FINA 2303 Chapter 6 Bonds Part2 Spring 2023

FINA 2303 Spring 2023
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Chapter 6: Bonds
Part 2
Ekkachai Saenyasiri Page 1 2/25/2023

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Time and Bond Prices
As the maturity date approaches, the market value of a bond approaches its par value.
Assume YTM = 5%
face value = $100
coupon paid annually
69.26
69.72
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Prices of 30-year bonds (right after each coupon being paid out  clean price)
Assume YTM = 5%

= 69.72
at the end of year
(Price excluded the
0 1 2 15 29 30
coupon on the payout
date)  Clean price
Zero coupon bond 23.14 24.29 25.51 48.10 95.24 100.00

Bond with 3% coupon 69.26 69.72 70.20 79.24 98.10 100.00 If buy the bonds at
these prices, YTM
will be 5%
Bond with 5% coupon 100.00 100.00 100.00 100.00 100.00 100.00

Bond with 10% coupon 176.86 175.71 174.49 151.90 104.76 100.00
If you hold the 3% coupon bond for one year, what is the rate of return you will receive in one
year?
- 69.26 3+ 69.72
t =0 t =1 = 5% = YTM

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Suppose you purchase a 30-year, zero coupond bond with a YTM of 5% with a face value
of $100,
Bond price at time 0 = 100/1.0530 = 23.140
Bond price 2 years from now = 100/1.0528 = 25.51
Suppose you can sell the bond at the end of time 2 at 25.51, what will be the rate of return
of your investment?
FV = PV (1+r)n
25.51 = 23.14 (1+r)2
r = 5% per year
The rate of return you receive is the same as the YTM of the bond

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Interest Rate Risk and Bond Prices
 Long-term bonds with lower coupon are more risky than short-term bond with
higher coupon
 PV of the cash flows in the later years are more sensitive to interest rate changes.
PV = FV / (1+r)n
When “n” is very small (for example, n = 0.01 year), PV is not sensitive to “r”
When “n” is large, PV is more sensitive to “r”

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Maturity, PV, and Interest Rate Change
Compare PV of two cash flows when r declines from 6% to 5%
A) 100 at the end of year 1 PV = 100/(1+r)1
B) 100 at the end of year 10  PV = 100/(1+r)10
PV PV change
r = 6% r = 5% $ %
100 at the end of year 1 100/1.061 = 94.33 100/1.051 = 95.24 95.24-94.33 = 0.91 0.91/94.33 = 0.96%
100 at the end of year 10 100/1.0610 = 55.84 100/1.0510 = 61.39 61.39-55.84 = 5.55 5.55/55.84 = 9.94%
PV of cash flows in the later years are more sensitive to interest rate changes

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Example: Bond A: 1-year coupon bond with 10% annual coupons
Bond B: 30-year coupon bond with 10% annual coupons
Both bonds have $1,000 face value. By what percentage will the price of each
bond change if its YTM decreases from 10% to 5%?
PV PV change
YTM = 10% YTM = 5% $ %
1-year bond with 10% coupons 1,000 1,047.62 47.62 4.76%
30-year bond with 10% coupons 1,000 1,768.62 768.62 76.86%
C = 100, N = 30, I/Y = 5, FV 1,000  PV = 1,768.62
The price of 1-year bond rises by 4.76%

The price of 30-year bond rises by 76.86%
The 30-year bond is more sensitive to changes in YTM than the 1-year bond

