Topic 6: Bonds – Part 1

FIN 3702B
Investment Analysis and Portfolio Management
Arkodipta Sarkar
 Outline
• What are bonds? What kind of bonds are traded?
• Default Risk and Bond Ratings.
• Bond Pricing.
• Bond Yields.
• The Term Structure of Interest Rates.
• Interest Rate Risk and Duration.
 Outline
• What are bonds? What kind of bonds are traded?
• Default Risk and Bond Ratings.
• Bond Pricing.
• Bond Yields.
• The Term Structure of Interest Rates.
• Interest Rate Risk and Duration.
 What is a bond?
A bond is a security that is issued in connection with a borrowing arrangement.
• Issuer
– The borrower.
– e.g., Governments, Federal agencies, corporations
• Principal value (a.k.a par value or face value)
– Payment at maturity—typically $1,000 for U.S. bonds.
• Coupon Payments
– Payments are typically semi-annual
• Coupon amount is (Coupon rate * Face value)/2 every 6 months.
– Coupons are a fixed or floating percentage of par
• Maturity
– Date on which principal (and last coupon) is paid
 Definition of a Bond
• A bond is a legally binding contract between a borrower (bond issuer) and a lender
(bondholder)
– Borrower promises to make interest and principal payments
– All payments are determined in the contract
– Bonds can differ in several different respects: repayment type, issuer, maturity,
collateral, priority in case of default
• A bond species
– Principal/ Face / Par value, F dollars, to be paid at maturity
– Coupon rate, c, to be paid periodically
• % of par value, expressed an APR
– Maturity, T years, final repayment of the bond
• Most bonds pay a fixed coupon at fixed intervals (usually six months) and then repay
the principal at maturity
 Features of Bonds
• Indenture provision: is the written bond contract. It specifies the issuer’s legal
requirements.
• Nonrefunding provision: prohibits a call and premature retirement of a bond from the
proceeds of a lower rate bond.
• Sinking fund: a bond must be paid off systematically over its life rather than only at
maturity.
• Callable bonds
– Maturity: maturity may be uncertain with call features
– freely callable / deferred call (noncallable initially but callable after a specified term)
– Why do firms call?
• when cheaper bonds can be issued, i.e. interest rates are falling. Issuer can refinance if rates decline. That helps the issuer but
hurts the investor. Therefore, borrowers are willing to pay more, and lenders require more, on callable bonds.

• Secured Vs Unsecured Bonds

– Secured Bonds: backed by specified assets. Bond holder can claim the ownership of the
specified property on the issuer’s default. Unsecured: backed by promise and based on
the general credit of the issuer.
 Example of a Bond
• Consider a four-year Government of Canada bond with a 6% annual coupon
rate, issued on 1/1/2019 and maturing on 12/31/2022
– The par value of the bond is $1,000
– Coupons are paid semi-annually: June 30 and December 31
– The semiannual coupon payment is:
(𝐶𝑜𝑢𝑝𝑜𝑛 𝑅𝑎𝑡𝑒 × 𝑃𝑟𝑖𝑛𝑐𝑖𝑝𝑎𝑙 𝑉𝑎𝑙𝑢𝑒)
𝐶=
𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑝𝑎𝑦𝑚𝑒𝑛𝑡𝑠 𝑝𝑒𝑟 𝑦𝑒𝑎𝑟

0.06 × 1000
= 30
2
Example Coupon Bond
• 20-year bond issued by
US state of S.C. January
1867.
• Face value of $1000
• Interest rate of 6% paid
semiannually—each of
the coupons could be
turned in for $30 every
6 months.
Treasury Note
Price
 Example: Coupon Bonds
• Example: bond with par value of $1000, annual coupon rate of 8%, and maturity of
30 years.
0.08
• The bondholder is entitled to semiannual payments of $40 (= × 1000) for the
2
life of the bond, plus $1000 par value at maturity.
F = $1040
C=$40 C=$40 C=$40 C=$40
t=0

t=1 t=2 t=3 t=59 t=60

-Bond Price = - P(C, T) = - P(4%, 60)
 Example: Zero-Coupon Bonds
• Zero-coupon bonds (or discount bonds) make no coupon payments (zero-coupon
rate). Investors receive par value at maturity but no interest until then.
• Why would you buy such a bond?
F = $1000
C=$0 C=$0 C=$0 C=$0

t=0

t=1 t=2 t=3 t=59 t=60

-Bond Price = -P(0%, 60)

