FINANCE 361 – Topic 15 – Bonds

Paul Geertsema

1
Contents

1 Readings 4

2 What are we doing today 5

3 Introduction 6

4 So what is a bond? 8

5 Bond cash flow notation 9

6 Bond cash flows 12

7 Bond pricing with a constant discount rate 14

8 Accrued interest 19

2 FINANCE 361 Class Notes – University of Auckland – Dr Paul Geertsema

 Contents (cont.)

9 Yield to maturity (YTM or y) 25

10 Zero coupon bonds and the zero rate 28

11 Floating rate notes (FRN’s) 30

12 Credit risky bonds 31

13 Daycount conventions 34

3 FINANCE 361 Class Notes – University of Auckland – Dr Paul Geertsema

1 Readings

• Read BKM Ch 14
• We will be following BKM for bond valuations. So the slides won’t
be as detailed as before - much of the detail is in BKM. Read it!

4 FINANCE 361 Class Notes – University of Auckland – Dr Paul Geertsema

2 What are we doing today

• The cash flows and valuation of bonds

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3 Introduction

• We will start by looking at fixed interest coupon bonds issued by

safe corporates and governments
– Cash flows are known with certainty
• A subset of a much wider universe of bonds
– With different payouts (floating rate, callable, convertible, re-
setting, amortising, etc.)
– With different underlying risks (corporate, asset backed, project,
etc.)
• Bonds are a subset of what is known as Fixed Income
– Fixed income is, broadly, any security or contract that is sensitive
to interest rates
◦ Bonds, IR Swaps, IR Futures, IR Options, Swaptions

6 FINANCE 361 Class Notes – University of Auckland – Dr Paul Geertsema

 Introduction (cont.)

– “The Handbook of Fixed Income Securities” by Fabozzi is the

standard reference (1536 pages and weighing 5 pounds!)
– Fixed income pricing is essentially derivative pricing where the
underlying source of risk is interest rates
– This is fearsomely complicated if you do it properly ... (See
Veronesi if you are interested)
– Which is why we will stick to simple bonds in this paper...

7 FINANCE 361 Class Notes – University of Auckland – Dr Paul Geertsema

4 So what is a bond?

• A bond is debt packaged as a tradeable security.

• Since it is debt, it needs to be repaid eventually (called principal
when paid)
• Since it is debt, it incurs interest (called interest or coupons when
paid)
• The entity borrowing is called the issuer.
• The entity lending is holding the bond and is called the holder or
investor.

8 FINANCE 361 Class Notes – University of Auckland – Dr Paul Geertsema

5 Bond cash flow notation

• The cash flows of a bond (interest and principal) are set out in the
documents that legally constitutes the bond
• Principal is usually repaid in a lump sum on a date known as the
Maturity Date.
• Interest aka coupons are usually paid periodically in arrears
• NB: Coupons are not paid on the day the bond is issued. Coupons
are (normally) paid on the maturity date, which is usually chosen
to coincide with an interest payment date

9 FINANCE 361 Class Notes – University of Auckland – Dr Paul Geertsema

 Bond cash flow notation (cont.)

• My notation:
– F is the face value or par value of the bond in $. Usually $100
(NZ, UK) or $1,000 (US) per bond.
– C is the periodic coupon in $ paid by the bond on interest
payment dates. This corresponds to interest payments.
– c is the annual coupon rate, in %.
– ∆ is the length of the coupon period in years; it is the inverse
of the annual frequency of interest payments;
– Annual: ∆ = 1, Semi-annual: ∆ = 0.5, Quarterly: ∆ = 0.25,
Monthly: ∆ = 12 1
≈ 0.083333
– T is the maturity date of the bond (when principal is paid back)
and is measured in years from the valuation date.
– r is the annual discount rate used to calculate the present value
of bond cash flows, that is, the price of the bond.
– Bt is the value of the bond at time t
– Mt is the market value of the bond at time t
10 FINANCE 361 Class Notes – University of Auckland – Dr Paul Geertsema
 Bond cash flow notation (cont.)

