Chapter 2

Bond Prices and Yields

Quiz
Recession Normal Boom Prob
P0 10 10 10
P1 -10 10 20
P2.1 -4 15 25 0.35
P2.2 -8 10 20 0.30
P2.3 - 12 -4 15 0.10
Prob (P1) 0.35 0.29 0.36

Assuming risk free rate 5%, draw Probability Tree, and Calculate
coefficient of variation for this project.
•Fixed Income Security:
• Are debt instruments that pay a fixed amount of
interest, in the form of coupon
payments(Commonly distributed semiannually)
to the investors.
• The principle returned to the investor at maturity.
•Bond
• Security that obligates issuer to make
payments to holder over time.
 2.1 Bond Characteristics
•Face Value, Par Value
•Payment to bondholder at maturity of bond
•Coupon Rate
•Bond’s annual interest payment per dollar
of par value
 2.1 Bond Characteristics
•Yield to maturity
•The total return anticipated on a
bond if the bond is held until its
matures.(expressed Annual rate)
•Yield to maturity components are
risk free rate part (Inflation Risk)
added to Credit Risk this risk
composed from two parts issuer and
maturity.
 Figure 2.1 Prices/Yields of U.S. Treasury Bonds

U.S. Treasury Quotes: Treasury note and bond data are representative
over-the-counter quotations as of 3pm Eastern time.
Asked
Maturity Coupon Bid Asked Change Yield
8/15/2012 1.750 101.570 101.594 -0.016 0.151
8/15/2014 4.250 111.547 111.594 -0.094 0.358
12/31/2015 2.125 105.789 105.820 -0.164 0.769
8/15/2017 4.750 120.219 120.266 -0.234 1.234
2/15/2020 8.500 152.063 152.094 -0.344 1.847
8/15/2023 6.250 137.406 137.438 -0.688 2.598
2/15/2027 6.625 145.547 145.594 -0.719 2.941
2/15/2031 5.375 130.266 130.297 -0.953 3.263
11/15/2039 4.375 111.766 111.813 -0.813 3.697
5/15/2041 4.375 111.719 111.750 -0.938 3.718
2.1 Bond Characteristics
• Treasury Bonds
• Treasuries are debt obligations issued and
backed by the full faith and credit of the US
government. Because they are considered to
have low credit or default risk, they generally
offer lower yields relative to other bonds.
2.1 Bond Characteristics

Types of Treasury Bonds

Minimum Interest
Treasury denomination Sold at Maturity payments
4-, 8- , 13-, Interest and
US Treasury
$1,000 Discount 17-, 26-, and principal paid
bills
52-week at maturity
Interest paid
US Treasury 2-, 3-, 5-, 7-, semi-annually,
$1,000 Coupon
notes and 10-year principal at
maturity
Interest paid
US Treasury 20-year semi-annually,
$1,000 Coupon
bonds 30-year principal at
maturity
2.1 Bond Characteristics
Minimum Interest
Treasury denomination Sold at Maturity payments
Interest paid
semi-annually,
principal
redeemed at
Treasury
the greater of
inflation-
5-, 10-, and their inflation-
protected $1,000 Coupon
30-year adjusted
securities
principal
(TIPS)
amount or the
original
principal
amount
 Table 2.2 Principal and Interest Payments

Principal and interest payments for a Treasury Inflation Protected

Security
 2.1 Bond Characteristics
Minimum Interest
Treasury denomination Sold at Maturity payments
Interest paid
quarterly
based on
US Treasury
discount rates
floating rate $1,000 Coupon 2 years
for 13-week
notes (FRNs)
treasury bills,
principal at
maturity
Interest and
Treasury 6 months to
$1,000 Discount principal paid
STRIPS 30 years
at maturity
2.1 Bond Characteristics
2.1 Bond Characteristics
 2.1 Bond Characteristics
• Risks of Treasury Bonds
• Lower yields: Treasury securities typically pay
less interest than other securities in exchange for
lower default or credit risk.
• Interest rate risk: Treasuries are susceptible to
fluctuations in interest rates, with the degree of
volatility increasing with the amount of time until
maturity. As rates rise, prices will typically
decline.
 2.1 Bond Characteristics
• Risks of Treasury Bonds
• Inflation risk: With relatively low yields,
income produced by Treasuries may be lower
than the rate of inflation. This does not apply
to Treasury inflation-protected securities
(TIPS).
• Credit or default risk: Investors need to be
aware that all bonds have the risk of default.
Investors should monitor current events, as
well as the ratio of national debt to gross
domestic product.
 2.1 Bond Characteristics