 What kind of bonds are traded?
• Sovereign bonds—issued by governments
– Treasury Bonds (US), Gilts (UK)
– Emerging Market Debt (e.g. Brazilian Treasuries)
• Corporate bonds—issued by corporations
– Investment grade / Speculative Grade (“Junk”)
• International bonds
– The Eurodollar market refers to dollar-denominated bonds sold outside the US (not just in
Europe)
• Bonds with special features
– Option features (Callable bonds / Puttable Bonds / Convertible Bonds)
– Indexed bonds make payments that are tied to a general price index (e.g. inflation, TIPS) or the
price of a particular commodity
 US Treasuries
• Easiest to value
– Only fixed (as opposed to floating) coupons
– To price bonds we need to quantify:
• Interest rate risk
• Default risk (none)
• Recovery risk (none)
• Three types:
– T-bills (maturities up to 1 year)
– T-notes (1-10 year maturities)
– T-bonds (more than 10 years)
• Coupons:
– T-bills have no coupons (zero coupons)
– T-notes and T-bonds: semi-annual coupons
 Outline
• What are bonds? What kind of bonds are traded?
• Default Risk and Bond Ratings.
• Bond Pricing.
• Bond Yields.
• The Term Structure of Interest Rates.
• Interest Rate Risk and Duration.
 Fixed Income?
• Are coupons/par value guaranteed?
– Default on coupon/principal payments
Treasury Inflation-Protected Securities (TIPS): Securities whose
principal is tied to the Consumer Price Index (CPI), whereby the
principal increases with inflation and decreases with deflation.
When the security matures, the US Treasury pays the original or
adjusted principal, whichever is greater.

– Liquidity: delay in payment

– Floating rate coupons: interest rate risk
– Real income: inflation risk
• Recent defaults:
– Corporates (Enron, WorldCom, Parmalat, Lehman)
– Sovereign debt: Russia (1998), Argentina (2001), Greece (2012)
 Default Risk and Bond Ratings
• Bond cash flows are uncertain.
– Bonds generally promise a fixed flow of income, but that income is only risk free if the investor is
sure of no default.
• US debt is conventionally treated as being free of default risk.
– Recent congressional budget disputes have raised questions about whether it is really free from
default risk.
• Corporate bonds treated as risky
– If the company goes bankrupt, bondholders will not receive all the cash flows that they were
promised.
▪ Bond default risk is measured by Moody’s Investor Services
(http://www.moodys.com) and Standard & Poor’s Corporation
(http://www.standard-poors.com) among others.
▪ Junk-bonds: lower rated bonds for which default risk is high.
 Credit Ratings and Rating Agencies
• Rating agencies provide measures (ratings) of the risk of default by the company (or credit risk)

• Rating agencies provide two types of ratings:

– A rating with respect to a specific financial obligation
– A rating for a corporation/obligor as a whole

• The two largest rating agencies are:

– Standard and Poor's Corporation (http://www.standard-poors.com)
– Moody's Investors Service (http://www.moodys.com)

• In order for companies to be able to issue bonds their debt must be rated.
 Default Risk and Bond Ratings
Standard
Moody' s & Poor's Safety

