Chapter
Valuing Bonds
5.7 Summary
Investment in a new plant and equipment requires moneyoften a lot of money. Sometimes
firms may be able to save enough out of previous earnings to cover the cost of investments, but
often they need to raise cash from investors. In broad terms, we can think of two ways to raise
new money from investors: borrow the cash or sell additional shares of common stock for
cash.
If companies need the money for only a short while, they may borrow it from a bank; if they
need it to make longterm investments, they generally issue bonds, which are simply longterm
loans. When companies issue bonds, they promise to make a series of fixed interest payments
and then to repay the debt. As long as the company generates sufficient cash, the payments on
a bond are certain. In this case, bond valuation involves straightforward timevalueofmoney
computations. But there is some chance that even the most bluechip company will fall on hard
times and will not be able to repay its debts. Investors take this default risk into account when
they price the bonds and demand a higher interest rate to compensate.
Companies are not the only bond issuers. Provincial and local governments also raise money
by selling bonds. So does the Government of Canada. There is always some risk that a company,
province or municipality will not be able to come up with the cash to repay its bonds. However,
investors in Government of Canada issues can be confident that the federal government will
make the promised payments because they can print money. Therefore, in the first part of this
chapter we focus on Government of Canada bonds and sidestep the issue of default. We show
how bond prices are determined by market interest rates and how those prices respond to
changes in rates. We also consider the yield to maturity and discuss why a bonds yield may vary
with its time to maturity.
Later in the chapter we look at corporate bonds where there is also a possibility of default.
We will see how bond ratings provide a guide to the default risk and how lowgrade bonds offer
higher promised yields.
In Chapter 13 we will look in more detail at the securities that companies issue, and we will
see that there are many variations on bond design. But for now, well keep our focus on garden
variety bonds and general principles of bond valuation.
After studying this chapter you should be able to
Distinguish among the bonds coupon rate, current yield, and yield to maturity.
Find the market price of a bond given its yield to maturity, find a bonds yield given its price,
and demonstrate why prices and yields vary inversely.
Explain what a yield curve is and why expected shortterm interest rates affect its shape.
Show why bonds exhibit interest rate risk and how interest rate risk affects the shape of the
yield curve.
Understand why investors pay attention to bond ratings and demand a higher interest rate for
bonds with low ratings.
1 In
Canada, these coupon payments typically would come in two semiannual instalments of $27.50 each. To keep things
simple for now, we will assume one coupon payment per year.
Figure 5.1
Cash flows to an investor in $1,055
the 5.5% coupon bond,
maturing in the year 2010
$1,000
$55 $55
$55
Price
Figure 5.2
Government of Canada bond Coupon Bid Ask Bid Ask
quotes for June 1, 2007. Issuer Rate Maturity Price Price Yield Yield
CANADA
COUPON 0 12/1/2007 89.97 89.99 4.70 4.69
CANADA
COUPON 0 12/1/2008 93.52 93.54 4.56 4.55
CANADA
COUPON 0 9/15/2009 89.97 89.99 4.70 4.69
CANADA 10 6/1/2008 105.2 105.23 4.59 4.56
CANADA 4.25 12/1/2008 99.48 99.49 4.62 4.61
CANADA 11 6/1/2009 112.03 112.08 4.60 4.58
CANADA 5.5 6/1/2009 101.69 101.7 4.60 4.60
CANADA 4.25 9/1/2009 99.23 99.24 4.61 4.61
CANADA 9.75 3/1/2010 113.09 113.18 4.60 4.57
CANADA 9.5 6/1/2010 113.55 113.58 4.60 4.58
CANADA 5.5 6/1/2010 102.48 102.52 4.60 4.59
CANADA 9 3/1/2011 115.01 115.05 4.58 4.57
CANADA 6 6/1/2011 105.1 105.14 4.58 4.57
CANADA 3.75 6/1/2012 96.38 96.42 4.57 4.56
CANADA 5.25 6/1/2013 103.68 103.73 4.54 4.53
CANADA 11.25 6/1/2015 144.76 144.81 4.51 4.51
CANADA 4 6/1/2016 96.23 96.28 4.51 4.51
CANADA 4 6/1/2017 95.86 95.91 4.52 4.51
CANADA 8 6/1/2023 139.91 140.01 4.48 4.47
CANADA 8 6/1/2027 146.56 146.66 4.46 4.45
CANADA 5.75 6/1/2033 120.95 121.05 4.39 4.38
CANADA 5 6/1/2037 110.77 110.87 4.35 4.35
CANADA
RRB 4.25 12/1/2026 136.09 136.29 2.00 1.99
CANADA
RRB 4 12/1/2031 138.6 138.8 2.00 1.99
dealers earn their living by reselling cars at higher prices than they paid for them, so the bond
dealer needs to charge a spread between the bid and asked prices.
The next two columns, Bid Yield and Ask Yield, stand for bid yield to maturity and ask yield
to maturity. The Ask Yield measures the return that investors will receive if they buy the bond at
the asked price and hold it to maturity in 2010. We will explain shortly how these figures are
calculated.
If you wanted to buy the Canada 5.5s of 2010, you would contact a bond dealer. Dealers hold
inventories of bonds and are typically part of financial institutions such as banks and brokerage
houses. For example, TD Waterhouse offers bonds to retail investors through its online brokerage
service (www.TDWaterhouse.ca). At TD Waterhouses Web site on June 1, 2007, you could sell
the 5.5 percent bond for $1,020.1 (bid price) and buy it for $1,030 (ask price). The spread
between the bid and ask prices is $1,030 2 $1,020.1 $9.9, or about 1 percent of the bonds
value. The spread for a large investor, such as a pension fund, would be much smaller, closer to
the spread reported in the newspaper for that day, $1,025.2 2 $1,024.8 $0.40, or about
.04 percent of the bonds value.