• Corporate Bonds
• Call provisions on corporate bonds
• Callable bonds: May be repurchased by
issuer at specified call price during call
period
• Convertible bonds
• Allow bondholder to exchange bond for
specified number of common stock shares
 2.1 Bond Characteristics

• Corporate Bonds
• Puttable bonds
• Holder may choose to exchange for par
value or to extend for given number of years
• Floating-rate bonds- Notes (FRN)
• Coupon rates periodically reset according to
specified market date
• The London Interbank Offered Rate (LIBOR) is a
benchmark interest rate at which major global banks
lend to one another in the international interbank
market for short-term loans.
 2.1 Bond Characteristics

• Preferred Stock
• Commonly pays fixed dividend
• Floating-rate preferred stock becoming
more popular
• Dividends not normally tax-deductible
• Corporations that purchase other
corporations’ preferred stock are taxed on
only 30% of dividends received
 2.1 Bond Characteristics

• Other Domestic Issuers

• State, local governments (municipal bonds)
• Federal Home Loan Bank Board
• Farm Credit agencies
• Ginnie Mae, Fannie Mae, Freddie Mac
 2.1 Bond Characteristics
• International Bonds
• Foreign bonds
• Issued by borrower in different country than
where bond sold, denominated in currency
of market country
 2.1 Bond Characteristics
• International Bonds
• Euro(External)bonds
• A Eurobond is a fixed-income debt instrument
(security) denominated in a different currency
than the local one of the country where the bond's
been issued.
• Hence, it is a unique type of bond. Eurobonds
allow corporations to raise funds by issuing
bonds in a foreign currency.
 2.1 Bond Characteristics
• International Bonds
• Euro(External)bonds
• The first Eurobond was issued in 1963 by
Autostrade, the company that ran Italy's national
railroads.
• It was a $15 million Euro-Dollar bond designed
by bankers in London, issued at Amsterdam
Airport Schiphol and paid in Luxembourg to
reduce taxes. It provided European investors with
a safe, dollar-denominated investment.
 2.1 Bond Characteristics
• International Bonds
• Euro(External)bonds
• Issuers run the gamut from multinational corporations to
sovereign governments and supranational organizations.
• The size of a single bond issuance can be well over a
billion dollars, and maturities are between five and 30
years, although the largest portion has a maturity of fewer
than 10 years.
• Eurobonds are especially attractive to issuers based in
countries that do not have a large capital market while
offering diversification to investors.
 2.1 Bond Characteristics
• International Bonds
• Euro(External)bonds
• Eurobonds are frequently grouped together by the
currency in which they are denominated, such as
Euro-Dollar or Euro-yen bonds.
• Eurobonds are important because they help
organizations raise capital while having the
flexibility to issue them in another currency.
 2.1 Bond Characteristics
• International Bonds
• Euro(External)bonds
• Issuance of Eurobonds is usually handled by an
international syndicate of financial institutions on
behalf of the borrower, one of which may
underwrite the bond, thus guaranteeing the
purchase of the entire issue.
 2.1 Bond Characteristics
• International Bonds
• Euro(External)bonds
• Eurobonds as a financing tool reflects their high degree of
flexibility as they offer issuers the ability to choose the
country of issuance based on the regulatory landscape,
interest rates, and depth of the market.
• They are also attractive to investors because they usually
have small par values or face values providing a low-cost
investment.
• Eurobonds also have high liquidity, meaning they can be
bought and sold easily.
 2.1 Bond Characteristics
• Innovation in the Bond Market
• Inverse floaters
• is a bond or other type of debt whose coupon
rate has an inverse relationship to a benchmark
rate.
• An inverse floater the coupon rate on the bond
varies inversely with the benchmark interest
rate.
 2.1 Bond Characteristics
• Innovation in the Bond Market
• Inverse floaters
• Inverse floaters come about through the
separation of fixed-rate bonds into two classes:
a floater, which moves directly with some
interest rate index, and an inverse floater, which
represents the residual interest of the fixed-rate
bond, net of the floating-rate.
 2.1 Bond Characteristics
• Innovation in the Bond Market
• Benefits of an Inverse Floater
• An investor would want to invest in an inverse floater if
the benchmark rate is high and they believe the rate
will decrease in the future at a faster rate than the
forward contracts indicate.
• Another strategy is to buy an interest rate floater if the
rates are low now and it is expected that they stay low,
even though the forward contracts are implying an
increase. If the investor is correct and the rates do not
change, the investor will outperform the floating rate
note by holding the inverse floater.
 2.1 Bond Characteristics
• Innovation in the Bond Market
• Asset-backed bonds
• is a type of financial investment that is collateralized
by an underlying pool of assets—usually ones that
generate a cash flow from debt, such as loans, leases,
credit card balances, or receivables.
 2.1 Bond Characteristics
• Innovation in the Bond Market
• Pay-in-kind bonds
• Issuers can pay interest in cash or additional
bonds
• Catastrophe bonds
• Higher coupon rates to investors for taking on
risk
 2.1 Bond Characteristics
•
2.2 Bond Pricing
 2.2 Bond Pricing

