Investments (BUS2007)

Spring 2023

Lecture Note 10.

Bond prices and yields
(Reference Book Chapter 10)

Da-Hea Kim
 Overview
 Measuring interest rates

 Bond
 Yields
 Market price quotes
 Default risk

 The term structure of interest rates

 Spot rate
 Forward rate
 Theories of the term structure of interest

Da-Hea Kim Lecture note 10. Bond prices and yields 2

 Measuring interest rates (1)
 Ex) • Interest rate on one-year deposits: 10% per annum.
• If you deposit $100 today, how much will it be in one year?

 Actual amount of interest implied in a stated interest rate depends on the following:

 Simple interest rate vs. Compound interest rate

 Frequency of interest payments

Da-Hea Kim Lecture note 10. Bond prices and yields 3

 Measuring interest rates (2)
 Simple interest rate vs. Compound interest rate

Simple interest rate Compound interest rate

Interests are earned only on Interests are earned on

the original principal the principal & the interests received

 Frequency of interest payments Compounding Interest rate

frequency applied each time

 The number of times the interest is earned per year Annually (m=1) R
𝑹 𝟏
 R% per annum, frequency=m ⇔ % per year Semiannually (m=2) R/2
𝒎 𝒎

Quarterly (m=4) R/4

Monthly (m=12) R/12

Da-Hea Kim Lecture note 10. Bond prices and yields 4

 Measuring interest rates (3)
 Ex) • Interest rate on one-year deposits: 10% per annum, Frequency=2
• If you deposit $100 today, how much will it be in one year?

 Simple The value of $100 in one year

100 =
0 0.5 1

 Compound
The value of $100 in one year
100
=
0 0.5 1

Da-Hea Kim Lecture note 10. Bond prices and yields 5

 Measuring interest rates (4)
 Ex) • Interest rate on one-year deposits: 10% per annum, Frequency=4
• If you deposit $100 today, how much will it be in one year?

 Simple The value of $100 in one year

=
100

0 0.5 1

 Compound
The value of $100 in one year

=
100

0 0.5 1

Da-Hea Kim Lecture note 10. Bond prices and yields 6

 Measuring interest rates (5)
 Summary
Today Future
 Interest rate: R per annum 0 T

 Future value of $1 today after T years

$1
R per annum ?

Simple Compound
Frequency
interest rate interest rate

Da-Hea Kim Lecture note 10. Bond prices and yields 7

 Measuring interest rates (6)
 Summary
Today Future
 Interest rate: R per annum 0 T

 Present value of $1 paid after T years

? R per annum
$1

Simple Compound
Frequency
interest rate interest rate

Da-Hea Kim Lecture note 10. Bond prices and yields 8

 Measuring interest rates (7)
 Conventions for annualizing rates of returns

 Sometimes rates of return are given for a period shorter than a year

 Annual Percentage Rate (APR) vs. Effective Annual Rate (EAR)

(Notation) 𝒓: Per-period rate, 𝒏: The number of periods per year

o APR
• Rate that annualizes per-period rates using a simple interest approach, ignoring compound interest
• APR=_______________

o EAR
• Rate at which money actually grows over a year
• Compound rate with annual compounding frequency
• EAR=____________________

o Relation between APR and EAR

•

Da-Hea Kim Lecture note 10. Bond prices and yields 9

 Measuring interest rates (8)
 Example) APR vs. EAR

 An interest rate on a credit card loan is 1.5 percent month, with the interest compounded monthly.

• What is an APR on the credit card loan?

• What is an EAR on the credit card loan?

Da-Hea Kim Lecture note 10. Bond prices and yields 10

 Bond: Basics (1)
 What is a bond?
 A security issued in connection with a borrowing arrangement.

 The borrower issues (i.e., sells) a bond to the lender for some amount of cash.
Bond
Issuer Holder
= Borrower =Lender
$X

 The “IOU” of the borrower.

 The arrangement obligates the issuer to make specified payments to the bondholder on

specified dates.