When you buy a bond, you pay more than the quoted price if you happen to buy the bond
accrued interest Coupon between coupon payments. The reason: The buyer compensates the seller for the coupon interest
interestearnedfromthelast earned from the time of the last coupon payment to the purchase (settlement) date. This amount
couponpaymenttothepurchase is called accrued interest and is calculated as
dateofthebond.
number of days from last coupon to purchase date
clean bond price Bondprice Accrued interest 5 coupon payment 3 (5.1)
excludingaccruedinterest.
number of days in coupon period
dirty bond price Bondprice Bond prices are typically quoted without the accrued interest and are known as clean prices.
includingaccruedinterest. When the accrued interest is included, the price is referred to as the dirty price.
Example 5.1
whAt you reAlly PAy when you Buy A Bond
Suppose today is August 14, 2010, and the quoted clean price of a Canada 6 percent bond maturing
June 1, 2012, is 107.7. The bond pays semiannual interest. The last $30 coupon was paid on
June 1, 2010, and the next coupon will be paid on December 1, 2010. The number of days from
the last coupon payment to the purchase date is 74 (29 days from June 1 to June 30, 31 days in July,
and 14 days in August) and the total number of days in the coupon period is 183 (from June 1 to
December 1). The accrued interest is $30 74/183 $12.13, making the total cost of buying one
bond $1,077 1 $12.13, or $1,089.13.
Traditionally, bonds have been traded in an overthecounter market, where securities are
not traded in one central place but traded over the telephone. However, the development of
electronic markets for bond trading, such as CBID (found at www.pfin.ca) and CanDeal
(www.CanDeal.ca), are changing the operation of the Canadian bond market. Both CBID and
CanDeal allow institutional investors, who trade large dollar values of bonds, to see bond quotes
from multiple bond dealers at the same time, rather than having to telephone each dealer for a
quote. They can then execute a buy or sell order at the best price. CBID also has an electronic
retail bond market, providing trading of smaller dollar amounts of bonds by retail investment
advisors. The electronic bond trading platforms increase the competitiveness of the bond market,
reducing the spread between the bid and the ask prices.
Check Point 5.1 Find the 11.25 percent June 1, 2015, Canada bond in Figure 5.2.
a. If you already own this bond, at what price can you sell it?
b. If you want to buy the bond, what price will you pay?
c. Why is the selling price different than the purchase price?
d. What annual interest payment does the bond make?
e. What is the bonds ask yield to maturity?
5 $55 3 .046
1
2
1
.046(1.046)
3
1, 000 3
1
1.046 3
Check Point 5.2 Calculate the present value of a 6year bond with a 9 percent coupon. The interest rate
is 12 percent.
Example 5.2
Bond Prices and Semiannual Coupon Payments
Thus far weve assumed that interest payments occur annually. This is the case for bonds in many
European countries, but in Canada and the US most bonds make coupon payments semiannually.
So when you hear that a bond in Canada has a coupon rate of 5.5 percent, you can generally
assume that the bond makes a payment of $55/2$27.50 every 6 months. Similarly, when investors
in Canada refer to the bonds interest rate, they usually mean the semiannually compounded inter
est rate. Thus an interest rate quoted at 4.6 percent really means that the 6month rate is
4.6/22.3 percent.2
The actual cash flows on the Canada bond are illustrated in Figure 5.3. To value the bond more
precisely, we should have discounted the series of semiannual payments by the semiannual rate
of interest as follows:
which is slightly more than the value of $1,024.694 that we obtained when we treated the coupon
payments as annual rather than semiannual.3 Since semiannual coupon payments just add to the
arithmetic, we will often stick to our simplification and assume annual interest payments.
Figure 5.3
Cash flows to an investor in $1,027.50
the 5.5 percent coupon bond,
maturing in 2010. The bond
$1,000
pays semiannual coupons,
so there are two payments of $27.50 $27.50 $27.50 $27.50 $27.50
$27.50 each year.
June 2007 $27.50
2 Youmay have noticed that the interest rate compounded semiannually on the bond is also the bonds APR, although
this term is generally not used by bond investors. To find the effective rate, we can use a formula that we used in
Section 4.6:
APR m
Effective annual rate 1 1 21
m
where m is the number of payments each year. In the case of our Canada bond,
.046
2
Effective annual rate 1 1 2 1 (1.023) 2 2 1 .0465, or 4.65%
2
3 Why is the present value a bit higher in this case? Because now we recognize that half the annual coupon payment
is received six months into the year, rather than at yearend. Because part of the coupon income is received earlier,
its present value is higher. To match the price reported in Figure 5.2, calculate the bonds value with semi
annual payments and a 6month rate of 2.3027 percent. You should get the bonds value to be $1,024.80.
Example 5.3
Bond Prices and Interest Rates
Investors will pay $1,000 for a 5.5 percent, 3year Canada bond, when the interest rate is
5.5 percent. Suppose that the interest rate is higher than the coupon rate at, say, 15 percent.
Now what is the value of the bond? Simple! We just repeat our initial calculation but with
r.15:
This is a key bond pricing rule. When the market interest rate exceeds the coupon
rate, bonds sell for less than face value. When the market interest rate is below the
coupon rate, bonds sell for more than face value. When the market rate of interest
equals the coupon rate, the bond sells at face value.
Suppose interest rates rise. On hearing the news, bond investors appear sad. Why? Dont they
like higher interest rates? If you are not sure of the answer, look at Figure 5.4, which shows the
present value of the 5.5 percent Canada bond for different interest rates. For example, imagine
the interest rate soars from 4.6 to 10 percent. The Canada 5.5s of 2010 would be worth less than
$900, creating a loss to bondholders of some 13 percent. Conversely, bondholders have reason
to celebrate when market interest rates fall. You can see this also by looking at Figure 5.4. For
instance, if interest rates fall to 2 percent, the value of our 5.5 percent bond would increase
to $1,100.
Figure 5.4 illustrates a fundamental relationship between interest rates and bond prices:
When the interest rate rises, the present value of the payments to be received by the
bondholder falls, and bond prices fall. Conversely, declines in the interest rate
increase the present value of those payments and result in higher bond prices.
