Ch 6 Bonds

07/03/2023
Basics of Bond Valuation| Chapters 6 Prof. Nisan Langberg
Basics of Bod Valuation

Chapters 6
Introduction and Yield to Maturity (YTM)
Terminology
Government Bonds The Treasury Yield Curve
Corporate bonds
Wrapping up
Introduction
Agenda for this Unit
Debt Market in a Glance
Bond Payments Terminology
Check yourself
Bond Price Terminology
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The Debt Market in a glance
US Bond Market
Debt holders
Households
Mortgages, Home‐Equity loans, Car loans, Student loans
States and Local Municipalities

Infrastructure, fund projects with public benefit
Government
Government operations and Infrastructure
Corporations
Capital Expenditures, Investments
The Debt Market in a glance

Classic types of debt securities
Public debt
Traded on exchanges and include government and corporate bonds
Private debt
Bank loans and loans provided by private debt funds
“Risk free” Payments

Government debt, debt issued by government sponsored
agencies (Fannie Mae and Freddie Mac)
Risky Payments
Corporate debt, Mortgage Backed Securities,
Asset Backed Securities
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Contract Payment Schedule
Face value
Principal amount paid at maturity date and used to
calculate the coupon payments
Coupons
Periodical payments made out to bond holders (e.g., quarterly,
semi‐annually or annually)
Coupon rate
The annual amount of dividends is given by the coupon rate times the
face value. This amount is then dividend by the number of coupon
payments per year to obtain each coupon payment amount. 5
Spelling out the Payments
Face value: $10,000 paid on May 15, 1985
Coupons: Semi-annual
(every six months)
Coupon rate: 4.25% of $10,000 or $425 per-annum
Coupon payment: Each coupon payment = $212.5
=(Coupon Rate)x(Face Value)/(# payments per annum)
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Check yourself
Face value: $1,000 paid at maturity
Coupon rate: 5% semi-annual
Coupon payment: $25 every six months
Bond Price Terminology
Relating Price to Face Value
A bond is issued at a Premium 𝑷𝟎 𝑭 Are investors better off investing

Annual coupon rate is higher than
in bonds issued at a discount?
the ytm of the bond
A bond is issued at a Discount 𝑷𝟎 𝑭

Annual coupon rate is lower than
the ytm of the bond
A bond is issued at Par 𝑷𝟎 𝑭

Annual coupon rate equals
the ytm of the bond 8
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Yield to Maturity (YTM)
Definition of YTM
Bond Prices and Yield to Maturity (YTM)
Calculating YTM
Yield to Maturity (YTM)
The Yield to Maturity of a bond or YTM is the discount rate
that sets the present value of the promised bond payments
equal to the current market price of the bond.
𝑷𝟎 𝑃𝑉 𝐶𝑜𝑛𝑡𝑟𝑎𝑐𝑡 𝐶𝑜𝑢𝑝𝑜𝑛𝑠 𝑎𝑛𝑑 𝑃𝑟𝑖𝑛𝑐𝑖𝑝𝑎𝑙 𝑃𝑎𝑦𝑚𝑒𝑛𝑡𝑠, 𝒚𝒕𝒎
Different way to look at it: The bond YTM is basically the potential IRR
of the investment in the bond if all bond payments are received
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Bond Prices and Yields

The value of a bond depends on
Specified payments
Interest rates in the economy
Risk of default
The Yield to Maturity (YTM) is implied by the Price
Market information on bonds is often quoted in terms of

the implied YTM and not the actual prices.
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Calculating YTM
Problem: Consider a ten‐year $1000 bond with a 5% coupon rate and annual coupons. If the bond
is currently trading for a price of $962.31, what is the bond’s yield to maturity?
$50 $1,000
$𝟗𝟔𝟐. 𝟑𝟏
1 𝒚𝒕𝒎 1 𝒚𝒕𝒎
How can we solve this equation?

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𝑃𝑉 𝐶𝑜𝑛𝑡𝑟𝑎𝑐𝑡 𝐶𝑜𝑢𝑝𝑜𝑛𝑠 𝑎𝑛𝑑 𝑃𝑟𝑖𝑛𝑐𝑖𝑝𝑎𝑙 𝑃𝑎𝑦𝑚𝑒𝑛𝑡𝑠, 𝒛

Calculating YTM
$50 1 $1,000
Look for the solution f 𝑧 ∗ 962.31: f 𝒛 1
𝒛 1 𝒛 1 𝒛
f 𝑧∗ 962.31 → 𝑧 ∗ 5.5%
𝒚𝒕𝒎=5.5%
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Government Issued Bonds
Types of government bonds
YTM of government bonds
The treasury yield curve
Deriving the treasury yield curve
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Types of Government Bonds
Long term coupon paying bonds What is an important difference

between government issued
Government bonds mature anywhere between 10 to 20 bonds and corporate bonds from
years the perspective of inventors?
Mid term coupon paying bonds
Treasury notes mature anywhere between 2 to 10 years

and offer semiannual coupons
Short term “zero coupon” bonds

Treasury bills mature anywhere between four weeks to one
year and often do not pay coupons
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YTM of Government Bonds
The price of a government issued bond depends on
Specified contract payments

