Valuing Bonds

Chapter 6 & Section 5.3

Introductory Example
• In 08/2005, the US government started issuing 30-year Treasury bonds again after
4 years.

• The move was due in part to the government’s need to borrow to fund record
budget deficits; the decision to issue 30-year bonds was also a response to investor
demand for long-term, risk-free securities backed by the U.S. government.

• In 09/2017, the value of traded U.S. Treasury debt was approximately $14.2 T.

• This is $5.4 T more than the value of all publicly traded U.S. corporate bonds.

• If we include bonds issued by municipalities, government agencies, and other

issuers, investors had over $40 T invested in U.S. bond markets, compared with just
over $27 T in U.S. equity markets.

à Which role do bonds play for the cost of capital?

à What can we learn from the pricing of bonds regarding how securities are priced in
a competitive market?
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Learning objectives

• Understand the basic types of bonds and their

structure

• Zero-coupon vs. Coupon-paying bonds

• Risk-free vs. risky bonds

• The zero-coupon bond yield curve, its shape, and

bond arbitrage

• Safe and risky bonds, credit ratings, and

corporate yield curves
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No-arbitrage and the Law of
One Price in security pricing
• How do (financial) markets help us to set prices and returns?

• Arbitrage

• The practice of buying and selling equivalent [including financial]

assets to take advantage of a price difference

• An arbitrage opportunity occurs when it is possible to make a profit

without taking any risk or making any investment

• At equilibrium, there cannot be arbitrage opportunities on the

financial market(s) – “like money on the street”

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No-arbitrage and the Law of
One Price
• Law of One Price

• If equivalent investment opportunities trade

simultaneously, then they must trade for the same
price

• Otherwise, an arbitrage opportunity arises and

exploiting it causes a change in one of the
prices until such an opportunity vanishes

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An example of intertemporal
arbitrage
• Consider a financial security that pays you $1000 in one year, for sure. The risk-
free interest rate is 5%:

• Assume the price of the security, i.e., the bond is $940.

• What is the present value of the future payment, today?

• PV= 1000/(1 + 5%) = $952.38

• The opportunity for arbitrage will force the price of the security to rise until it equals
$952.38.

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An example of intertemporal
arbitrage
• Assume now that its price is $960

• The opportunity for arbitrage will force the price of

the bond to fall until it is equal to $952.38

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No-arbitrage and security
prices
• Unless the price of the security equals the present
value of the security’s cash flows, an arbitrage
opportunity will appear.

• A necessary condition: Law of One Price

• No Arbitrage Price of a Security:

Price(Security) = PV (All cash flows paid by the security)

• Alternatively: NPV(trading security) = 0

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Bonds
• Bonds (or obligations) are contracts that are concluded between
borrowers and lenders

• Specify the amount borrowed

• Specify the interest (coupons) or the absence thereof (zero

coupons)

• Specify the maturity (=repayment date)

• Examples: zero-coupon bonds, coupon paying bonds,

government (risk-free) bonds, corporate (risky) bonds, etc.

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Bond valuation: zero-coupon
bonds
• Zero-Coupon Bond

• Does not make coupon payments

• Always sells at a discount (a price lower than its

face value), so they are also called pure discount
bonds (à you buy at the PV of the face value)

• Treasury Bills are U.S. government zero-coupon

bonds with a maturity of up to one year

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Zero-coupon bonds

• Suppose that a one-year, risk-free, zero-coupon bond with

a $100,000 face value has an initial price of $96,618.36.
The cash flows would be:

• Although the bond pays no “interest”, your compensation is

the difference between the initial price and the face value
à recognizes time value of money

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Zero-coupon bonds

• Yield to Maturity

• The discount rate that sets the present value of the

promised bond payment(s) equal to the current
market price of the bond (= IRR of bond investment).