A warning! People sometimes confuse the interest, or coupon, payment on the bond with the
interest ratethat is, the return that investors require. The $55 coupon payments on our Canada
bond are fixed when the bond is issued. The coupon rate, 5.5 percent, measures the coupon
Figure 5.4
The value of the 5.5 percent $1,200
bond is lower at higher
discount rates. The yield to $1,150
maturity is the discount rate
at which price equals present $1,100
value of cash flows.
$1,050
Bond Price
$1,000 Price $1,024.69
$950
$900
$800
0% 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 11% 12% 13%
Discount rate
payment ($55) as a percentage of the bonds face value ($1,000) and is therefore also fixed.
However, the interest rate changes from day to day. These changes affect the present value of the
coupon payments but not the payments themselves.
Notice that in each year you earn 10 percent on your money ($100/$1,000). In the final year
you also get back your original investment of $1,000. Therefore, your total return is 10 percent,
the same as the coupon rate.
Now suppose that the market price of the 3year bond is $1,136.16. Your cash flows are as
follows:
Cash Paid to You in Year
You Pay 1 2 3 Rate of Return
$1,136.16 $100 $100 $1,100 ?
Whats the rate of return now? Notice that you are paying out $1,136.16 and receiving
an annual income of $100. So your income as a proportion of the initial outlay is
current yield Annual coupon $100/$1,136.16.088, or 8.8 percent. This is sometimes called the bonds current yield.
payment divided by bond price. However, total return depends on both interest income and any capital gains or losses. A cur
rent yield of 8.8 percent may sound attractive, only until you realize that the bonds price must
fall. The price today is $1,136.16, but when the bond matures 3 years from now, the bond will
sell for its face value, or $1,000. A price decline (i.e., a capital loss) of $136.16 is guaranteed,
so the overall return over the next 3 years must be less than the 8.8 percent current yield.
Let us generalize. A bond that is priced above its face value is said to sell at a premium and
premium bond Bond that sells is called a premium bond. Investors who buy a bond at a premium face a capital loss over the
for more than its face value. life of the bond, so the return on these bonds is always less than the bonds current yield. A bond
discount bond Bond that sells priced below face value sells at a discount and is called a discount bond. Investors in discount
for less than its face value. bonds face a capital gain over the life of the bond; the return on these bonds is greater than the
current yield:
Because it focuses only on current income and ignores prospective price increases
or decreases, the current yield mismeasures the bonds total rate of return. It over
states the return of premium bonds and understates that of discount bonds.
We need a measure of return that takes account of both current yield and the change in a bonds
yield to maturity Interest rate value over its life. The standard measure is called yield to maturity. The yield to maturity is the
for which the present value of the answer to the following question: At what interest rate would the bond be correctly priced?
bonds payments equals the price.
The yield to maturity is defined as the discount rate that makes the present value of
the bonds payments equal to its price.
If you can buy the 3year bond at face value, the yield to maturity is the coupon rate, 10 per
cent. We can confirm this by noting that when we discount the cash flows at 10 percent, the
present value of the bond is equal to its $1,000 face value:
$100 $100 $1,100
PV at 10% 1 2
1 $1, 000.00
(1.10) (1.10) (1.10)3
But if you have to buy the 3year bond for $1,136.16, the yield to maturity is only 5 percent.
At that discount rate, the bonds present value equals its actual market price, $1,136.16:
$100 $100 $1,100
PV at 5% 1 2
1 $1,136.16
(1.05) (1.05) (1.05)3
Example 5.4
Calculating Yield to Maturity for the Canada Bond
We found the value of the 5.5 percent coupon Canada bond by discounting at a 4.6 percent interest
rate. We could have phrased the question the other way around: If the price of the bond is
$1,024.694, what return do investors expect? We need to find the yield to maturity, in other words,
the discount rate r that solves the following equation:
To find the yield to maturity, most people use a financial calculator or a spreadsheet. For our
Canada bond you would enter a PV of $1,024.694.4 The bond provides a regular payment of $55,
entered as PMT55. The bond has a future value of $1,000, so FV1,000. The bond life is
See Boxes, 3 years, so n3. Now compute the interest rate, and you will find that the yield to maturity is
PP. 139141 4.6 percent. The nearby Financial Calculator and Excel Spreadsheet boxes review the use of the
financial calculator and spreadsheets in bond valuation problems.
4 Actually on most calculators you would enter 1,024.694 as a negative number, (21,024.694), because the purchase of
the bond represents a cash outflow.
In Chapter 4 we saw that financial calculators can compute the Your calculator should now display a value of 21,024.694. The
present values of level annuities as well as the present values of one minus sign reminds us that the initial cash flow is negative: You have
time future cash flows. Coupon bonds present both of these character to pay to buy the bond.
istics: The coupon payments are level annuities and the final payment You can also use the calculator to find the yield to maturity of a
of par value is an additional onetime payment. Thus for the coupon bond. For example, if you buy this bond for $1,024.694, you should
bond we looked at in Example 5.4, you would treat the periodic find that its yield to maturity is 4.6 percent. Lets check that this is
payment as PMT $55, the final or future onetime payment as so. You enter the PV as 21,024.694 because you buy the bond
FV $1,000, the number of periods as n 3 years, and the interest rate for this price. Thus to solve for the interest rate, use the following
as the yield to maturity of the bond, i 4.6 percent. You would thus key strokes:
compute the value of the bond using the following sequence of key
strokes. By the way, the order in which the various inputs for the bond HewlettPackard Sharpe Texas Instruments
valuation problem are entered does not matter. HP10B EL733A BA II Plus
55 PMT 55 PMT 55 PMT
HewlettPackard Sharpe Texas Instruments
HP10B EL733A BA II Plus 1000 FV 1000 FV 1000 FV
The yield to maturity is a measure of a bonds total return, including both coupon income and
capital gain. If an investor buys the bond today and holds it to maturity, his return will be the
yield to maturity. Bond investors often refer loosely to a bonds yield. Its a safe bet that they
are talking about its yield to maturity rather than its current yield.