• Important: In my notation
– the discount rate r is always annual.
– the time index t is always in years
– this way we avoid some of the confusion that can arise when
dealing with bonds that pay monthly, quarterly, etc.
– it is also the way practitioners at hedge funds and banks typically
work
– I only stress this since its is different from the convention in
BKM
◦ In BKM r is the discount rate per coupon period (not per
year)
◦ In BKM t is a count of coupon periods (not time in years)
– You are free to use either convention as long as you are consist-
ent (if you are not consistent, you won’t get the right answers)

11 FINANCE 361 Class Notes – University of Auckland – Dr Paul Geertsema

6 Bond cash flows

• The coupon paid on each interest payment date is

–C =c×F ×∆
– Important: c is the percentage of the bond face value that is
paid out over the course of the year. If the bond pays interest
more than once per year, then the payments are split equally.
There is no adjustment for time value of money! (Remember:
It is lawyers that draft bond documentation)
– So the bond pays C at the end of each coupon period (of which
there are ∆1 per year), including at maturity.
– Also, at maturity (only) the bond pays F

12 FINANCE 361 Class Notes – University of Auckland – Dr Paul Geertsema

 Bond cash flows (cont.)

• An example (hereafter “the example bond”). Spark (a large NZ

telecoms company) issues a bond today that matures in exactly 2
years and pays interest on a quarterly basis. The coupon rate is
8% and the face value is $100. List the cash flows:
• F = $100, ∆= 0.25, c = 8%, T = 2 years, C = c × F × ∆ =
8% ∗ 100 ∗ 0.25 = $2
t (in years) C F Bond Cash Flows (CF)
0
0.25 2 2
0.50 2 2
0.75 2 2
1.00 2 2
1.25 2 2
1.50 2 2
1.75 2 2
2.00 2 100 102

13 FINANCE 361 Class Notes – University of Auckland – Dr Paul Geertsema

7 Bond pricing with a constant discount rate

• Remember the underlying theme of this course is that “anything

can be valued by discounting its expected cash flows at
an appropriate risk-adjusted discount rate”.
• In the context of bonds the cash flows are straight-forward to cal-
culate (see previous example)
• And the discount rate is usually given or inferred from similar traded
bonds
– In this lecture we keep the discount rate constant: r
– In the next lecture we will generalise to discount rates that vary
across different time horizons (aka tenors): rt
• So, fairly simple then... Continue with our example. Since the cash
flows are safe (= risk free) we can discount them at the risk free
rate. Assume a constant risk free rate of r = 5% (annual).

14 FINANCE 361 Class Notes – University of Auckland – Dr Paul Geertsema

 Bond pricing with a constant discount rate (cont.)

• Introduce the concept of a discount factor (d) for time t given by

t . Then the present value of some cash flow CFt at time
1
dt = (1+r)
t is given by CFt × dt
1
t (in years) C F CFr dt = (1+r)t PV(CF)
0.00 5% 1.0000 -
0.25 $2.00 $2.00 5% 0.9879 1.9758
0.50 $2.00 $2.00 5% 0.9759 1.9518
0.75 $2.00 $2.00 5% 0.9641 1.9281
1.00 $2.00 $2.00 5% 0.9524 1.9048
1.25 $2.00 $2.00 5% 0.9408 1.8817
1.50 $2.00 $2.00 5% 0.9294 1.8589
1.75 $2.00 $2.00 5% 0.9182 1.8363
2.00 $2.00 $100.00 $102.00 5% 0.9070 92.5170
Total 105.8543
• The bond is valued at $105.85.

15 FINANCE 361 Class Notes – University of Auckland – Dr Paul Geertsema

 Bond pricing with a constant discount rate (cont.)

• Let’s convert all this into formulas

• General Idea: B0 = P V (P rincipal) + P V (Interest)
• Let K be the set of all interest payment dates (in years from today):
K = {∆, 2∆, 3∆..., T − ∆, T }
– 2 year bond, annual coupons: ∆ = 1, K = {1, 2}
– 2 year bond, quarterly coupons: ∆ = 0.25, K = {0.25, 0.50, ..., 1.75, 2.00}
" # " #
• B0 = F
+ C
X
(1+r)T t
t∈K (1+r)
• Using discount factors:
• B0 = [F × dT ] + [C × dt]
X

t∈K
• Or even matrix notation (C is a column vector of coupons and d
is a column vector of discount factors)
• B0 = C0d + F × dT
• Excel: “=sumproduct(<cashflowrange>,<discountfactorrange>)”

16 FINANCE 361 Class Notes – University of Auckland – Dr Paul Geertsema

 Bond pricing with a constant discount rate (cont.)