Da-Hea Kim Lecture note 10. Bond prices and yields 11

 Bond: Basics (2)
Bond indenture: a contract b/w the issuer and the bondholder

Specification

Coupon rate Face value, Par value

Types of a bond Maturity date
(Interest rate) (Principal)

Coupon bond Finite Positive value Paid at the maturity

Zero-coupon bond Finite Zero Paid at the maturity

Perpetual bond Infinite Positive value Notional

Da-Hea Kim Lecture note 10. Bond prices and yields 12

 Bond: Basics (3)
 Example
 Coupon bond
• Face value: $100, Coupon rate: 6% per annum (m=1), Maturity: 2 years

• Cash flows

0 1 2

 Coupon bond
• Face value: $100, Coupon rate: 6% per annum (m=2), Maturity: 2 years

• Cash flows

0 1 2

Da-Hea Kim Lecture note 10. Bond prices and yields 13

 Bond: Basics (4)
 Example

 Zero-coupon bond
• Face value: $100, Maturity: 2 years
• Cash flows

0 1 2

 Perpetuity bond
• Face value: $100, Coupon rate: 6% per annum (m=2)
• Cash flows

0 1 2 3

Da-Hea Kim Lecture note 10. Bond prices and yields 14

 Bond pricing (1)
 Think about

 A company issues two kinds of bonds with the identical conditions except for a
coupon rate.

 Is the high-coupon bond always superior to the low-coupon bond?

Da-Hea Kim Lecture note 10. Bond prices and yields 15

 Bond pricing (2)
 Theoretical price of the bond

 The sum of present values of all the expected cash flows from the bond

 Discounted cash flows with the appropriate required rate of returns, reflecting the riskiness.

 There may be different discount rates for cash flows accruing in different periods.
C
C C C F

0 t1 t2 … tn

𝑷𝑽(𝑪)
Discounted by 𝑟
𝑷𝑽(𝑪)
Discounted by 𝑟
…

+) 𝑷𝑽(𝑪 + 𝑭)
Discounted by 𝑟
Bond price

Da-Hea Kim Lecture note 10. Bond prices and yields 16

 Bond pricing (3)
 Ex) Face value: $100, Coupon rate: 6% per annum (m=2), Maturity: 2 years
 Cash flows from the bond

Interest Rate
0 0.5 1 1.5 2 Maturity
(% per annum,
(years)
semi-annual compounding)
0.5 5.0
1.0 5.8
1.5 6.4
2.0 6.8

Da-Hea Kim Lecture note 10. Bond prices and yields 17

 Bond pricing (4)
 Ex) Face value: $100, Coupon rate: 12% per annum (m=2), Maturity: 2 years
 Cash flows from the bond

Interest Rate
0 0.5 1 1.5 2 Maturity
(% per annum,
(years)
semi-annual compounding)
0.5 5.0
1.0 5.8
1.5 6.4
2.0 6.8

Da-Hea Kim Lecture note 10. Bond prices and yields 18

 Bond yields (1)
 Current yield

 Annual coupon/Bond price

• Cf) Coupon rate= Annual coupon/Face value

 Example1) A $1,000 face value bond paying semiannual coupons of $40 has a price of $1,032.25.

o Coupon rate:

o Current yield:

 Example2) A $1,000 face value bond paying semiannual coupons of $40 has a price of $969.75.

o Coupon rate:

o Current yield:

Da-Hea Kim Lecture note 10. Bond prices and yields 19

 Bond yields (2)
 Yield-to-maturity, YTM
 A single discount rate that equates the present value of its future cash flows with its market price.
 Loosely referred to as Yields

 Ex) Zero-coupon bond, Face value: $100, Maturity: 2 years, Bond price: $95

𝒚 : YTM with annual compounding frequency

0 0.5 1 1.5 2

Da-Hea Kim Lecture note 10. Bond prices and yields 20

 Bond yields (3)
 Yield-to-maturity, YTM (Continued)
 Ex) Coupon bond, Face value: $100, Maturity: 2 years, Coupon: 6% per annum (m=2), Bond price: $98.596