The only general procedure for calculating yield to maturity is trial and error. You guess at an
interest rate and calculate the present value of the bonds payments. If the present value is greater
than the actual price, your discount rate must have been too low, so try a higher interest rate
(since a higher rate results in a lower PV). Conversely, if PV is less than price, you must reduce
the interest rate. In practice, investors use a financial calculator or a computer spreadsheet to do
the trial and error for them. The nearby boxes provide examples.
Example 5.5
yield to MAturity with seMiAnnuAl CouPon PAyMents
Lets redo Example 5.4, but this time assume the coupons are paid semiannually. Instead of three
annual coupons of $55, the bond makes six semiannual payments of $27.50. We can find the semi
annual yield to maturity on our calculators by using these inputs: n 6 (semiannual) periods,
PV 21,024.694, FV 1,000, PMT 27.50. We then compute the interest rate to find that it is 2.3047
percent. This of course is a sixmonth, not an annual, rate. Bond dealers typically annualize the semi
annual rate by doubling it, so the yield to maturity would be quoted as 2.3047 2 4.6094 percent,
see Box P. 140 which rounds to 4.61 percent. In Excel (see nearby Excel Spreadsheet box), you can confirm that
YIELD(DATE(2007,6,1), DATE(2010,6,1),.055,102.48,100,2) .0461. A better way to annualize
would be to account for compound interest. A dollar invested at 2.3047 percent for two 6month peri
ods would grow to $1 (1.023047)2 $1.0466. The effective annual yield is therefore 4.66 percent.
Check Point 5.3 A 4year maturity bond with a 14 percent coupon rate can be bought for $1,200. What
is the yield to maturity if the coupon is paid annually? What if it is paid semiannually?
You will need a spreadsheet or a financial calculator to answer this question.
139
A B C D E F G H
1
2 Valuing bonds using a spreadsheet
3
4 5.5% coupon 6% coupon
5 maturing June 2010 10year maturity
6
7 Settlement date 6/01/2007 1/1/2000
8 Maturity date 6/01/2010 1/1/2010
9 Annual coupon rate .055 0.06
10 Yield to maturity .046 0.07
11 Final payment (% of face value) 100 100
12 Coupon payments per year 1 1
13
14 Bond price (% of par) 102.469 92.976
15
16
17 The formula entered here is: PRICE(B7,B8,B9,B10,B11,B12)
excel and most other spreadsheet programs provide builtin Notice that the coupon rate and yield to maturity are expressed
functions to compute bond values and yields. they typically ask you as decimals, not percentages. In most cases, final payment will be
to input both the date you buy the bond (called the settlement date) 100 (i.e., 100 percent of face value), and the resulting price will be
and the maturity date of the bond. expressed as a percentage of face value. Occasionally, however,
The Excel function for bond value is you may encounter bonds that pay off at a premium or discount to
PRICE(settlement date, maturity date, annual coupon rate, yield face value. One example would be callable bonds, discussed at the
to maturity, final payment, number of coupon payments per end of the chapter.
year). The value of the bond assuming annual coupon payments is
For our 5.5 percent coupon bond, we would enter the values in 102.469 percent of face value, or $1,024.69. If we wanted to
column B of the spreadsheet above. Alternatively, we could simply assume semiannual coupon payments, we would simply change
enter the following function in Excel: the entry in cell B12 to 2, and the bond value would change to
102.495 percent of face value, as we found in Example 5.2.
PRICE(DATE(2007,06,01),DATE(2010,06,01),.055,.046,100,1).
In this example, we assume that the first coupon payment comes
the Date function in excel, which we use for both the settlement in exactly one period (either a year or a halfyear). In other words,
and maturity date, uses the format Date(year,month,day). the settlement date is precisely at the beginning of the period.
140
Excel Sp readsheet
A B C D E F G H
1
2 Finding yield to maturity using a spreadsheet
3 June 2010 maturity bond, coupon rate 5.5%, maturity 3 years
4
5 Annual coupons Semiannual coupons
6
7 Settlement date 6/01/2007 6/01/2007
8 Maturity date 6/01/2010 6/01/2010
9 Annual coupon rate .055 .055
10 Bond price 102.469 102.469
11 Final payment (% of face value) 100 100
12 Coupon payments per year 1 2
13
14 Yield to maturity (decimal) .0460 .0461
15
16
17 The formula entered here is: YIELD(B7,B8,B9,B10,B11,B12)
However, the PRICE function will make the necessary adjustments value on your calculator using the inputs: n10, i7, FV1000,
for intraperiod purchase dates. PMT60.
Suppose now that you wish to find the price of a 10year matu Excel also provides a function for yield to maturity. It is
rity bond with a coupon rate of 6 percent (paid annually), selling YIELD(settlement date, maturity date, annual coupon rate,
at a yield to maturity of 7 percent. You are not given a specific bond price, final payment as percentage of face value, number of
settlement or maturity date. You can still use the PRICE function to coupon payments per year).
value the bond. Simply choose an arbitrary settlement date
For example, to find the yield to maturity in Example 5.4, we
(January 1, 2000 is convenient) and let the maturity date be 10
would use column B of the above spreadsheet. If the coupons were
years hence. The appropriate inputs appear in column E of the
paid semiannually, as in Example 5.5, we would change the entry
spreadsheet on the previous page, with the resulting price, 92.976
for payments per year to 2 (see cell E12), and the yield would
percent of face value, appearing in cell E14. You can confirm this
increase to 4.61 percent.
Do not confuse the bonds rate of return over a particular investment period with its yield to
maturity. The yield to maturity is defined as the discount rate that equates the bonds price to the
present value of all its promised cash flows. It is a measure of the average rate of return you will
earn over the bonds life if you hold it to maturity. In contrast, the rate of return can be calculated
for any particular holding period and is based on the actual income and the capital gain or loss
on the bond over that period. The difference between yield to maturity and rate of return for a
particular period is emphasized in the following example.