• A short-cut formula to use if the discount rate is constant, mak-

ing use of the formula for an annuity (the coupon payments are
effectively an annuity from t = ∆ to t = T )
 

• B0 = F
+ 1 −
(1+r)T
C
s where s = (1 + r)∆ − 1 is the
1
T /∆

(1+s)
periodic discount rate corresponding to the annual discount rate r
• (This formula looks different from that in BKM p 447; it is because
in my formula t is always in years and the discount rate r is always
annual. Try it, it works.)
• Example: Value the example bond as per the previous table
 
F C  1
1 −

B0 = T + 
T /∆ 

(1 + r) s 
(1 + s)
1
with s = (1 + r)∆ − 1 = (1.05)

4 − 1 = 0.012272234

100 2 1
1 −
 
= 2 +  
2/0.25 

(1 + 0.05) 0.012272234 
(1 + 0.012272234)
= 90.7029 + 15.1514 = 105.8543
17 FINANCE 361 Class Notes – University of Auckland – Dr Paul Geertsema
 Bond pricing with a constant discount rate (cont.)

• Hint: This is a useful formula to know about in case you have to

value a bond with 60 coupon payments in an exam...

18 FINANCE 361 Class Notes – University of Auckland – Dr Paul Geertsema

8 Accrued interest

• Some aspects that are relevant when trading bonds

• Coupon record dates
– Coupon record date: The date at which the name of the current
holder of the bond is recorded for the purpose of paying the
coupon on the next coupon date (which may be a few days
later)
– Ex-coupon date: The day after the coupon record date.

19 FINANCE 361 Class Notes – University of Auckland – Dr Paul Geertsema

 Accrued interest (cont.)

– It is 2 October 2017. Consider now a bond owned by person

A that will pay a coupon of $2 on 15 October 2017 with the
coupon record date being 8 October 2017.
◦ Person A sells the bond to Person B on 4 October 2017. By
8 October the bond has settled (that is, transfer of ownership
has taken place), Person B is the official owner of record on
the coupon record date and will receive the coupon on 15
October 2017.
◦ Person A sells the bond to Person B on 9 October 2017 (the
ex-coupon date). As of 8 October 2017 person A was still
the owner of record, and hence will Person A will receive
the coupon on 15 October 2017 even though at 15 October
Person B is now the owner of record.
– The person that officially owned the bond (on the re-
gister of bond holders maintained by the paying agent)
on the coupon record date will receive the coupon,
even if the bond is subsequently traded.

20 FINANCE 361 Class Notes – University of Auckland – Dr Paul Geertsema

 Accrued interest (cont.)

• Accrued Interest
– Now consider a bond that pays annual coupons of 10% on each
December 15th, so the coupon per $100 face value is $10
– The clean price or flat price of a bond is the present value of
the bond cash flows (but EXCLUDING the next coupon
to be paid)
– The coupon record date is December 8th. On December 1st,
Person A sells the bond to Person B for $96 (the clean price,
equal to the present value of future bond cash flows – but ex-
cluding the next coupon – at that date). So Person B will be the
holder of record on December 8th and will receive the coupon
of $10.
– The problem here is that Person B receives the interest on the
bond from 15 December of the previous year until 15 December
of the current year, even though Person B has only owned the
bond for 15 days. One year of interest for investing money for
15 days!
21 FINANCE 361 Class Notes – University of Auckland – Dr Paul Geertsema
 Accrued interest (cont.)

◦ That would be a bargain for Person B

◦ And a disaster for Person A, who has held the bond for 350
days without receiving any interest
– So, being a sensible trader, Person A would not sell the bond
to Person B for at the clean price of $96
– Instead, Person A would like to be compensated for the interest
he has earned by holding the bond for 350 days and has not yet
received - known as accrued interest.
– So Person A sells the bond to Person B for $96 (the flat or clean
price) PLUS accrued interest of $10*(350/365) = $9.59 for a
total price of $96+$9.59=$105.59 (the invoice, dirty or all-in
price).
– So, simply put, accrued interest is paid by the buyer
of a bond to the seller of the bond to compensate
the seller for interest accrued but not received on the
bond. This payment is in addition to the clean price
of the bond at the time of the trade.