𝑷𝟎 𝑃𝑉 𝑠𝑝𝑒𝑐𝑖𝑓𝑖𝑒𝑑 𝑏𝑜𝑛𝑑 𝑝𝑎𝑦𝑚𝑒𝑛𝑡𝑠, 𝒚𝒕𝒎
Interest rates in the economy
Risk of default
How do short-term and long-

The Treasury Yield Curve or Term Structure of
Interest Rates term yields relate?
The U.S. Treasury yield curve is the benchmark for the credit
market because it reports the yields of risk‐free fixed income
investments across a range of maturities.
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Lookup Dynamic Yield Curve

The Treasury Yield Curve https://stockcharts.com/freecharts/yieldcurve.php
Four classic shapes
Upward slopping
Long term yields are higher than short term yields
Downward slopping (inverted)

Long term yields are lower than short term yields
Flat
Little variation between short‐term and long‐ What’s the current shape
term yields of the Yield Curve?
Humped
Highest rates are in the mid‐term
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Deriving the Treasury Yield Curve from

Prices of Zero Coupon Bonds
The Yield to Maturity of a government issued zero coupon bond with price 𝑷𝟎 and s
years to maturity is denoted by 𝒚𝒕𝒎𝒔 Can two “zero coupon” Gov bonds with same
maturity trade with different ytm’s?
𝟏
𝐹𝑎𝑐𝑒 𝑉𝑎𝑙𝑢𝑒 𝐹𝑎𝑐𝑒 𝑉𝑎𝑙𝑢𝑒 𝒔
𝑷𝟎 ⟹ 𝒚𝒕𝒎𝒔 1
1 𝒚𝒕𝒎𝒔 𝑷𝟎
The No‐Arbitrage Principle implies that 𝒚𝒕𝒎𝒔 is the appropriate risk free rate to
discount all risk free cash flows received in s years from any traded security
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Practice (Bond price from Yield Curve)
Problem: Consider a four‐year $10,000 treasury note with a 7% coupon rate and annual coupons.
What is the price of this bond if 𝑦𝑡𝑚 2%, 𝑦𝑡𝑚 3%, 𝑦𝑡𝑚 5%, 𝑦𝑡𝑚 5.5%?
$ $ $ $ ,
𝑷𝟎
𝒚𝒕𝒎𝟏 𝒚𝒕𝒎𝟐 𝒚𝒕𝒎𝟑 𝒚𝒕𝒎𝟒
$686 $660 $605 $8,637 $10,588
Does it surprise you that this bond is trading

at a premium?
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Practice (Yield Curve from Bond Prices)
Problem: Consider the following government issued bonds and calculate 𝑦𝑡𝑚 , 𝑦𝑡𝑚 , 𝑦𝑡𝑚 , 𝑦𝑡𝑚 .
$10,000 $10,000
𝑃 $9,852.2 ⟹ 𝒚𝒕𝒎𝟏 1 1.5%
1 𝒚𝒕𝒎𝟏 $9,852.2
$10,000 $10,000
𝑃 $9,518.1 ⟹ 𝒚𝒕𝒎𝟐 1 2.5%
1 𝒚𝒕𝒎𝟐 $9,518.1
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Practice (continued)
Problem: Consider the following government issued bonds and calculate 𝑦𝑡𝑚 , 𝑦𝑡𝑚 , 𝑦𝑡𝑚 , 𝑦𝑡𝑚 .
$100,000 $100,000
𝑃 $92,183.8 ⟹ 𝒚𝒕𝒎𝟑 1 2.75%
1 𝒚𝒕𝒎𝟑 $92,183.8
$100,000 $100,000
𝑃 $88,848.7 ⟹ 𝒚𝒕𝒎𝟒 1 3.0%
1 𝒚𝒕𝒎𝟒 $88,848.7
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Corporate Bonds
YTM of Corporate Bonds
The expected return on debt
A glance into credit risk
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YTM of Corporate Bonds

Yields on Five‐Year bonds
Why are corporate yields higher

than the treasury yield?
Should the investor in Smithfield

Foods bond expect 5% return?
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Introducing the Expected Return on Debt

Corporate Bond Price:
𝑃𝑉 𝑷𝒓𝒐𝒎𝒊𝒔𝒆𝒅 𝐵𝑜𝑛𝑑 𝑃𝑎𝑦𝑚𝑒𝑛𝑡𝑠, 𝒚𝒕𝒎 𝑬𝒙𝒑𝒆𝒄𝒕𝒆𝒅 𝑷𝒓𝒐𝒎𝒊𝒔𝒆𝒅

Expected return on debt
𝒓𝑫 𝒚𝒕𝒎
𝑃
𝑃𝑉 𝑬𝒙𝒑𝒆𝒄𝒕𝒆𝒅 𝐵𝑜𝑛𝑑 𝑃𝑎𝑦𝑚𝑒𝑛𝑡𝑠, 𝒓𝑫
What can we say about the relation

between ytm and rD?
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A Glance into Credit Risk