Example 5.6
Rate of Return versus Yield to Maturity
Our 5.5 percent coupon bond with maturity in 2010 currently has 3 years left until maturity and
sells today for $1,024.69. Its yield to maturity is 4.6 percent. Suppose that by the end of the year,
interest rates have fallen and the bonds yield to maturity is now 2 percent. What will be the bonds
oneyear rate of return?
141
At the end of the year, the bond will have only two years to maturity. If investors then demand
an interest rate of 2 percent, the value of the bond will be
$55 $1,055
PV at 2% 1 $1,067.95
(1.02) (1.02)2
You invested $1,024.69. At the end of the year you receive a coupon payment of $55 and have
a bond worth $1,067.95. Your rate of return is therefore
The yield to maturity at the start of the year was 4.6 percent. However, because interest rates fell
during the year, the bond price rose, and this increased the rate of return.
Check Point 5.4 Suppose that the bonds yield to maturity had risen to 5 percent during the year. Show
that its rate of return would have been less than the yield to maturity.
Is there any connection between yield to maturity and the rate of return during a particular
period? Yes: If the bonds yield to maturity remains unchanged during an investment period, its
rate of return will equal that yield. We can check this by assuming that the yield on 5.5 percent
Canada bonds stays at 4.6 percent. If investors still demand an interest rate of 4.6 percent at the
end of the year, the value of the bond will be
$55 $1, 055
PV 1 $1, 016.83
(1.046) (1.046)2
At the end of the year you receive a coupon payment of $55 and have a bond worth $1,016.83,
somewhat less than you paid for it. Your total profit is $55 1 ($1,016.83 2 $1,024.69) $47.14.
The return on your investment is therefore $47.14/$1,024.69 .046, or 4.6 percent, just equal to
the yield to maturity.
When interest rates do not change, the bond price changes with time so that the total
return on the bond is equal to the yield to maturity. If the bonds yield to maturity
increases, the rate of return during the period will be less than that yield. If the yield
decreases, the rate of return will be greater than the yield.
Check Point 5.5 Suppose you buy the bond next year for $1,016.83, and hold it for yet another year, so
that at the end of that time it has only 1 year to maturity. Show that if the bonds yield
to maturity is still 4.6 percent, your rate of return also will be 4.6 percent and the bond
price will be $1,008.60.
The solid curve in Figure 5.5 plots the price of a 30year maturity, 5.5 percent Canada bond
over time assuming that its yield to maturity remains at 4.6 percent. The price declines gradually
until the maturity date, when it finally reaches face value. In each period, the price decline offsets
the coupon income by just enough to reduce total return to 4.6 percent. The dotted curve in
Figure 5.5 shows the corresponding price path for a 30year maturity, 2 percent coupon Canada
bond, also assuming its yield to maturity remains at 4.6 percent. This lowcoupon bond currently
Figure 5.5
Bond prices over time, $1,200 Price path for bond currently at a premium over face value
assuming an unchanged yield (coupon rate of 5.5% is greater than discount rate of 4.6%)
to maturity. Prices of both $1,100
premium and discount bonds
approach face value as their $1,000
maturity date approaches. Price path for bond currently at a discount to face value
$900 (coupon rate of 2% is less than discount rate of 4.6%)
Bond price
$800
$700
$600
Today Maturity date
$500
0 5 10 15 20 25 30
Time (years)
sells at a discount to face value. The coupon income provides less than a competitive rate of
return, so the bond sells below par. Its price gradually approaches face value, however, and the
price gain each year brings its total return up to the market interest rate of 4.6 percent.
As you can see, taxes have a material effect on the rate of return on your investment! Here,
the 9.59 percent beforetax rate of return is only 6.97 percent once you consider the taxes you
must pay on your investment income.
Check Point 5.6 Suppose you bought an 8 percent coupon bond for $1,200 and sold it 1 year later for
$1,215. Calculate the beforetax and aftertax rate of return on your investment, if your
personal tax rate is 40 percent.
In our examples we have considered only oneyear investments. How do you calculate the
rate of return if the investment lasts longer than one year? Suppose you buy the 5.5 percent
coupon bond for $1,024.69 and sell it in 2 years for $1,015.5. You receive cash flows at two
different points in time: a $55 coupon payment after one year, and then another $55 coupon plus
the cash from selling the bond after 2 years. If you ignore the fact that you received the first
$55 early, you can add up all the coupon payments and calculate the rate of return like we
did above. This method understates your rate of returnyou ignored the value of investing the
first coupon during the time of the bond investment. The standard approach to calculating the
rate of return is to assume that the first coupon is reinvested for the remaining life of the invest
ment. In other words, calculate the future value of that first coupon payment at the end of the
second year.
Suppose when you received the first coupon payment you immediately invested at 4 percent
for 1 year. That coupon payment will be worth $55 1.04, or $57.2, 1 year later. At the end of
the 2 years, the total value of coupon income received is $57.2 1 $55, or $112.2. The price
change on the bond is a capital loss: $1,015.5 2 $1,024.69, or 2$9.19. Using Equation 5.3, the
rate of return on the investment is
coupon income 1 price change
Rate of return
investment
$112.2 2 $9.19
.1005, or 10.05%
$1, 024.69
Did you notice that this is a twoyear rate of return? Rates of return are normally reported on
an annual basis so this twoyear rate of return must be converted into its oneyear equivalent. The
effective annual equivalent is (1.1005)1/2 2 1, or 4.9 percent. Your annual rate of return is
4.9 percent.
How do you know the rate at which the intermediate coupon payments are invested? You can
use the actual rates available at the time you received the coupons. Another approach is to use a
variation on the yieldtomaturity calculation. Using this method, your rate of return is the dis
count rate that equates the purchase price to the present value of the coupons and the price you
receive when you sell the bond. This assumes that all of the coupons are invested at that discount
rate for the remaining time you own the bond. You can use this approach to calculate the aftertax
rate of return toojust use the aftertax cash flows. We will see this approach to calculating rates
of return again in Chapter 7, but there we will call it the internal rate of return.