𝒚 : YTM with semi-annual compounding frequency

$3
$3 $3 $3 $100
0 0.5 1 1.5 2

Da-Hea Kim Lecture note 10. Bond prices and yields 21

 Bond yields (4)
 Yield-to-maturity, YTM (Continued)
 Finding the YTM of coupon-bearing bonds by trial and error
𝟑 𝟑 𝟑 𝟏𝟎𝟑
(𝟏 𝒚/𝟐) (𝟏 𝒚/𝟐)𝟐 (𝟏 𝒚/𝟐)𝟑 (𝟏 𝒚/𝟐)𝟒

Finding 𝒚∗ 𝒔. 𝒕. 𝐁 𝒚∗ = 𝟗𝟖. 𝟓𝟗𝟔

Try y 𝐁(𝒚)

1
2
3
4
…

Da-Hea Kim Lecture note 10. Bond prices and yields 22

 Bond yields (5)
 Yield-to-maturity, YTM (Generalization)

 𝐁 : bond price, 𝒚 : YTM with m compounding frequency

C+F
C C C
0 ∆t 𝟐∆t … (𝐧 − 𝟏)∆t n∆t=T

B=

Da-Hea Kim Lecture note 10. Bond prices and yields 23

 Bond yields (6)
 Yield-to-maturity, YTM (Generalization, continued)

 𝐁 : bond price, 𝒚 : YTM with m compounding frequency

𝒏 𝑪 𝑭 𝟏 𝟏 𝑭
𝑩= 𝒊∆𝒕×𝒎
+ 𝒎×𝑻 =𝑪× 𝟏− +
𝒊 𝟏 𝒚 𝒚 𝒚 ∆𝒕×𝒎 𝒚 𝑻×𝒎 𝒚 𝒎×𝑻
𝟏+𝒎 𝟏+𝒎 𝟏+𝒎 −𝟏 𝟏+ 𝟏+
𝒎 𝒎

Finite sum of geometric series

𝟏 𝒓𝒏
𝟏 𝒓

𝑪 𝟏
where 𝒚𝒎 ∆𝒕×𝒎 𝒚𝒎 ∆𝒕×𝒎
𝟏 𝟏
𝒎 𝒎

Da-Hea Kim Lecture note 10. Bond prices and yields 24

 Bond yields (7)

C+F
C C C C 𝟏 𝟏 𝑭
𝑩= 𝑪× ∆𝒕×𝒎
𝟏− 𝑻×𝒎
+ 𝒎×𝑻
0 ∆t 𝟐∆t 3∆t … (𝐧 − 𝟏)∆t n∆t 𝒚 𝒚 𝒚
𝟏+ −𝟏 𝟏+ 𝟏+
=T 𝒎 𝒎 𝒎

 Example)
 Annual coupon payments with a YTM with an annual compounding frequency

C+F ∆𝒕 =
C C C C ⇒𝑩=
T
𝒎=
0 𝟏 𝟐 3 … (𝐓 − 𝟏)

 Semi-annual coupon payments with a YTM with an semi-annual compounding frequency

C+F ∆𝒕 =
C C C C ⇒𝑩=
T
𝒎=
0 𝟎. 𝟓 𝟏 1.5 … (𝐓 − 𝟎. 𝟓)

Da-Hea Kim Lecture note 10. Bond prices and yields 25

 Bond yields (8)
 Example) YTM and bond prices
 Face value: $1,000, Coupon rate: 8% per annum (m=2), Maturity: 30 years
 Find a bond price when

a) a YTM is 4% per annum with a semi-annual compounding

b) a YTM is 8% per annum with a semi-annual compounding

c) a YTM is 12% per annum with a semi-annual compounding

Da-Hea Kim Lecture note 10. Bond prices and yields 26

 Bond yields (9)
 Inverse relation between YTM and bond prices

Relation b/w
Price of an 8% coupon bond

Types of a bond
with a face value of $1,000

YTM & Coupon rate

Premium bond
(bond price > face value)

Par bond
(bond price = face value)

Discount bond
(bond price < face value)

8%
Yield-to-maturity

Da-Hea Kim Lecture note 10. Bond prices and yields 27

 Bond yields (10)
 Price changes of premium, par, and discount bonds over time

Total rate of returns

170
Coupon Price changes
Premium bond High Capital loss
Discount bond Low Capital gain

 The price of each bond is set to offer the

68
Today
Maturity Date same total rate of returns.

 Security returns all should be comparable

on risk-adjusted basis.
Assmp. The market interest is constant.