Credit Rating Agency (CRA) How do credit ratings relate to bond yields?
CRAs evaluate the likelihood of

default and provide bond ratings
Credit Rating Agency (CRA)

Ratings divide bonds into risk categories later
used by investors, banks and regulators in
their risk management.
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Wrapping Up: Basics of Bond

Valuation
Chapter 6
Bond Terminology Yield to Maturity
Treasury Yield Curve Deriving bond prices from the
yield curve
Deriving the yield curve Debt cost of capital verses YTM
from bond prices
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Ch 6 Bonds

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07/03/2023

Basics of Bond Valuation| Chapters 6 Prof. Nisan Langberg

Basics of Bod Valuation

Introduction and Yield to Maturity (YTM)

Government Bonds The Treasury Yield Curve

Basics of Bond Valuation| Chapters 6 Prof. Nisan Langberg

Agenda for this Unit

Debt Market in a Glance

Bond Payments Terminology

Bond Price Terminology

Basics of Bond Valuation| Chapters 6 Prof. Nisan Langberg

The Debt Market in a glance

States and Local Municipalities

Basics of Bond Valuation| Chapters 6 Prof. Nisan Langberg

The Debt Market in a glance

“Risk free” Payments

Basics of Bond Valuation| Chapters 6 Prof. Nisan Langberg

Bond Payments Terminology

Contract Payment Schedule

face value. This amount is then dividend by the number of coupon

payments per year to obtain each coupon payment amount. 5

Basics of Bond Valuation| Chapters 6 Prof. Nisan Langberg

Bond Payments Terminology

Spelling out the Payments

Face value: $10,000 paid on May 15, 1985

Coupon rate: 4.25% of $10,000 or $425 per-annum

Coupon payment: Each coupon payment = $212.5

=(Coupon Rate)x(Face Value)/(# payments per annum)

Basics of Bond Valuation| Chapters 6 Prof. Nisan Langberg

Face value: $1,000 paid at maturity

Coupon rate: 5% semi-annual

Coupon payment: $25 every six months

Basics of Bond Valuation| Chapters 6 Prof. Nisan Langberg

Bond Price Terminology

Relating Price to Face Value

A bond is issued at a Premium 𝑷𝟎 𝑭 Are investors better off investing

A bond is issued at a Discount 𝑷𝟎 𝑭

A bond is issued at Par 𝑷𝟎 𝑭

Basics of Bond Valuation| Chapters 6 Prof. Nisan Langberg

Yield to Maturity (YTM)

Agenda for this Unit

Bond Prices and Yield to Maturity (YTM)

Basics of Bond Valuation| Chapters 6 Prof. Nisan Langberg

Yield to Maturity (YTM)

The Yield to Maturity of a bond or YTM is the discount rate

that sets the present value of the promised bond payments

equal to the current market price of the bond.

𝑷𝟎 𝑃𝑉 𝐶𝑜𝑛𝑡𝑟𝑎𝑐𝑡 𝐶𝑜𝑢𝑝𝑜𝑛𝑠 𝑎𝑛𝑑 𝑃𝑟𝑖𝑛𝑐𝑖𝑝𝑎𝑙 𝑃𝑎𝑦𝑚𝑒𝑛𝑡𝑠, 𝒚𝒕𝒎

of the investment in the bond if all bond payments are received

Basics of Bond Valuation| Chapters 6 Prof. Nisan Langberg

Bond Prices and Yields

The Yield to Maturity (YTM) is implied by the Price

Market information on bonds is often quoted in terms of

Basics of Bond Valuation| Chapters 6 Prof. Nisan Langberg

𝑷𝟎 𝑃𝑉 𝐶𝑜𝑛𝑡𝑟𝑎𝑐𝑡 𝐶𝑜𝑢𝑝𝑜𝑛𝑠 𝑎𝑛𝑑 𝑃𝑟𝑖𝑛𝑐𝑖𝑝𝑎𝑙 𝑃𝑎𝑦𝑚𝑒𝑛𝑡𝑠, 𝒚𝒕𝒎

How can we solve this equation?

Basics of Bond Valuation| Chapters 6 Prof. Nisan Langberg

𝑃𝑉 𝐶𝑜𝑛𝑡𝑟𝑎𝑐𝑡 𝐶𝑜𝑢𝑝𝑜𝑛𝑠 𝑎𝑛𝑑 𝑃𝑟𝑖𝑛𝑐𝑖𝑝𝑎𝑙 𝑃𝑎𝑦𝑚𝑒𝑛𝑡𝑠, 𝒛

Basics of Bond Valuation| Chapters 6 Prof. Nisan Langberg

Government Issued Bonds

Agenda for this Unit

Types of government bonds

YTM of government bonds

The treasury yield curve