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Example: Compute % price change of each bond if YTM falls from 6% to 5%. Assume
face value = 100. Which bond is the most sensitive to interest rate?
Bond Coupon Rate Maturity Bond Price Price change
(annual payments) (years) YTM = 6% YTM = 5% %
A 0% 10 55.84 61.39 9.94%
(61.39 - 55.84)/55.84
B 4% 10 85.28 92.28 8.21% = 9.94%
C 8% 10 114.72 123.17 7.37%
D 0% 15 41.73 48.10 15.26%
E 4% 15 80.58 89.62 11.22%
F 8% 15 119.4245 131.139 9.81%
+100
| | | | | | | | | | | Bond A
0 1 2 3 4 5 6 7 8 9 10
8 8 8 8 8 8 8 8 8 8+100
Bond C
| | | | | | | | | | |
0 1 2 3 4 5 6 7 8 9 10
Bond with smaller coupon payments  larger fraction of its cash flows are received later
 more sensitive to changes in interest rates
FINA 2303
Bond Prices in Practice Spring 2023
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The graphs illustrate
changes in price and yield
for a 30-year zero-coupon
bond over its life.
Because the YTM does not

remain constant over the
bond’s life, the bond price
fluctuates as it converges to
the face value over time

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The Term Structure of Interest Rates
Term structure is the relationship between time to maturity and yields
Three basic components of yield curve (investors’ required rate of return)
 Real rate  the compensation that investors demand for forgoing the other uses of
their money
 Inflation premium  Investors recognize that future inflation erodes the value of the
dollars
 Interest rate risk premium  Investors recognize that long-term bonds have much
greater risk of loss resuting from increase in interest rates.
Note that if inflation is expected to decline by a small amount, we could still get an upward-
slope because of the interest rate risk premium
Other factors that affect required return include default risk premium (high default risk
high return) and liquidity premium (low liquidity  high return).

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U.S. Interest Rates and Bond Yields
(Annual, Percent)
Source: SIFMA Fact Book 2021

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Yield Curves
Default spread or credit

spread between AA
and U.S. Treasury
Securities
= 5.7% - 4.8% = 0.9%

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Example: Your firm has a credit rating of AA. You notice that the credit spread for 15-
year maturity debt is 90 basis points (0.90%). Your firm decides to issue 15-year bonds
with a coupon rate of 5% paid semiannually with $100 face value.
You see that 15-year Treasury notes are being traded at par with a coupon rate of 4.8%.
What should be the price of the bond?
If your firm wants to raise $2,000,000, how many bonds the firm must sell to investor?
Solution
New 10-year treasuries are issued at par  YTM = coupon rate = 4.8% for risk-free securities
YTM for your firm’s bonds (rated AA) = Risk free + Risk premium = 4.8% + 0.9% = 5.7%
Coupon = $5 per year  2.5 every 6 months Credit Spread
YTM = 5.7% per year  2.85% per 6 months
Bond price =
To raise $2 million, the firm must issue 2,000,000 / 93.005 = 21,504.22  21,505 bonds

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Evaluate
 Your bonds offer a higher coupon (5% vs. 4.8%) than treasuries of the same maturity, but
sell for a lower price ($94.72 vs. $100). The reason is the credit spread
 Your firm’s higher probability of default leads investors to demand a higher YTM on your
debt. To provide a higher YTM, the purchase price for the debt must be lower
 If your debt paid 5.7% coupons, it would sell at $100, the same as the treasuries. But to get
that price, you would have to offer coupons that are 90 basis points higher than those on the
treasuries – exactly enough to offset the credit spread.

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Nominal Rate vs Real Rate

Nominal interest rate = “quoted rate” indicating the rate at which money will grow
Real interest rate = the rate of increase in actual purchasing power after
adjusting for inflation
Conceptually:
Nominal Real Expected

Interest Rate = Interest Rate + Inflation Rate
Mathematically: (1+ nominal) = (1+ real) (1+ inflation)  called “Fisher Effect”

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Example:
Suppose the U.S. Treasury Bill rate is 8%, the expected inflation rate is 4.85%.
How much is the real rate of return if you invest in the T-Bill?
(1+ nominal rate) = (1 + real rate) (1+ inflation)
(1+ 8%) = (1+ real rate) (1+ 4.85%)
1.08/1.0485 = (1+ real rate)
1.03 = (1+ real rate)
3% = real rate = real increasing in purchasing power
Note: 8% – 4.85% = 3.15%  approximation