Da-Hea Kim Lecture note 10. Bond prices and yields 28

 Bond yields (11)
 YTM vs. Realized compound return

 The YTM is a standard measure of the total rate of return on the bond.

 Will the YTM be the same as the realized compound return?

Da-Hea Kim Lecture note 10. Bond prices and yields 29

 Bond yields (12)
 YTM vs. Realized compound return (Continued)

 Example) Par bond with coupon rate: 10% per annum (m=1), Maturity: 2 years
• 1-year reinvestment rate at the end of the year=10% per annum (m=1)
• What is the realized compound return (m=1) at the maturity?

Da-Hea Kim Lecture note 10. Bond prices and yields 30

 Bond yields (13)
 YTM vs. Realized compound return (Continued)

 Example) Par bond with coupon rate: 10% per annum (m=1), Maturity: 2 years
• 1-year reinvestment rate at the end of the year=8% per annum (m=1)
• What is the realized compound return (m=1) at the maturity?

Da-Hea Kim Lecture note 10. Bond prices and yields 31

 Quoted bond prices (1)
 Quoting convention
 U.S. Treasury Quotes
Source: The Wall Street Journal Online, May, 27, 2019 (http://www.wsj.com/mdc/public/page/2_3020-treasury.html )

Asked
Maturity Coupon Bid Asked Change
Yield (%)
9/30/2019 1.75 99.742 99.758 -0.008 2.463
… … … … … …
8/15/2020 11 107.680 107.695 -0.125 2.303

 When you buy the bond expiring Aug. 15, 2020, which quote applies?

 The bond prices quoted in the financial page ≠ The prices investors pay for the bond.
• Market convention of quoting prices excluding accrued interest.

Da-Hea Kim Lecture note 10. Bond prices and yields 32

 Quoted bond prices (2)
 Bond prices are typically quoted as the clean price.

 Clean price=Cash price - Accrued interest since last coupon date

 Cash price
• The price you actually pay
• Full or invoice price
• Dirty price

 Accrued interest
• The prorated share of the upcoming coupon
• When a bond pays its coupon, accrued interest reverts to zero.

Da-Hea Kim Lecture note 10. Bond prices and yields 33

 Quoted bond prices (3)
 Ex) Now: May 27, 2019
 Bond • Coupon: 11% per annum (semiannually-paid)
• Maturity: Aug 15, 2020
• Quoted price : $107.695
• The most recent coupon date: Feb 15, 2019
• The next coupon date: Aug 15, 2019

2019/02/15 2019/05/27 2019/08/15 2020/08/15

 Accrued interest: _________________________________

 Cash price:_______________________________________

Da-Hea Kim Lecture note 10. Bond prices and yields 34

 Bond: Default risk (1)
 Listing of corporate bonds
Source: FINRA, May, 27, 2019 (http://finra-markets.morningstar.com/BondCenter/TRACEMarketAggregateStats.jsp)

Issuer Name Symbol Coupon Maturity Yield% Moody’s/S&P

MICROSOFT CORP MSFT4451230 2.88% 02/06/2024 2.538 Aaa/AAA
BERKSHIRE HATHAWAY INC DEL BRK4343179 2.20% 03/15/2021 2.408 Aa2/AA
GENERAL ELEC CAP CORP GE.GWJ 5.55% 01/05/2026 3.877 Baa1/BBB+
NEW HOME CO INC NWHM4537300 7.25% 04/01/2022 12.498 B3/B-
ENSCO PLC ESV4586294 7.75% 02/01/2026 12.937 Caa1/
… … … … … …

 Bonds issued by different companies are priced to provide different YTMs.

• A bond YTM varies with the default risk.