• Prices fall as market interest rate rises

• Interest rate fluctuations are primary source of
bond market risk
• Bonds with longer maturities more sensitive to
fluctuations in interest rate
Figure 2.3 Inverse Relationship between Bond Prices and Yields
Straight Bond
• Obligates the issuer of the bond to pay the
holder of the bond:
• A fixed sum of money (principal, par value, or face
value) at the bond’s maturity
• Constant, periodic interest payments (coupons)
during the life of the bond (Sometimes)

• Special features may be attached

• Convertible bonds
• Callable bonds
• Putable bonds
Straight Bond Basics

• $1,000 face value

• Semiannual coupon payments
Annual Coupon
(10.1) Coupon Rate 
Par Value

Annual Coupon
(10.2) Current Yield 
Bond Price
Straight Bonds
• Suppose a straight bond pays a semiannual
coupon of $45 and is currently priced at
$960.
• What is the coupon rate?
• What is the current yield?
$45  2
(10.1) Coupon Rate   9.00 %
$1,000

$45  2
(10.2) Current Yield   9.375 %
$960
Straight Bond Prices & Yield to
Maturity
• Bond Price:
• Present value of the bond’s coupon
payments
• + Present value of the bond’s face value

• Yield to maturity (YTM):

• The discount rate that equates today’s
bond price with the present value of the
future cash flows of the bond
 Bond Pricing Formula
 
C  1  FV
(10.3) Bond Price  1
YTM 
 1 
 YTM
2

2M 
1  YTM
2
 2M

PV of coupons PV of FV

Where:
C = Annual coupon payment
FV = Face value
M = Maturity in years
YTM = Yield to maturity
Straight Bond Prices
Calculator Solution

 
C  1  FV
(10.3) Bond Price  1
YTM 
 
1  YTM 2 
2M  
 1 
YTM
2

2M

Where:
N = 2M
C = Annual coupon payment
I/Y = YTM/2
FV = Face value PMT = C/2
M = Maturity in years FV = 1000
YTM = Yield to maturity CPT PV
Straight Bond Prices
 
C  1  FV
(10.3) Bond Price  1
YTM 
 
1  YTM 2 
2M 

 1 
YTM
2

2M

PV of coupons PV of FV

For a straight bond with 12 years to maturity, a coupon

rate of 6% and a YTM of 8%, what is the current price?
 
60  1   $457 .41
PV of Coupons  1
.08 
 
1  .08 2 
24 

1000
PV of FV   $390 .12

1  .08 224

Price = $457.41 + $390.12 = $847.53

Calculating a Straight Bond Price Using Excel
• Excel function to price straight bonds:

=PRICE(“Today”,“Maturity”,Coupon
Rate,YTM,100,2,3)

• Enter “Today” and “Maturity” in quotes, using mm/dd/yyyy

format.
• Enter the Coupon Rate and the YTM as a decimal.
• The "100" tells Excel to us $100 as the par value.
• The "2" tells Excel to use semi-annual coupons.
• The "3" tells Excel to use an actual day count with 365 days per
year.
Note: Excel returns a price per $100 face.
Spreadsheet Analysis
Par, Premium and Discount Bonds
Par bonds: Price = par value
YTM = coupon rate
Premium bonds: Price > par value
YTM < coupon rate
The longer the term to maturity,
the greater the premium over par
Discount bonds: Price < par value
YTM > coupon rate
The longer the term to maturity,
the greater the discount from par
Premium Bond Price
12 years to maturity
8% coupon rate, paid semiannually
YTM = 6%

 
80  1   $677 .42
PV of Coupons  1
.06 
 
1  .06
2

24 

1000
PV of FV   $491 .93

1  .03 2
24

Price = $457.41 + $390.12 = $1,169.36
Discount Bonds
Consider two straight bonds with a coupon rate of 6%
and a YTM of 8%.
If one bond matures in 6 years and one in 12, what
are their current prices?

