Chapter 6.

Bonds, bond prices

and interest rates
• Bond prices and yields
• Bond market equilibrium
• Bond risks
Bonds: 4 types
• zero coupon bonds
 e.g. Tbills
• fixed payment loans
 e.g. mortgages, car loans
• coupon bonds
 e.g. Tnotes, Tbonds
• consols
Zero coupon bonds

• discount bonds
 purchased price less than face
value
-- F > P
 face value at maturity
 no interest payments
example

• 91 day Tbill,
• P = $9850, F = $10,000
• YTM solves

$10,000
$9850  91
(1  i ) 365
 $10,000
$9850  91
(1  i ) 365

10000
1  i 
91
365 
9850
365
 10000  91
1 i   
 9850 

365
 10000  91
i   1  6.25%
 9850 
yield on a discount basis (127)

• how Tbill yields are actually quoted

• approximates the YTM

F-P 360
idb = x
F d
example

• 91 day Tbill,
• P = $9850, F = $10,000
• discount yield =

 $150   360 
    5.93%
 $10,000   91 
• idb < YTM
• why?
 F in denominator
 360 day year
• fixed-payment loan
 loan is repaid with equal (monthly)
payments
 each payment is combination of
principal and interest
example 2: fixed pmt. loan

• $20,000 car loan, 5 years

• monthly pmt. = $500
• so $15,000 is price today
• cash flow is 60 pmts. of $500
• what is i?
• i is annual rate
 (effective annual interest rate)
• but payments are monthly, &
compound monthly
• (1+im)12 = i
• im= i1/12-1
• im is the periodic rate
• note: APR = im x 12
 500 500 500
20000    ... 
1  im  1  im  2
1  im  60

im=1.44%

i=(1+. 0144)12 – 1 =18.71%

APR  .0144 12  17.28%

• how to solve for i?
 trial-and-error
 table
 financial calculator
 spreadsheet
Coupon bond

• (chapter 4)
Bond Yields

• Yield to maturity (YTM)

 chapter 4
• Current yield
• Holding period return
Yield to Maturity (YTM)

• a measure of interest rate

• interest rate where
P = PV of cash flows
Current yield

• approximation of YTM for coupon

bonds

annual coupon payment

ic =
bond price
• better approximation when
 maturity is longer
 P is close to F
example

• 2 year Tnotes, F = $10,000

• P = $9750, coupon rate = 6%
• current yield

ic = 600
= 6.15%
9750
• current yield = 6.15%
• true YTM = 7.37%
• lousy approximation
 only 2 years to maturity
 selling 2.5% below F
Holding period return

• sell bond before maturity

• return depends on
 holding period
 interest payments
 resale price
example

• 2 year Tnotes, F = $10,000

• P = $9750, coupon rate = 6%
• sell right after 1 year for $9900
 $300 at 6 mos.
 $300 at 1 yr.
 $9900 at 1 yr.
 300 9900  300
9750  
1 i
2 
1  i 
2
2

i/2 = 3.83%
i = 7.66%
• why i/2?
• interest compounds annually not
semiannually
The Bond Market

• Bond supply
• Bond demand
• Bond market equilibrium
Bond supply

• bond issuers/ borrowers

• look at Qs as a function of price,
yield
• lower bond prices
 higher bond yields
 more expensive to borrow
 lower Qs of bonds
• so bond supply slopes up with price
Bond
price

Q of bonds
• Changes in bond price/yield
 Move along the bond supply curve
• What shifts bond supply?
Shifts in bond supply

• Change in government borrowing

 Increase in gov’t borrowing
• Increase in bond supply
• Bond supply shifts right
P
S
S’

Qs
• a change in business conditions
 affects incentives to expand production

exp. supply of
profits bonds
(shift rt.)
 exp. economic expansion shifts bond supply rt.
• a change in expected inflation
 rising inflation decreases real cost of borrowing

exp. supply of
inflation bonds
(shift rt.)
Bond Demand

• bond buyers/ lenders/ savers

• look at Qd as a function of bond
price/yield
 Bond Qd of
yield bonds

price Qd of
of bond bonds

• so bond demand slopes down with

respect to price
Bond
price

Quantity of bonds
• Changes in bond price/yield
 Move along the bond demand
curve
• What shifts bond demand?
• Wealth
 Higher wealth increases asset
demand
• Bond demand increases
• Bond demand shifts right
P

D
D
Qd
• a change in expected inflation
 rising inflation decreases real
return

inflation demand for

expected bonds
to (shift left)
• a change in exp. interest rates
 rising interest rates decrease value
of existing bonds

int. rates demand for

expected bonds
to (shift left)
• a change in the risk of bonds relative
to other assets

relative demand for

risk of bonds
bonds (shift left)
• a change in liquidity of bonds
relative to other assets

relative demand for

liquidity bonds
of bonds (shift rt.)
Bond market equilibrium

• changes when bond demand shifts,

and/or bond supply shifts
• shifts cause bond prices AND
interest rates to change
Example 1: the Fisher effect
• expected inflation 3%
• exp. inflation rises to 4%
 bond demand
-- real return declines
-- Bd decreases
 bond supply
-- real cost of borrowing declines
-- Bs increases
• bond price falls
• interest rate rises
Fisher effect
• expected inflation rises,
nominal interest rates rise
Example 2: economic slowdown
• bond demand
 decline in income, wealth
 Bd decreases
 P falls, i rises
• bond supply
 decline in exp. profits
 Bs decreases
 P rises, i falls
• shift Bs > shift in Bd
• interest rate falls
Why shift Bs > shift Bd?

• changes in wealth are small

• response to change in exp. profits is
large
 large cyclical swings in investment
• interest rate is pro-cyclical
Why are bonds risky?

• 3 sources of risk
 Default
 Inflation
 Interest rate
Default risk

• Risk that the issuer fails to make

promised payments on time
• Zero for U.S. gov’t debt
• Other issuers: corporate, municipal,
foreign have some default risk
• Greater default risk means a greater
yield
Inflation risk

• Most bonds promise fixed dollar

payments
 Inflation erodes the real value of
these payments
• Future inflation is unknown
• Larger for longer term bonds
Interest rate risk

• Changing interest rates change the

value (price) of a bond in the
opposite direction.
• All bonds have interest rate risk
 But it is larger for the long term
bonds