Da-Hea Kim Lecture note 10. Bond prices and yields 35

 Bond: Default risk (2)
 Measurement of bond default risk
 Three major rating agencies
• Standard & Poor’s Corporation, Moody’s Investor Services, and Fitch Investors Service

 Determinants of bond safety

Coverage Leverage Liquidity Profitability

• Times-interest-earned • Debt-to-equity ratio • Current ratio • Return on asset
ratio
𝑫𝒆𝒃𝒕 𝒗𝒂𝒍𝒖𝒆 𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝒂𝒔𝒔𝒆𝒕(𝑪𝑨) 𝑬𝑩𝑰𝑻
𝑬𝑩𝑰𝑻 = = =
𝑬𝒒𝒖𝒊𝒕𝒚 𝒗𝒂𝒍𝒖𝒆 𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝒍𝒊𝒂𝒃𝒊𝒍𝒊𝒕𝒊𝒆𝒔 𝑻𝒐𝒕𝒂𝒍 𝒂𝒔𝒔𝒆𝒕
Financial =
𝑰𝒏𝒕𝒆𝒓𝒆𝒔𝒕 𝒐𝒃𝒍𝒊𝒈𝒂𝒕𝒊𝒐𝒏
ratios • Quick ratio • Return on equity
*EBIT:
Earning Before Interest 𝑪𝑨 − 𝒊𝒏𝒗𝒆𝒏𝒕𝒐𝒓𝒊𝒆𝒔 𝑵𝒆𝒕 𝒊𝒏𝒄𝒐𝒎𝒆
= =
and Taxes 𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝒍𝒊𝒂𝒃𝒊𝒍𝒊𝒕𝒊𝒆𝒔 𝑬𝒒𝒖𝒊𝒕𝒚 𝒗𝒂𝒍𝒖𝒆

Prediction for
bond safety

Da-Hea Kim Lecture note 10. Bond prices and yields 36

 Bond: Default risk (3)
 Bond rating classes

Investment grade bond

Speculative grade bond

Junk bond
High yield bond

Da-Hea Kim Lecture note 10. Bond prices and yields 37

 Bond: Default risk (4)
 Yield spreads 20
Aaa-rated
 Increment over the risk-free rate 16
Baa-rated
 Compensation for default risk 12

Yield spread (%)

High yield
8
 The higher the default risk,
the higher the yield spreads.
4

-4
1970

1973

1976

1979

1982

1985

1988

1991

1994

1997

2000

2003

2006

2009

2012

2015
▲ Yield spreads between corporate and 10-year Treasury bonds
(Aaa-rated, Baa-rated, Junk bonds)

Da-Hea Kim Lecture note 10. Bond prices and yields 38

 Term structure of interest rates (1)
 n-year Spot rate
 The rate of interest earned on an investment starting today and lasting for n years

 All the interest and principal is realized at the end of n years

 There are no intermediate payments

 n-year Zero-coupon interest rate, or Zero rate

• The YTM of a n-year zero-coupon bond
• Ex) The price of 3-year zero-coupon bond (Face value=100): 75.13
𝟏𝟎𝟎 = 𝟕𝟓. 𝟏𝟑(𝟏 + 𝑹)𝟑

𝟏𝟎𝟎 𝟏/𝟑
𝑹= − 𝟏 = 𝟏𝟎%
𝟕𝟓.𝟏𝟑

⇔ 3-year zero rate =10% per annum with an annual compounding

Da-Hea Kim Lecture note 10. Bond prices and yields 39

 Term structure of interest rates (2)
 Term structure of interest rates
Spot Rate
Maturity
(% per annum,
(years)
annual compounding)
0.5 5.0
1.0 5.8
1.5 6.4
2.0 6.8

 Yield curve 8.0

7.0
6.0
% per annum

5.0
4.0
3.0
2.0
1.0
0.0
0 0.5 1 1.5 2 2.5
Years

Da-Hea Kim Lecture note 10. Bond prices and yields 40

 Term structure of interest rates (3)
 What determines the shape of the yield curve?
Yield

Yield

Yield
Maturity Maturity Maturity

 Two theories of the term structure of interest rates

 Expectation theory

 Liquidity preference theory

Da-Hea Kim Lecture note 10. Bond prices and yields 41

 Forward rate (1)
 The rates of interest implied by current zero rates for a future period of time