Example 5.7
CAlCulAting the rAte oF return on A twoyeAr Bond inVestMent
You buy a 5.5 percent bond for $1,024.69 and sell it 2 years later for $1,015.5. What is the rate of
return on your investment if you use the yieldtomaturity approach? Using a calculator, enter
PV 2$1,024.69, PMT $55, FV $1,015.5, and n 2. Now compute the interest rate, which is
your rate of return. You should get 4.93 percent.
Figure 5.6
The yield curve. A plot of 0.14
yield to maturity as a function 0.13
of time to maturity for 0.12 July 31, 1990
Government of Canada bills 0.11
Yield to maturity (%)
Source: Bank of Canada. Adapted from the Statistics Canada CANSIM database (http://cansim2.statcan.ca) series B14059,
B14060, B14061, B14062, B14067, B14068, B14069, B14070, B14071, and B14072.
rate on the bonds depends on the rate of inflation. For example, if the nominal rate of interest is
4.6 percent and the inflation rate is 2.4 percent, then the real interest rate is calculated as
follows:
1 1 nominal interest rate 1.046
(1 1 real interest rate) 1.0215
1 1 inflation rate 1.024
Real interest rate .0215, or 2.15%
Since the inflation rate is uncertain, so is the real rate of interest on the Canada bonds.
real return bond Bond with You can nail down a real rate of interest by buying an indexed or real return bond, whose pay
variable nominal coupon payments, ments are linked to inflation. The Government of Canada began issuing inflationindexed or real
determined by a fixed real coupon
return bonds, RRBs, in 1991. The real cash flows are fixed, but the nominal cash flows (coupon
payment and the inflation rate.
payments and principal) are increased as the consumer price index increases. For example, the
4.25 percent RRB due December 1, 2026, pays annual real coupons of $42.50. In Figure 5.2, the
prices and yields of two issues of Government of Canada real return bonds are seen at the bottom.
To see how the nominal coupon is calculated, suppose the Government of Canada issues a
3 percent, 2year real return bond. The real cash flows are fixed but the nominal cash flows will
depend on the actual increase in the consumer price index. Suppose inflation turns out to be
5 percent in Year 1 and a further 4 percent in Year 2. The real and nominal cash flows of the bonds
would be
Year 1 Year 2
Real cash flows $30 $1,030
Nominal cash flows $301.05$31.50 $1,0301.051.04$1,124.76
For the 4.25 percent RRB, the nominal value of each coupon is calculated when the coupon
payment is due and reflects the inflation that has occurred since the issue of the bond. We wont
know the nominal value of the principal until just before the bond matures in 2026.
From Figure 5.2 we can see that the yield to maturity on the 4.25s of 2026 Canada RRBs was
about 2.0 percent in June 2007. This yield is a real interest rate. It measures the amount of extra
goods your investment will allow you to buy. Figure 5.2 also shows that the yield to maturity on
the 8s of 2027 Canada bonds was 4.46 percent. An estimate of the expected annual inflation rate
used by market participants when discounting future cash flows can be found by rearranging the
formula for the real interest rate:
1 1 nominal interest rate 1.0446
(1 1 inflation rate) 1.0241
1 1 real interest rate 1.02
inflation rate .0241, or 2.41%
If the annual inflation rate proves to be higher than 2.41 percent, you will earn a higher
nominal return by holding RRBs; if the inflation rate is lower than 2.41 percent, the reverse will
be true.
Inflationindexed bonds have been issued by other governments and corporations. The United
Kingdom has issued indexed bonds since 1982. The United States Treasury began to issue
Treasury InflationProtected Securities, or TIPs, in 1997 and structured them similarly to the
Government of Canada Real Return Bonds. In 2000, 407 International Inc., owner of the largest
electronic toll highway in Canada, just north of Toronto, sold real return bonds with a 5.29 per
cent real coupon rate, maturing in 2039.
What determines the real rate of interest demanded by investors? The classical economist
Irving Fishers answer is that real interest rates depend on the supply of savings and the demand
for new investment.5 As this supplydemand balance changes, real interest rates change. But they
do so gradually.
5 See Irving Fishers great book: The Theory of Interest: As Determined by Impatience to Spend Income and Opportunity
to Invest It, August M. Kelley, New York, 1965; originally published in 1930.
According to Fisher, the nominal interest rate reflects both the real interest rate and the expect
ed inflation. In other words, the nominal interest rate is determined by the real rate of interest and
Fisher effect Thenominal the expected inflation. This is known as the Fisher effect. More formally, the Fisher effect is
interestrateisdeterminedbythe
realinterestrateandtheexpected 1 nominal interest rate 5 (1 real interest rate) 3 (1 expected inflation rate) (5.4)
rateofinflation.
When inflation and the real interest rate are not high, a reasonable approximation to
Equation (5.4) is
Nominal interest rate 5 real interest rate expected inflation rate (5.5)
Suppose that investors upwardly revise their forecast of inflation by 1 percent. How will this
affect interest rates? According to Fisher, if investors are concerned about the purchasing power
of their money, the changed forecast should not affect the real rate of interest. The nominal interest
rate must therefore rise by 1 percent to compensate investors for the higher inflation prospects.
How well does Fishers theory of interest rates work? The gold line in Figure 5.7 shows that
the real interest rate on the Government of Canada Real Return bonds has fluctuated within a
relatively narrow range, between 1.5 percent and 5 percent since 1991. The blue line shows the
nominal interest rate on ordinary longterm Government of Canada bonds. The nominal rate is
more variable than the real rate, ranging between 4 percent and 9.5 percent since 1991.