• Price of a Zero-Coupon bond

FV
P =
(1 + YTM n ) n

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Yield to Maturity

• Yield to Maturity

• For the one-year zero coupon bond:

100,000
96,618.36 =
(1 + YTM 1 )

100,000
1 + YTM 1 = = 1.035
96,618.36

• Thus, the YTM is 3.5%

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Yield to Maturity

• Yield to Maturity of an n-Year Zero-Coupon

Bond

1
æ FV ö n
YTM n = ç ÷ - 1
è P ø

04/03/2024 Corporate Finance 14

Exercise 1 æ FV ö
1
n
YTM n = ç ÷ - 1
è P ø
• Suppose that the following zero-coupon bonds are selling at the prices shown
below per $100 face value. Determine the corresponding yield to maturity for
each bond

Maturity 1 year 2 years 3 years 4 years

Price $98.04 $95.18 $91.51 $87.14

A. 2%, 2.5%, 3.25%, 4%

B. 2%, 2.5%, 3.5%, 4%

C. 2%, 2.5%, 3%, 4%

D. 2%, 2.5%, 3%, 3.5%

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Exercise 2
• Suppose the current zero-coupon yield curve for risk-free bonds
is as follows:

Maturity (years) 1 2 3 4 5
YTM 3.25% 3.50% 3.90% 4.25% 4.40%

• The price per $100 face value of a three-year, zero-coupon, risk-free

bond is closest to:

A) $93.80 C) $89.16

B) $90.06 D) $86.39
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The Yield Curve and Discount
Rates
• Term Structure: The relationship between the
investment term (time horizon) and the interest rate

• Yield Curve: A graph of the term structure

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A More Recent Yield Curve…
US Treasury Yield Curve as of 2018−09−10
Source: Capital IQ

3.09
●

3.02
●

2.94
●

2.89●

2.83
●

2.8
2.78
●

2.73
●
Yield, %

2.54
●

2.4

2.32
●

2.14
●

2.0
1.98
●

1M 3M 6M 1Y 2Y 3Y 5Y 7Y 10Y 20Y 30Y

Maturity in months or years

04/03/2024 Corporate Finance 22

A More Recent Yield Curve…
US Treasury Yield Curve as of 2019−08−26
Source: Capital IQ

2.09
●

2.04
●
2.03
●

2.0
2.01
●

1.9
●

1.84
●

1.8
Yield, %

1.75
●

1.6

1.54
● 1.54
●

1.49
●

1.47
●

1.43
●

1.4
1M 2M 3M 6M 1Y 2Y 3Y 5Y 7Y 10Y 20Y 30Y
Maturity in months or years

04/03/2024 Corporate Finance 23

 A More Recent Yield Curve…
US Treasury Yield Curve as of 2020−11−10
Source: Capital IQ
• Higher interest rates tend to
1.75
reduce the NPV of typical
investment projects.
1.5
1.53 • Changing interest rates =
instrument by central banks to
stimulate / moderate investments.
• Interest rates differ with the
1.0 investment horizon. A graph
Yield, %

0.98

plotting interest rates as a

function of the horizon is called
0.72
yield curve.
0.5
0.46
• The shape of the yield curve
tends to vary with investors’
0.26 expectations of future economic
0.19

0.09 0.09 0.1 0.11 0.12 growth & interest rates: inverted
1M 2M 3M 6M 1Y 2Y 3Y 5Y 7Y 10Y 20Y 30Y
prior to recessions and steep
Maturity in months or years
coming out of a recession.
04/03/2024 Corporate Finance 24
Coupon bonds

• Pay face value at maturity

• Pay regular coupon interest payments

• Risk-free: US Treasury ($-denominated),

German Bund (EUR-denominated)

• Risky: other sovereign bonds, corporate

bonds

04/03/2024 Corporate Finance 25

Coupon bonds: an example

• The U.S. Treasury has just issued a ten-year,

$1000 bond with a 4% coupon and semi-
annual coupon payments. What cash flows
will you receive if you hold the bond until
maturity?

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Coupon bonds: an example
• The face value of this bond is $1000

• Because this bond pays coupons semiannually, you will receive a

coupon payment every six months of $1000 X 4%/2 = $20

• The last payment occurs ten years (twenty periods) from now and
is composed of both a coupon payment of $20 and the face value
payment of $1000

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Coupon bonds: the price?