Aaa AAA The strongest rating; ability to repay interest and principal
is very strong.
Aa AA Very strong likelihood that interest and principal will be
Investment
repaid
A A Strong ability to repay, but some vulnerability to changes in grade
circumstances
Baa BBB Adequate capacity to repay; more vulnerability to changes
in economic circumstances
Ba BB Considerable uncertainty about ability to repay.
B B Likelihood of interest and principal payments over
sustained periods is questionable.
Caa CCC Bonds in the Caa/CCC and Ca/CC classes may already be
Junk
Ca CC in default or in danger of imminent default bonds
C C C-rated bonds offer little prospect for interest or principal
on the debt ever to be repaid.
 Outline
• What are bonds? What kind of bonds are traded?
• Default Risk and Bond Ratings.
• Bond Pricing.
• Bond Yields.
• The Term Structure of Interest Rates.
• Interest Rate Risk and Duration.
BOND PRICING
 Bond Pricing
• Before: we value a cash flow stream using the Present Value (PV) rule. Apply same
concepts to bonds.
𝑽𝒂𝒍𝒖𝒆 𝒐𝒇 𝑩𝒐𝒏𝒅 = 𝑷𝑽 𝒐𝒇 𝑬𝒙𝒑𝒆𝒄𝒕𝒆𝒅 𝑭𝒖𝒕𝒖𝒓𝒆 𝑪𝒂𝒔𝒉 𝑭𝒍𝒐𝒘
• Practically:
– 1. Identify the size and timing of cash flows
– 2. Discount them at the correct discount rate, which depends on the default risk of
the bond
• Intrinsic risk of the issuer (often rated by an agency, e.g.Moody's, S&P)
• Collateralized or non-collateralized debt
• Seniority
 Zero-Coupon Bonds (ZCB)
• Zero-coupon bonds do not pay coupons (c = 0)
– Time to maturity, T = Maturity date - today's date; Face value F; Discount rate r

• ZCB always sell at a discount (price lower than the principal), also known as pure
discount bonds
• Treasury Bills (T-bills) are U.S. government zero-coupon bonds with a maturity of up to
one year
 Coupon Bonds
• Coupon Bonds pay out a fixed coupon every period until maturity (c > 0%)
• To value a level-coupon bond, we need
– Coupon payment dates and time to maturity, T
– Coupon rate, c = (Total Coupons (Cs) per year )=F
– Coupon payment (C) per period and Face value, F
– Discount rate, r
 Coupon Bonds
• Value of a coupon bond = PV of coupons + PV of face Value

• The coupons are an annuity, so we can write

• Note: Zero-coupon bonds are just a special case where C = $0

 Coupon Bonds: Example
• Suppose that the stated discount rate (semiannually compounded) is 5%.
What is the value (as of January 1, 2017), of a 6% coupon Government of
Canada bond with semi-annual payments, face value of $1,000 and a
maturity date of December 31, 2020?
Coupon Bonds: Example
 Bond Pricing
• Example: 8% coupon, 30-year maturity bond, par value of $1,000, semi-
annual coupon payments.
• Suppose the discount rate is 4% per six-month period. The value of the
bond:
 Bond Pricing
• Example: 8% coupon, 30-year maturity bond, par value of $1,000, semi-
annual coupon payments.
• Suppose the discount rate is 4% per six-month period. The value of the bond:

60
1 1
𝑃𝑟𝑖𝑐𝑒 = ෍ 𝑡
× 40 + 60
× 1,000 = 1,000
1 + 0.04 1 + 0.04
𝑡=1

• In this example the coupon rate equals the discount rate, and the bond price
equals par value.
• What if the discount/interest rate is higher?
 Bond Price at different interest rates
• Market Interest/Discount Rate Bond Price
4%
6%
8%
10%
12%

• Price (= PV(payments)) falls as interest rates rise.

– Crucial general rule in bond valuation.
 Bond Price at different interest rates
• Market Interest/Discount Rate Bond Price
4% $1,695.22
6% $1,276.76
8% $1,000.00
10% $810.71
12% $676.77

• Price (= PV(payments)) falls as interest rates rise.

– Crucial general rule in bond valuation.
 Bond Pricing
▪ Price of the 30-year, 8% coupon bond for a range of interest rates:

3000

2500

2000
Price ($)

1500

1000

500

0
0% 5% 10% 15% 20% 25%
Interest Rate
 Bond Pricing: Price vs. ‘r’ graph
• Negative slope means price falls as r rises.
– If you buy a bond at par for 8% and market interest rates rise, then you
suffer a loss.
– Intuition is you tied up your money earning 8% when alternative
investments now earn higher returns.
• The (convex) shape means an increase in interest rates results in a
price decline that is smaller than the price increase resulting from
an interest rate fall of equal magnitude.
– From prior example, compare rate changes of +/- 2%
– This property is called “convexity”.
 Outline
• What are bonds? What kind of bonds are traded?
• Default Risk and Bond Ratings.
• Bond Pricing.
• Bond Yields.
• The Term Structure of Interest Rates.
• Interest Rate Risk and Duration.
BOND YIELDS
 Different Definitions of Yields