Some economists disagree with Fishers theory that inflation does not affect the real rate of
interest. For example, if inflation causes companies to change their investment activities, the real
interest rate will change. Looking at Figure 5.7 you can clearly see the impact of the steady decline
in inflation during most of the 1990s. This caused nominal yields to fall but the real yield fell only
slightly. In the 2000s, the real yield fell significantly and so did the nominal yield. Unfortunately, no
one has yet sorted out the complex relationship between inflation and interest rates. However, a
financial manager can use the Fisher effect as a valuable rule of thumb. If the expected inflation rate
changes, it is a good bet that there will be a corresponding change in the nominal interest rate.
Check Point 5.7 Go back to Figure 5.6. Do you think the inflation rate in 1990 was higher or lower than
the 2007 inflation rate? Explain your thinking.
Figure 5.7
The bottom line shows the 10
real yield on longterm 9
Canada Real return bonds.
8
The top line shows the yield Nominal yield
Yield to maturity (%)
3
Real yield
2
0
Nov. Oct. Oct. Oct. Oct. Oct. Oct. Oct. Oct. Oct. Oct. Oct. Oct. Oct. Oct. Oct. Oct.
91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07
Date
Source: Statistics Canada CANSIM database (cansim2.statcan.ca) series V122553 and V122544.
exPeCtAtions theory
A major factor determining the shape of the yield curve is expected future interest rates. To see
why, consider the following example. Suppose you want to invest your money for two years. You
could buy a oneyear bond now. A year from now when the bond matures, you reinvest the pro
ceeds in another oneyear bond at whatever rate the bond market offers then. Alternatively, you
could buy a twoyear bond today. According to the expectations theory of interest rates, interest
rates will adjust such that you dont care whether you invest in a twoyear loan or in two succes
sive oneyear loans. This means an upwardsloping yield curve tells you that investors expect
shortterm interest rates to rise. Likewise, a downwardsloping yield curve means that investors
expect shortterm rates to fall.
Why would future shortterm interest rates be expected to be higher than todays current
shortterm rate? As we saw above, expected inflation is a key component of nominal interest
rates. So, if investors expect inflation to increase, they will demand higher shortterm rates in the
future, which tends to result in an upwardsloping yield curve. Expected decreases in future
inflation will tend to lead to a downwardsloping yield curve.
Check Point 5.8 Suppose that the interest rate rises overnight from 4.6 percent to 10 percent. Calculate
the present values of the 5.5 percent, 3year bond and of the 5.5 percent, 30year bond
both before and after this change in interest rates. Confirm that your answers correspond
with Figure 5.8. Use your financial calculator or a spreadsheet.
Figure 5.8
Plots of bond prices as a $3,000
function of the interest rate.
Longterm bond prices are
more sensitive to the interest $2,500
rate than prices of shortterm 30year bond, 5.5% coupon rate
bonds.
$2,000
Bond price
When interest rate equals the
5.5% coupon rate, both bonds
$1,500 sell for face value
$1,000
3year bond, 5.5% coupon rate
$500
$0
0.0% 1.0% 2.0% 3.0% 4.0% 5.0% 6.0% 7.0% 8.0% 9.0% 10.0%11.0%12.0%
Interest rate
We saw in Figure 5.8 that a longerterm bond has greater interest risk than a shortterm bond
with the same coupon rate. If two bonds have the same maturity but unequal coupons, the bond
with the lower coupon will have the greater interest rate risk. In Appendix 5A, available on the
Online Learning Centre at www.mcgrawhill.ca/olc/brealey, we examine why coupon rates affect
bonds interest rate risk and introduce the important concept of duration, a method of measuring
a bonds life. We show that bonds with longer duration also have greater interest rate risk.
If investors dont like price fluctuations, they invest their funds in shortterm bonds unless
they receive a higher yield to maturity on longterm bonds. This extra return has various names
including a liquidity premium, a maturity risk premium, and an interest rate risk premium.
According to this theory, known as the liquidity preference theory, the yield curve will tend to
upward sloping because of the liquidity premium needed to induce investors to buy the riskier
longer bonds.
The expectations theory and the liquidity preference theory together predict that the yield
curve will tend to be upward sloping both because of increases in future inflation and the liquid
ity premium. A downwardsloping yield curve is still possible when future shortterm interest
rates are expected to fall. However, with the liquidity premium, the declining yield curve will be
less steep. In Appendix 5B we provide a more detailed look at the expectations and liquidity
preference theories.
other countries. The bonds may be denominated in Canadian dollars, US dollars, and sometimes
in another currency, such as the British pound or Japanese yen.
There is an important distinction between bonds issued by corporations and those issued by the
Government of Canada. National governments dont go bankruptthey just print more money.6
So investors do not worry that the Canadian government will default on its bonds. However, there
is some chance that corporations may get into financial difficulties and may default on their
bonds. Thus the payments promised to corporate bondholders represent a bestcase scenario: The
firm will never pay more than the promised cash flows, but in hard times it may pay less.
default (or credit) risk The The risk that a bond issuer may default on its obligations is called default (or credit) risk. It
risk that a bond issuer may default should be no surprise to find that to compensate for this default risk companies need to promise
on its bonds.
a higher rate of interest than the Canadian government when borrowing money. The difference
between the promised yield on a corporate bond and the yield on a Canada bond with the same
default premium or credit coupon and maturity is called the default premium, or credit spread. The greater the chance that
spread The additional yield on the company will get into trouble, the higher the default premium demanded by investors.
a bond that investors require for
The safety of most corporate bonds can be judged from bond ratings provided by the
bearing credit risk.
Dominion Bond Rating Service (DBRS), Moodys, Standard & Poors (S&P), or other bond
rating firms. Table 5.1 lists the possible bond ratings in declining order of quality. For example,
the bonds that receive the highest rating are known as AAA, or triple A bonds. Then come AA,
investment grade Bond rated or double A, A bonds, BBB bonds, and so on. Bonds rated BBB and above are called
Baa or above by Moodys, or BBB investment grade, while those with a rating of BB or below are referred to as speculative grade,
or above by Standard and Poors
or DBRS.
highyield, or junk bonds.