60  1 
 1000
Bond Price (6 yr) 
.08 

1

1 .08 
12

2  1


.08
2
12

 $906 .15

 
60  1  1000
Bond Price (12 yr)  1  $847 .53
.08 
 1  .082 
24

 1 
.08
2
 24
Premium Bonds
Consider two straight bonds with a coupon rate of 8% and
a YTM of 6%.
If one bond matures in 6 years and one in 12, what are
their current prices?

 
80  1  1000
Bond Price (6 yr)  1  $1,099 .54
.06 
  
12 

1  .06 2  1  .06 2

12

 
80  1  1000
Bond Price (12 yr)  1  $1,169 .36
.06 

1 .06
2

24 


1 
 .06
2

24
Bond Value ($) vs Years to Maturity

Premium CR>YTM
8%>6%

YTM = CR
1,000 M

CR<YTM
Discount 6%<8%

12 6 0
Premium and Discount Bonds
• In general, when the coupon rate and YTM
are held constant:

For premium bonds: the longer the term to

maturity, the greater the premium over par
value.

For discount bonds: the longer the term to

maturity, the greater the discount from par
value.
Relationships among Yield
Measures
For premium bonds:
coupon rate > current yield > YTM

For discount bonds:

coupon rate < current yield < YTM

For par value bonds:

coupon rate = current yield = YTM
A Note on Bond Quotations
• If you buy a bond between coupon
dates:
• You will receive the next coupon payment
• You might have to pay taxes on it
• You must compensate the seller for any
accrued interest.
A Note on Bond Quotations
• Clean Price = Flat Price
• Bond quoting convention ignores accrued interest.
• Clean price = a quoted price net of accrued
interest

• Dirty Price = Full Price = Invoice Price

• The price the buyer actually pays
• Includes accrued interest added to the clean
price.
Clean vs. Dirty Prices
Example

• Today is April 1. Suppose you want to buy a

bond with a 8% annual coupon payable on
January 1 and July 1.
• The bond is currently quoted at $1,020

• The Clean price = the quoted price = $1,020

• The Dirty or Invoice price = $1,020 plus
(3mo/6mo)*$40 = $1,040
Calculating Yields

 
C  1  FV
Bond Price  1 
YTM 

 1 YTM 2M

2  1
YTM
2
2M

• Trial and error

• Calculator
• Spreadsheet
Calculating Yields
Trial & Error
A 5% bond with 12 years to maturity is priced at
90% of par ($900).
Selling at a discount YTM > 5%
Try 6% --- price = $915.32 too high
Try 6.5% --- price = $876.34 too low
Try 6.25% --- price = $895.56 a little low
Actual = 6.1933%
Calculating Yields
Calculator
A 5% bond with 12 years to maturity is priced at
90% of par ($900).
N = 24
PV = -900
PMT = 25
FV = 1000
CPT I/Y = 3.0966 x 2 = 6.1933%
Calculating Yields
Spreadsheet
5% bond with 12 years to maturity,priced at 90% of par
=YIELD(“Now”,”Maturity”,Coupon, Price,100,2,3)
“Now” = “06/01/2008”
“Maturity” = “06/01/2020”
Coupon = .05
Price = 90 (entered as a % of par)
100 redemption value as a % of face value
“2” semiannual coupon payments
“3” actual day count (365)
=YIELD(“06/01/2008”,”06/01/2020”,0.05,90,100,2,3) = 0.06193276
Spreadsheet Analysis
Callable Bonds
• Gives the issuer the option to:
• Buy back the bond
• At a specified call price
• Anytime after an initial call protection
period.

• Most bonds are callable Yield-to-call may

be more relevant
 Yield to Call
 
C  1  CP
Callable Bond Price  1
YTC 
 1 YTC
2

2T
 
 1  YTC 2T
2

Where:
C = constant annual coupon
CP = Call price of bond
T = Time in years to earliest call date
YTC = Yield to call
Yield to Call
• Suppose a 5% bond, priced at 104% of par with 12
years to maturity is callable in 2 years with a $20
call premium. What is its yield to call?

N=4 # periods to first call date

PV = -1040
PMT = 25
FV = 1,020 Face value + call premium
CPT I/Y = 1.9368 x 2 = 3.874%

Remember: resulting rate = 6 month rate

Interest Rate Risk
• Interest Rate Risk = possibility that changes
in interest rates will result in losses in the
bond’s value

• Realized Yield = yield actually earned or

“realized” on a bond

• Realized yield is almost never exactly equal

to the yield to maturity, or promised yield
Interest Rate Risk and Maturity