• Nominal yield: coupon rate is the nominal yield

• Current yield: coupon divided by the current price of the bond
• Yield to maturity: is the yield an investor gets if the bond is held to
maturity
• Yield to call: is the yield if the bond is called at the first opportunity
• Time until call replaces time until maturity
• Call price replaces the par value.
• Realized yield: is equal to yield to maturity if all coupons are reinvested at
an interest rate equal to the bond’s yield to maturity.
 Yield to Maturity
• Yield to maturity (YTM), or simply “yield”, is a measure of the per period
return (also called internal rate of return, IRR) earned from holding a
bond to maturity
– YTM is the discount rate y that equates the observed price to the present value
of cash flows

– When the interest rate, r , is constant for all maturities (and so far, we assumed
it is), y = r
– What is the relation between bond prices and bond yields?
 Comparing bonds with different characteristics
• Consider three bonds:
– Bond 1: T=2, C=2%, P=90.92
– Bond 2: T=2, C=8%, P=102.26
– Bond 3: T=2, C=0%, P=87.14

• A natural metric is to compare the expected returns

– a.k.a. computing the “yield”
 Yield-To-Maturity (YTM)
• The constant discount rate which equates the PV of all bond’s cash
flows and its market price is the bond’s yield (i.e., yield to maturity).
For a semi-annual bond:

2𝑇 𝐶
2 𝐹
𝑃𝑇 = ෍ 𝑡+ 2𝑇
𝑦𝑇 𝑦𝑇
𝑡=1 1 + 1+
2 2
• yT is the IRR of the bond (discount rate that equates the PV of the cash
flows with the market price)
 Back to example
• Consider Bond 1: T=2, C=2%, P=90.92
• Yield solves:
1 1 101 1
90.92 = + + + 4
𝑦 1 𝑦 2 𝑦 3 𝑦
1+ 1+ 1+ 1+
2 2 2 2

• Which gives y=6.941% (annualized)

Calculator: PV = -90.92, PMT = 1, FV =100, T = 4

I = ? = 3.47 → YTM = 2 x 3.47 = 6.94%
 Interpreting the “yield”
• Yield is the expected rate of return on a bond if
1. Coupons are paid
2. You re-invest coupons at y
3. You hold the bond to maturity

• Either way, yields provide a useful benchmark for comparison

Bond Price and Yields
 Bond Pricing Terminology
• Recall c is the coupon rate such that 𝐶 = 𝑐 × 𝑃𝑟𝑖𝑛𝑐𝑖𝑝𝑎𝑙 (assume annual
cash flows)
• Bond trades at par, bond price is equal to the principal
– P=F
– y=c
• Bond trades at premium: bond price is larger than the principal
– P>F
– y<c
• Bond trades at discount: bond price is smaller than the principal
– P<F
– y>c
• Question: Are zero coupon bonds sold at par, at discount, or at premium?
 Relationship between P, y, and C
2𝑇 𝐶
2 100
𝑃𝑇 = ෍ 𝑡+ 2𝑇
𝑦𝑇 𝑦𝑇
𝑡=1 1 + 1+
2 2

• If yT ↑ then PT ↓
– prices and yields move in opposite directions.
• If C ↑ then PT ↑
– prices and coupons move in the same direction
Callable Bonds vs. Straight Bonds
Illustration for Yield to 1st Call

yC
yC 1st Call Price
yC coupons

1 2 NC
B0

𝐶1 𝐶2 𝐶𝑁𝐶 + 𝐹𝑖𝑟𝑠𝑡 𝐶𝑎𝑙𝑙 𝑃𝑟𝑖𝑐𝑒

𝐵0 = 1
+ 2
+ ⋯+
(1 + 𝑦𝑐 ) (1 + 𝑦𝑐 ) (1 + 𝑦𝑐 )𝑁𝐶
 Example:
Realized
Yield

𝐵0 (1 + 𝑟)𝑁 = 𝐹𝑉𝑁

What are the realized

yield for A and B if the
bond price is at $1,000,
respectively?
 Example:
Realized
Yield

𝐵0 (1 + 𝑟)𝑁 = 𝐹𝑉𝑁

What are the realized 𝑟𝐴 = 10%

yield for A and B if the
bond price is at $1,000,
respectively?