Maturity Spot Rate Forward Rate 𝑹𝟏 𝑭𝟏𝟐

(years) (Annual compounding) (Annual compounding)

T1 R1
0 T1 T2
T2 R2 F12

𝑹𝟐

 The relation between spot rates and forward rate

Da-Hea Kim Lecture note 10. Bond prices and yields 42

 Forward rate (2)
 Example) Calculation of forward rates

Maturity Spot Rate Forward Rate

(years) (% annual comp) (% annual comp) Note.
• Forward rate tends to be increasing for upward-
1 3.0 sloping zero curve.
2 4.0 • Forward rate tends to be decreasing for downward-
sloping zero curve.
3 4.6

4 5.0

Da-Hea Kim Lecture note 10. Bond prices and yields 43

 Short rate
 The rate for a given maturity at different points in time
 Cf. Spot rate: the rate that prevails today for a given maturity

Short rate
𝒓𝟎𝟏 = 𝟑% 𝒓𝟏𝟐 𝒓𝟐𝟑 𝒓𝟑𝟒 in each year

Current spot rates

for various maturities

𝑹𝟏 = 𝟑%
𝑹𝟐 = 𝟒%
𝑹𝟑 = 𝟒. 𝟔%
𝑹𝟒 = 𝟓%

Da-Hea Kim Lecture note 10. Bond prices and yields 44

 Theories of the term structure of interest rates (1)
 Expectation theory

 Forward rate=E{future short rate}

 Long-term interest rates should reflect expected future short-term interest rates.

 Upward sloping yield curve implies that interest rates will increase in the future.

 Empirical observation
Short rate
𝒓𝟎𝟏 = 𝟑% 𝒓𝟏𝟐 𝒓𝟐𝟑 𝒓𝟑𝟒
• Upward sloping yield curve in each year

• Decrease in interest rates

Current spot rates
for various maturities
𝑹𝟏 = 𝟑%
𝑹𝟐 = 𝟒%
𝑹𝟑 = 𝟒. 𝟔%
𝑹𝟒 = 𝟓%

Da-Hea Kim Lecture note 10. Bond prices and yields 45

 Theories of the term structure of interest rates (2)
 Liquidity preference theory

 Forward rate=E{future short rate} + Liquidity premium

 Lenders prefer to preserve their liquidity and lend funds for short period of time.

 Borrowers prefer to borrow at fixed rates for long periods of time.

Short rate
𝒓𝟎𝟏 = 𝟑% 𝒓𝟏𝟐 𝒓𝟐𝟑 𝒓𝟑𝟒 in each year

Current spot rates

for various maturities
𝑹𝟏 = 𝟑%
𝑹𝟐 = 𝟒%
𝑹𝟑 = 𝟒. 𝟔%
𝑹𝟒 = 𝟓%

Da-Hea Kim Lecture note 10. Bond prices and yields 46

 Homework (1)
 Great Wall Pizzeria issued 10-year bonds with the face value of $100 one year ago at a
coupon rate of 6.20 percent. Coupons are paid semiannually. If the YTM on these bonds is
7.4 percent per annum with a semiannual compounding frequency, what is the current
bond price?

Da-Hea Kim Lecture note 10. Bond prices and yields 47

 Homework (2)
 Ghost Rider Corporation has bonds on the market with 10 years to maturity, a YTM of 7.5
percent per annum with a semiannual compounding frequency, and a current price of $938.
What must the coupon rate be on the company’s bonds? Assume that coupons are paid
semiannually and the face value is $1,000.

Da-Hea Kim Lecture note 10. Bond prices and yields 48

 Homework (3)
 Consider the following spot interest rates for maturities of one, two, three, and four years.

𝟏 , 𝟐 , 𝟑 , 𝟒

What are the following forward rates, 𝟏,𝟏 𝟏,𝟐 and 𝟏,𝟑 , where 𝟏,𝒌 refers to a forward
rate for the period beginning in one year and extending for k years?
(Assume that all interest rates are expressed with an annual compounding frequency.)

Da-Hea Kim Lecture note 10. Bond prices and yields 49