• How do we find the price of a coupon paying bond if

we have the YTM paid by the bond?

• The YTM is the SINGLE discount rate that equates the

present value of the bond’s remaining cash flows to its
current price

1 æ 1 ö FV
P = CPN ´ ç 1 - ÷ +
y è (1 + y ) N ø (1 + y ) N

04/03/2024 Corporate Finance 28

Coupon bonds: the price?

• How do we find the price of a coupon paying

bond if we DO NOT have the YTM paid by the
bond?

• Hint: the law of one price!

à i.e., we can replicate a coupon paying bond by
using several zero-coupon bonds.

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Replicating a coupon bond

• Replicating a three-year $1000 bond that pays 10%

annual coupon using three zero-coupon bonds:

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Replicating a coupon bond

• Yields and Prices (per $100 Face Value) for

Zero Coupon Bonds

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Replicating a coupon bond

• By the Law of One Price, the three-year

coupon bond must trade for a price of $1153

04/03/2024 Corporate Finance 32

Interest rate changes and
bond prices
• Remember:

• The YTM is the rate you effectively earn when you

invest in a bond

• The coupon rate is the rate, i.e., basically an

“annuity”, the bond regularly pays on its face value

04/03/2024 Corporate Finance 33

Exercise 3

The Danome Company has a bond outstanding with a

face value of $1,000 that reaches maturity in 15 years.
The bond certificate indicates that the stated coupon
rate for this bond is 8% and that the coupon payments
are to be made semiannually.

A) How much will semi-annual coupon payments be?

B) What price will the bond trade for if YTM is 7.5%?

04/03/2024 Corporate Finance 34

Solution

!"#$"% &'() × +'!) ,'-#)

A) Coupon = %#./)& "+ !"#$"%0 $)& 1)'&

= (0.08 × 1,000) / 2 = $40

234 5 67
B) Price = × 1− +
1 1! 581 !
$:; 5 5;;;
= ;.;=>/@ × 1 − 5.;A=>"# + 5.;A=> "#

= $1044.57
04/03/2024 Corporate Finance 35
Exercise 4

Maturity 1 2 3 4 5
Zero-Coupon YTM 3.25% 3.50% 3.90% 4.25% 4.40%

A two-year default free security with a face value of

$1,000 and an annual coupon rate of 5% would be
traded at which price:

A) $1002.78 B) $1003.31

C) $1028.50 D) $1028.61
04/03/2024 Corporate Finance 36
Exercise 5

Suppose a five-year $1000 face value bond with

a 7% coupon rate and semiannual
compounding is trading for a price of $951.58.
Expressed as an APR with semiannual
compounding, this bond’s YTM is closest to:

A) 7.0% C) 7.8%

B) 8.2% D) 7.5%

04/03/2024 Corporate Finance 39

Corporate bonds and the risk
of default
• Bonds issued by a corporation à corporations have a
risk of default à credit risk

• Investors pay less for bonds with credit risk than they
would for an otherwise identical default-free bond

• The yield of bonds with credit risk will be higher than

that of otherwise identical default-free bonds

04/03/2024 Corporate Finance 45

Corporate bond yields

• No Default (prob. of default = 0%)

• Consider a 1-year, zero coupon US Treasury Bill

(considered safe) with a YTM of 4% and a face
value of $1000.

• What is the price?

1000 1000
P = = = $961.54
1 + YTM 1 1.04
• Since the $1000 are certain, 4% is also the risk free rate

04/03/2024 Corporate Finance 46

Corporate bonds yields
• Certain default: 100% chance the bond will default and return
$900 (prob. of default = 100%)

• The $100 lost is called the loss given default (equivalent to 90%
recovery rate)

• Although the bond defaults, the default is certain, hence $900 are
certain money

• P = 900 / 1.04 = $865.38

• YTM = 1000 / 865.38 - 1 = 0.1556 = 15.56% (> 4% exp. return of bond)

04/03/2024 Corporate Finance 47

Corporate bond yields

• Risk of Default (prob. of default > 0% & < 100% )