𝑟𝐵 = 9.91%
 Realized Yield
An 8% annual coupon bond with 3 years term is selling for $953.10.
The interest rates in the next 3 years will be, with certainty, r1 =8%,
r2 = 10%, and r3 = 12%. Calculate the yield to maturity and realized
yield of the bond.
1) Yield to maturity:
n = 3; PV = - 953.10; FV = 1000; PMT = 80;
This results in: YTM = ____________
2) Realized yield (when realized return changes every period):
First, find the future value (FV) of reinvested coupons and principal:
FV = ________________________________________________
Then find the realized yield that makes the FV of the purchase price
equal to FV, that is
$953.10 × (1 + realized yield)^3 = ___________________
➔Realized yield = ______________
 Realized Yield
An 8% annual coupon bond with 3 years term is selling for $953.10.
The interest rates in the next 3 years will be, with certainty, r1 =8%,
r2 = 10%, and r3 = 12%. Calculate the yield to maturity and realized
yield of the bond.
1) Yield to maturity:
n = 3; PV = - 953.10; FV = 1000; PMT = 80;
This results in: YTM = 9.89%
2) Realized yield (when realized return changes every period):
First, find the future value (FV) of reinvested coupons and principal:
FV = ($80 * 1.10 *1.12) + ($80 * 1.12) + $1,080 = $1,268.16
Then find the realized yield that makes the FV of the purchase price
equal to FV, that is
$953.10 × (1 + realized yield)^3 = $1,268.16
➔Realized yield = 9.99%
 Outline
• What are bonds? What kind of bonds are traded?
• Default Risk and Bond Ratings.
• Bond Pricing.
• Bond Yields.
• The Term Structure of Interest Rates.
• Interest Rate Risk and Duration.
 Term Structure of Interest Rates
➢ What is a term structure of interest rates (or yield curve)?
➢ Yield curve describes the yield and maturity relations for a given class of bonds (such as
government bonds or similarly rated corporate bonds etc.)

y7 y8
y6
y5
YTM y4
y3
y2
y1 Note that this figure shows the YTM
of 8 different bonds that have similar
ratings or issuers (e.g., AAA-rated
corporate bonds or government).

Maturity (years)
 US Treasury Curve

Generally, the yield curve is upward sloping, represented by the positive spread
btw long-term and short-term bonds
Yield to Maturity and Prices on Zero-Coupon Bonds
($1,000 Face Value)

Yield Curve for Zero-Coupon Bonds

10%
YTM (in %)

5%

0%
1 year 2 year 3 year 4 year
Maturity (in years)
 Application for Bond Pricing
(using the yield curve)
➢ If a yield curve is given for the zero-coupon bonds, the price
of a regular coupon-paying bond can be computed as a
portfolio of zero-coupon bonds

B1 y1
B2 y2
B3 y3
y4
B4 y5
B5 yN
BN
Pricing of A Coupon Bond using the Yield Curve
➢ Spot rate: YTM of a zero coupon bond
➢ Given the yield curve of the government bonds in the
economy is:
Maturity (Years) Zero-coupon Zero-Coupon Bond Price
Bond Yield
1 5% 1000/1.05 = 952.38
2 6% 1000/1.06^2 = 890.00
3 7% 1000/1.07^3 = 816.30

➢ What is the price of a 6% annual coupon bond with 3 year to

maturity? (with par value = $1,000)
Bond Price = _______________________________________
Pricing of A Coupon Bond using the Yield Curve
➢ Spot rate: YTM of a zero coupon bond
➢ Given the yield curve of the government bonds in the
economy is:
Maturity (Years) Zero-coupon Zero-Coupon Bond Price
Bond Yield
1 5% 1000/1.05 = 952.38
2 6% 1000/1.06^2 = 890.00
3 7% 1000/1.07^3 = 816.30