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Example: Assume nominal rate = 8% and inflation = 4.85%
 Suppose that a cup of coffee cost $1 now
 You have $100 now  can buy 100 cups of coffee now
 If you invest $100, after one year your will have $108
 Given that inflation is 4.85% a cup of coffee will cost $1.0485 next year
 After investing one year, you can buy 108/1.0485 = 103 cups of coffee
 100 cups  103 cups  real rate of return = 3%

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U.S. Interest Rates and Inflation Rates, 1955-2009

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Note:
 When inflation rate is high, a higher nominal rate is needed to induce individuals to
save
 Individuals’ willingness to save depends on the growth of purchasing power they

expect
o If real rate of return is high  save more, lending money to others

o If real rate of return is low  save less
 We always talking about interest rate in terms of nominal rate
 Every rate you see on newspaper and internet is nominal rate
 If we want to talk about real rate, we must tell you that the rate is real rate

FINA 2303 Chapter 6 Bonds Part2 Spring 2023

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FINA 2303 Spring 2023

Ekkachai Saenyasiri Page 1 2/25/2023

Ekkachai Saenyasiri Page 3 2/25/2023

Bond price at time 0 = 100/1.0530 = 23.140

Bond price 2 years from now = 100/1.0528 = 25.51

25.51 = 23.14 (1+r)2

Ekkachai Saenyasiri Page 4 2/25/2023

Interest Rate Risk and Bond Prices

When “n” is large, PV is more sensitive to “r”

Ekkachai Saenyasiri Page 5 2/25/2023

Maturity, PV, and Interest Rate Change

Compare PV of two cash flows when r declines from 6% to 5%

A) 100 at the end of year 1 PV = 100/(1+r)1

B) 100 at the end of year 10  PV = 100/(1+r)10

Ekkachai Saenyasiri Page 6 2/25/2023

C = 100, N = 30, I/Y = 5, FV 1,000  PV = 1,768.62

The price of 1-year bond rises by 4.76%

Ekkachai Saenyasiri Page 7 2/25/2023

Ekkachai Saenyasiri Page 8 2/25/2023

Because the YTM does not

Ekkachai Saenyasiri Page 10 2/25/2023

The Term Structure of Interest Rates

Term structure is the relationship between time to maturity and yields

Three basic components of yield curve (investors’ required rate of return)

Ekkachai Saenyasiri Page 11 2/25/2023

Ekkachai Saenyasiri Page 12 2/25/2023

Ekkachai Saenyasiri Page 13 2/25/2023

Source: SIFMA Fact Book 2021

Ekkachai Saenyasiri Page 14 2/25/2023

Ekkachai Saenyasiri Page 15 2/25/2023

Default spread or credit

Ekkachai Saenyasiri Page 16 2/25/2023

Coupon = $5 per year  2.5 every 6 months Credit Spread

YTM = 5.7% per year  2.85% per 6 months

Ekkachai Saenyasiri Page 17 2/25/2023

Ekkachai Saenyasiri Page 18 2/25/2023

Nominal Rate vs Real Rate

Nominal Real Expected

Ekkachai Saenyasiri Page 19 2/25/2023

(1+ nominal rate) = (1 + real rate) (1+ inflation)

(1+ 8%) = (1+ real rate) (1+ 4.85%)

1.08/1.0485 = (1+ real rate)

1.03 = (1+ real rate)

3% = real rate = real increasing in purchasing power

Note: 8% – 4.85% = 3.15%  approximation

Ekkachai Saenyasiri Page 20 2/25/2023

 Suppose that a cup of coffee cost $1 now

 100 cups  103 cups  real rate of return = 3%

Ekkachai Saenyasiri Page 21 2/25/2023

Ekkachai Saenyasiri Page 22 2/25/2023

 Individuals’ willingness to save depends on the growth of purchasing power they

o If real rate of return is high  save more, lending money to others

 We always talking about interest rate in terms of nominal rate

 Every rate you see on newspaper and internet is nominal rate

Ekkachai Saenyasiri Page 23 2/25/2023

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