22 FINANCE 361 Class Notes – University of Auckland – Dr Paul Geertsema

 Accrued interest (cont.)

• Example of a bloomberg YAS (yield and spread analysis)

screen for EDF 5 02/05/18 (“the EDF fives of eighteen”)
(from http://nitroxconsulting.com/blog/?p=56)

23 FINANCE 361 Class Notes – University of Auckland – Dr Paul Geertsema

 Accrued interest (cont.)

24 FINANCE 361 Class Notes – University of Auckland – Dr Paul Geertsema

9 Yield to maturity (YTM or y)

• The yield to maturity (YTM) of a bond is the internal rate of return

(IRR) of an investment in the bond assuming the bond is held to
maturity (and does not default)
• Putting it differently, the YTM is the discount rate that makes the
bond price equal to the market price
" # " #
– Some y such that M0 = F
+ C
X
(1+y)T t
t∈K (1+y)

• Refer back to the “example bond”.

– If it is priced in the market at $105.8543 (clean), what is the
YTM?
◦ It is 5%
– If it is priced at $102?
◦ The YTM is 7.1023% (See example below)

25 FINANCE 361 Class Notes – University of Auckland – Dr Paul Geertsema

 Yield to maturity (YTM or y) (cont.)

t (in years) Bond price Bond CF Total CF

0.00 -$102.00 -$102.00
0.25 $2.00 $2.00
0.50 $2.00 $2.00
0.75 $2.00 $2.00
1.00 $2.00 $2.00
1.25 $2.00 $2.00
1.50 $2.00 $2.00
1.75 $2.00 $2.00
2.00 $102.00 $102.00

Quarterly IRR 1.7301%

Annual IRR (y) 7.1023%

26 FINANCE 361 Class Notes – University of Auckland – Dr Paul Geertsema

 Yield to maturity (YTM or y) (cont.)

• If you use the IRR function of Excel or your calculator to calculate

YTM, the result will the IRR per coupon period. So you will need
to convert it back to annual form.
– In the example above, the Quarterly IRR is 1.7301%. Then the
Annual IRR = y = ((1+ QuarterlyIRR)^(4)) - 1
• You can test if you got it right by pricing the bond using r = y =
7.1023%. The bond price should then become $102.
• YTM is often used as a short-hand for the price of a bond in the
markets (if you have either the price or the YTM, you can always
calculate the other assuming the bond cash flows are known).
• YTM depends on the pattern of cash flows. Hence, if two bonds
do not share that same pattern of cash flows (coupons, frequency
and maturity), one cannot directly compare YTM’s

27 FINANCE 361 Class Notes – University of Auckland – Dr Paul Geertsema

10 Zero coupon bonds and the zero rate

• A zero coupon bond is a bond that does not pay coupons (or
equivalently, has a coupon rate of c = 0%, hence zero-coupon
bond)
• A zero coupon bond (or zero) has only one cash flow - the return
of the face value of the bond at maturity (t = T )
• This simplicity makes zero’s attractive both in practice and as a
building block in theory
• The price of a zero is simply the present value of its face value
– Introduce notation: the price today (t = 0) of a zero coupon
bond maturing at t = T is Z0,T .
– Z0,T = FT × d0,T where d0,T is the discount factor for cash
flows occuring at time T
• In the US, zero coupon bonds can be “created” through a program
administered by the Treasury that allows coupon bonds to be de-
28 FINANCE 361 Class Notes – University of Auckland – Dr Paul Geertsema
 Zero coupon bonds and the zero rate (cont.)

composed into interest and principal parts (known as STRIPS - see

BKM)
• Even if there are no zero coupon bonds traded, one can still create
a “synthetic” zero by forming a portfolio that is long and short
various bonds such that all cash flows net-off except on one date.
Since the portfolio has only one cash flow, it can be viewed as a
zero coupon bond with a face value equal to that cash flow.
• The YTM of a zero coupon bond is the zero rate. If the bond
is risk free, this is also the risk free rate applying from t = 0 to
t = T . And the price of a zero divided by its face value is the
discount factor for cash flows at t = T . (This is what makes zeros
so attractive as a building block in finance)