➢ What is the price of a 6% annual coupon bond with 3 year to

maturity? (with par value = $1,000)
Bond Price = 60/1.05 + 60/1.06^2 + 1060/1.07^3 = $975.82
Application to derive Future Short Rates under Certainty
(using yield curves)
Application to Derive Future Short Rates under Certainty
(using yield curves)
 Application to derive Forward Rates
(using yield curves)

1 + 𝑦𝑛 𝑛 = 1 + 𝑦𝑛−1 𝑛−1 (1 + 𝑓𝑛 )

1 + 𝑦𝑛 𝑛
1 + 𝑓𝑛 = 𝑛−1
1 + 𝑦𝑛−1
where
fn = the forward rate for period n.
yn = yield for a bond with a maturity of n

Note: One-year forward rate is the same as the future short rate
under certainty.
 Spot and Forward Yield Curve
Zero-Coupon Rates Bond Maturity
12% 1
11.75% 2
11.25% 3
10.00% 4
9.25% 5

Forward Rate in

2nd year: [(1.1175)2 / 1.12] - 1 = 0.1150

3rd year: ______________________________

4th year: ______________________________

5th year: ______________________________

 Example 7: Spot and Forward Yield
Curve
Zero-Coupon Rates Bond Maturity
12% 1
11.75% 2
11.25% 3
10.00% 4
9.25% 5

Forward Rate in

2nd year: [(1.1175)2 / 1.12] - 1 = 0.1150

3rd year: [(1.1125)3 / (1.1175)2] - 1 = 0.1025

4th year: [(1.1)4 / (1.1125)3] - 1 = 0.0633

5th year: [(1.0925)5 / (1.1)4] - 1 = 0.0630

 Term Structure Theories

➢ Theory 1: Expectations Hypothesis

➢ Long-Term rate = geometric mean of current and future Short-Term rates expected over
the maturity
1
1 + rt ,t + n = [(1 + rt ,t +1 )(1 + rt +1,t + 2 )  (1 + rt + n −1,t + n )] n

➢ Explain any shape of yield curve

➢expectation of rising future ST rates cause LT rate to rise, upward sloping curve
➢expectation of falling future ST rates cause LT rate to fall, downward sloping curve
➢humped curve
Expected inflation rate hike as a result of Federal
Reserve Announcement
 Yield Curve and Interest Rate Uncertainty

• Under Certainty, we have

(1 + 𝑟1 )(1 + 𝑟2 ) = (1 + 𝑦2 )2
• What if 𝑟2 is not known today, then we have expected short rate as the followings:
(1 + 𝑦2 )2 = (1 + 𝑟1 )(1 + 𝐸(𝑟2 ))

• Given that the actual spot rate in one year time can be different from the
expectation. Hence, the investor might ask for compensation for bearing the interest
rate risk.

• Hence, in reality, the forward rate f2 can be different from the expected interest rate
𝐸(𝑟2 ).

• If most investors are short-term investors, they will ask for liquidity premium: we will
have 𝑓2 > 𝐸(𝑟2 ). If all investors are long-term investors, we will have 𝑓2 < 𝐸(𝑟2 ).
𝑓𝑛 = 𝐸 𝑟𝑛 + 𝑙𝑖𝑞𝑢𝑖𝑑𝑖𝑡𝑦 𝑃𝑟𝑒𝑚𝑖𝑢𝑚
 Term Structure Theories (cont’d…)
➢ Theory 2: Liquidity Preference Theory
➢ LT yields more than ST because more price volatility
➢ upward sloping curve
➢ strong empirical support
𝑓𝑛 = 𝐸 𝑟𝑛 + 𝑙𝑖𝑞𝑢𝑖𝑑𝑖𝑡𝑦 𝑃𝑟𝑒𝑚𝑖𝑢𝑚
Illustrations of Liquidity Premium in Yield Curves
Price Volatility of Long-term Treasury Bonds
Term Spread: Yields on 10-year and
90-day Treasury Securities
 Outline
• What are bonds? What kind of bonds are traded?
• Default Risk and Bond Ratings.
• Bond Pricing.
• Bond Yields.
• The Term Structure of Interest Rates.
• Interest Rate Risk and Duration. (Part 2)