon Bond
over Time at a Yield to Maturity of 10%

Cover
image
 50

Default Risk and Ratings

 Rating companies
– Moody’s Investor Service
– Standard & Poor’s
– Fitch
 Rating Categories
– Investment grade
– Speculative grade

Cover
image
 51
Figure 14.8 Definitions of Each Bond Rating
Class

Cover
image
 52

Factors Used by Rating Companies

Coverage ratios
Leverage ratios
Liquidity ratios
Profitability ratios
Cash flow to debt

Cover
image
 53
Table 14.3 Financial Ratios and Default Risk by
Rating Class, Long-Term Debt

Cover
image
 54
Table 14.3 Financial Ratios and Default Risk by
Rating Class, Long-Term Debt

Cover
image
 55

Figure 14.9 Discriminant Analysis

Cover
image
 56

Protection Against Default

Sinking funds
Subordination of future debt
Dividend restrictions
Collateral

Cover
image
 57

Figure 14.10 Callable Bond Issue by Mobil

Cover
image
 58

Figure 14.10 Callable Bond Issue by Apple

Cover
image
 59

Default Risk and Yield

 We must distinguish between the bond’s

promised yield to maturity and its expected yield.
 The promised or stated yield will be
realized only if the firm meets the obligations of
the bond issue. The stated yield is the maximum
possible yield to maturity of the bond.
 The expected yield to maturity must
take into account the possibility of a default.

Cover
image
 60

Default risk and yield example

Suppose a firm issued a 9% coupon bond 20 years
ago. The bnd now has 10 years left until its maturity
date, but the firm is having difficulties. Investors believe
that the firm will be able to make good on the
remaining interest payments, but at the maturity date,
the firm will forced in to bankruptcy, and bond holders
will receive only 70% of par value. The bond is selling
at $750.
Expected YTM Stated YTM
Coupon payment $45 $45
Number of 20 kỳ 20 kỳ
semiannual periods
Final payment $700 $1000
Current price $750 $750
Cover
image
YTM 11.6% 13.67%
 61

Default risk and default premium

To compensate for default risk, corporate bond must

offer a default premium, also called risk structure of
interest rates. The default premium is the difference
between the promised yield on a corporate bond and
the yield of an otherwise-identical government bond
that is riskless in terms of default.
If the firm remains solvent and actually pays the
investor all of the promised cash flows, the investor
will realize a higher yield to maturity than would be
realized from the government bond. If, however, the
firm goes bankrupt, the corporate bond is likely to
provide a lower return than the government bond.

Cover
image
 62

Default risk and yield

 Default premium
– Depends on the possibility of default, high
rating bond has a low default premium.
– The default premium varies with the
economic cycle. When the economy is
contracted, the spreads between yields on
different rating bonds increase.

Cover
image
 63
Figure 14.11 Yields on Long-Term Bonds,
1954 – 2006

Cover
image
 64

Cover
image