29 FINANCE 361 Class Notes – University of Auckland – Dr Paul Geertsema

11 Floating rate notes (FRN’s)

• Not all bonds pay a fixed coupon. Some bonds pay a coupon linked
to some index, often LIBOR.
– As an aside, there was a bit of a scandal around the manipulation
of LIBOR some years ago - google “LIBOR scandal”
• For instance, a bond with quarterly coupons may state that the
coupon payment will be calculated as
– Face value x (3-month LIBOR + margin)
– $100 x (0.75% + 0.30%) = $1.05
– Assumes the 3-month LIBOR fix on the fixing date was 0.75%
• A fixed coupon bond may be described as “TNZ 5% 15/3/2018”,
a floating rate note would be “TNZ 3mLibor + 0.65% 15/3/2018”
• Pricing FRN’s are outside the scope of this paper.

30 FINANCE 361 Class Notes – University of Auckland – Dr Paul Geertsema

12 Credit risky bonds

• So far we have assumed that bond cash flows are certain, safe and
risk free. Hence discount rates are the same as risk free rates.
• But even bonds that never default are only risk free from a credit
perspective
– Changes in interest rates will move the price of the bond, so
there is still interest rate risk
– Example: a safe 10 year government bond is only safe if held
for 10 years (then the cash flows and returns are certain)
– If a safe 10 year government bond is held for only 1 year, un-
predictable changes in future interest rates makes the price at
which the bond will sell after one year uncertain, hence the re-
turn is uncertain and it is no longer a risk free investment over
a 1 year horizon.
• Credit risk is the risk of a bond not paying what it should (interest
and/or principal); this is different from interest rate risk
31 FINANCE 361 Class Notes – University of Auckland – Dr Paul Geertsema
 Credit risky bonds (cont.)

• So most bonds have some element of credit risk

– Corporate bonds
– Infrastructure bonds
– Asset backed securities
– Mortgage backed securities
– Catastrophe bonds
– etc.
• The approach remains consistent - discount the cash flows at the
appropriate risk-adjusted rate
– It is common in markets to assume the cash flows will be paid
in full, and make any adjustments for risk via the discount rate
– Hence bonds with credit risk should be valued using a higher
discount rate
– Equivalently, bonds with higher credit risk should trade at higher
YTM
32 FINANCE 361 Class Notes – University of Auckland – Dr Paul Geertsema
 Credit risky bonds (cont.)

• Measures of credit risk

– The amount of credit risk in a coupon bond is often estimated
by comparing that bond’s YTM to the YTM of a comparable
(safe) government bond of similar maturity
– This is known as the “spread”
◦ It is an inexact measure to the extent that the cash flows of
the bond in question is not identical to that of the comparable
government bond
– Another metric is the “z-spread” - the amount (in basis points)
that should be added to risk free discount rates for each period
so that the price of the bond equals its market price
– See if you can find these on the Bloomberg screen-shot

33 FINANCE 361 Class Notes – University of Auckland – Dr Paul Geertsema

13 Daycount conventions

• Finally, bonds use different so-called daycount conventions. These

conventions describe how one should calculate the number of days
in a coupon period for the purpose of calculating coupon payments.
• This won’t be tested - I’m just mentioning this so you don’t get
tripped up if you ever have to work with bonds outside of academia.
• A daycount convention specifies assumptions regarding the number
of days in a month and the number of days in a year. By convention
it is written as “<MonthDays>/<YearDays>
• So “30/360” means assuming 30 days in a month and 360 days in
a year.
• The abbreviation “ACT” is used for actual, that is the real number
of days between dates as per the calendar
• Here are a few common permutations
– ACT/ACT
34 FINANCE 361 Class Notes – University of Auckland – Dr Paul Geertsema
 Daycount conventions (cont.)

– ACT/365
– ACT/360
– 30/360
• It is all explained in detail in http://en.wikipedia.org/wiki/Day_count_convention

35 FINANCE 361 Class Notes – University of Auckland – Dr Paul Geertsema