• Consider a one-year, $1000, zero-coupon bond. Assume that

the bond payoffs are uncertain

• There is a 50% chance that the bond will repay its face value in
full and a 50% chance that the bond will default and you will
receive $900. Thus, the expected future value of the bond is
$950

• Because of the uncertainty, let’s suppose the discount rate is

5.1%

04/03/2024 Corporate Finance 48

Corporate bond yields

• Risk of Default

• The price of the bond (i.e., the PV of the bond’s

CFs) will be 950
P = = $903.90
1.051

• The yield to maturity will be

FV 1000
YTM = - 1 = - 1 = .1063
P 903.90

04/03/2024 Corporate Finance 49

Corporate bond yields

• The 10.63% promised yield is the most investors will

receive

• If the bond defaults investors receive: 900/903.90 – 1

= -0.43%

• If the bond does not default investors receive:

1000/903.90 – 1 = 10.63%

• The average return:

• 10.63% * 0.5 + (-0.43%) * 0.5 = 5.1%!

04/03/2024 Corporate Finance 50
Corporate bond yields

• Risk of Default

• A bond’s coupon rate will be less than the yield to maturity if

there is a risk of default.

• Why?

• The bond investors (=buyers) require a higher YTM to buy

and hold the bond

• This higher YTM corresponds to the return they ask to hold a

financial asset with the same risk as the bond

04/03/2024 Corporate Finance 51

Exercise 6
• IE-Ways is a newly-founded company that specializes on the
simulation of race car-driving, issues a one-year zero coupon
bond with a face value of $1,000. Investors estimate the chance
that the company will survive the first year at 60%. In case of
default, the investors expect only $500

• What do you expect to receive after 1 year?

• Given a discount rate of 8%, what is the price of the bond?

• What is the yield to maturity?

04/03/2024 Corporate Finance 52

Solution

• Expected payoff at year end:

0.6 x $1,000 + 0.4 x $500 = $800

• The price of the bond will be:

800
P = = $740.74
1.08
• The YTM is:
FV 1000
YTM = − 1 = − 1 = .3500
P 740.74
04/03/2024 Corporate Finance 53
Exercise 7
• Wyatt Oil is contemplating issuing a 20-year bond with semiannual coupons, a
coupon rate of 7%, and a face value of $1000. Wyatt Oil believes it can get a BBB
rating from Standard and Poor's for this bond issue (see the Table)
Security Term (years) Yield (%)
Treasury 20 5.5%
AAA Corporate 20 7.0%
BBB Corporate 20 8.0%
B Corporate 20 9.6%

• If Wyatt Oil is successful in getting a BBB rating, then the issue price for these
bonds would be closest to:

A) $800 B) $891

C) $901 D) $1,000

04/03/2024 Corporate Finance 54

Discussion
• The easiest way to price a bond is to discount the promised cash flows
by the YTM for this (particular) bond

• So far, we performed this by defining the price first via

• the opportunity cost

• the default probability and

• the recovery rate

• But in reality, neither of these is easy to obtain, hence specialized

institutions (rating agencies) do it for classes of default risk

04/03/2024 Corporate Finance 57

Bond ratings

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Bond ratings

04/03/2024 Corporate Finance 59

Yield curves

• There are corporate yield curves (risky) and

sovereign (for bonds issued by governments,
can be risky or safe) yield curves

• Credit Spread (or Default Spread):

• The difference between the yield on the bond and

the US Treasury yield

04/03/2024 Corporate Finance 60

Corporate yield curves for
various ratings, February 2009

04/03/2024 Corporate Finance 61

Corporate yield curves as of
rd
Sept. 3 , 2018

Source: Capital IQ

04/03/2024 Corporate Finance 62

Corporate bonds yield
spreads

04/03/2024 Corporate Finance 63

Takeaways

• Efficient capital markets imply that the Law of One Price

holds

• This allows for the valuation and pricing of any kind of

financial securities, bonds included

• The simplest types of bonds are special kind of securities

that can come with or without (i) coupons, and (ii) risk

• We can price these bonds with the zero-coupon bond yield

curve

04/03/2024 Corporate Finance 65