It is rare for highly rated bonds to default. For example, since 1971 fewer than one in 1000
junk bond Bond with a rating triple A bonds have defaulted within 10 years of issue. However, when an investmentgrade bond
below Baa or BBB. does default, the shock waves can be considerable. For example, in May 2001 WorldCom sold
$11.8 billion of bonds with an investmentgrade rating. Within little more than a year WorldCom
filed for bankruptcy and its bondholders had lost more than 80 percent of their investment. For
lowgrade issues, defaults are less rare. For example, almost half of the bonds that were rated
CCC by Standard & Poors at issue have defaulted within 10 years.
Of course, bonds rarely fall suddenly from grace. As time passes and the company becomes
progressively more shaky, the agencies revise the bonds rating downward to reflect the increas
ing probability of default. Consider the case of Air Canadas senior unsecured debt. Originally
rated BB by DBRS in 1997, it was downgraded to BB (low) in February 2001, in response to Air
Canadas large debt load, rising costs, and increased competition. With the terrorist attacks of
September 11, 2001, and the worsening economic slowdown, DBRS dropped the rating to B in
6 But they cant print money of other countries. Therefore, when a government borrows in a foreign currency, investors
worry that in some future crisis the government may not be able to come up with enough of the foreign currency to
repay the debt. This worry shows up in the yield that investors demand on such debt. For example, in the summer of
2002, concerns about a possible Brazilian default caused yields on the US dollar bonds issued by the Brazilian
government to rise to 13 percentage points above the yields on comparable US Treasury issues.
September 2001. As Air Canadas financial situation worsened, it filed for bankruptcy protection
in April 2003, prompting DBRS to lower the rating to C. By April 2004, the debt rating was cut
to D. Air Canada negotiated a debtforequity swap with its debtholders, who agreed to exchange
their debt for shares worth about onetenth of the amount owed. In September 2004, the company
emerged from bankruptcy protection with a substantially reduced debt load, carrying a B rating
and a new name, ACE Aviation Holdings.
As you would expect, the yield on corporate bonds varies with the bond rating. Figure 5.9
presents the yields to maturity on tenyear defaultfree, longterm Government of Canada bonds,
AAA and AArated corporate bonds, Arated bonds, and BBBrated bonds since 1992. You can
see that yields on the four groups of bonds track each other over time. At any point in time, the
promised yield is higher as bond safety gets lower. The yield spreads, seen as the distance
between the Canada bond and each of the other bonds, are bigger for riskier bonds but not con
stant over time. The yield spreads increase as overall risk rises. Notice the increase in the spreads
in 2007 and mid2008, corresponding to the slowdown in the economy. You might be attracted
to the higher promised yields on the lowergrade bonds. But remember, the riskier the bond, the
less likely the bond will keep its promise.
Example 5.8
Promised versus Expected Yield to Maturity
Bad Bet Inc. issued bonds several years ago with a coupon rate (paid annually) of 10 percent and
face value of $1,000. The bonds are due to mature in six years. However, the firm is currently in
bankruptcy proceedings, the firm has ceased to pay interest, and the bonds sell for only $200. Based
on promised cash flow, the yield to maturity on the bond is 63.9 percent. (On your calculator, set
PV2200, FV1,000, PMT100, n6, and compute i.) But this calculation is based on the very
unlikely possibility that the firm will resume paying interest and come out of bankruptcy. Suppose
that the most likely outcome is that after 3 years of litigation, during which no interest will be paid,
debtholders will receive $.27 on the dollarthat is, they will receive $270 for each bond with
$1,000 face value. In this case the expected return on the bond is 10.5 percent. (On your calculator,
set PV2200, FV270, PMT0, n3, and compute i.) When default is a real possibility, the
promised yield can depart considerably from the expected return. In this example, the default
premium is greater than 50 percent.
Figure 5.9 12
Yields on tenyear Canadian
corporate bonds and tenyear 10year BBBrated Corporate
Government of Canada 10 10year Arated Corporate
10year AArated Corporate
10year Canada
bonds. Bonds with greater
Yield to maturity (%)
0
D 94
D 93
D 99
D 01
D 03
D 04
D 92
D 2
D 98
D 00
D 96
D 06
D 5
D 5
D 97
7
0
9
0
0









ec
ec
ec
ec
ec
ec
ec
ec
ec
ec
ec
ec
ec
ec
ec
ec
D
Year
One of the worlds bestknown issuers has joined the parade of The IBRD hasnt been in a rush to raise capital in Canada since
issuers to the Maple Bond market, the domestic market where non the Maple market emerged. Last spring, it did a Canadian road show
Canadian borrowers raise Canadian dollardenominated debt that is in which it visited the major cities and talked to wouldbe bond
settled in Canada. buyers. But it didnt follow the script and raise capital. Instead, it
The International Bank for Reconstruction and Development, the waited until conditions were right so it could offer investors an
official name for the World Bank, priced an $850million, fiveyear, attractive yield but, more important, meet its own financing targets.
AAArated offering yesterday. That deal, upsized from an originally Its targets are defined in terms of a number that is below floatingrate
planned $500million, is the first in Canadian dollars under IBRDs so LIBOR (or London Interbank offer rate). To get there, it swaps the
called global debt issuance facility (GDIF). The IBRD, the king of the proceeds from the fixedrate Canadiandollar borrowing to a float
supranationals, was able to snare that debt at a yield of 4.323%, or 49.5 ing rate U.S.dollar obligation.
basis points above Canada bonds of a comparable term. (The coupon
Source: Excerpted from Barry Critchley, World Bank into Maple bonds, Financial
was 4.30% and the debt was issued at $99.899 per $100.) Almost Post, Wednesday, November 21, 2007, p. FP2. Material reprinted with the express
threequarters of the debt was placed with Canadian investors. permission of The National Post Company, a Canwest Partnership.
Figure 5.10
Prices of callable versus $2,000
straight debt. When interest $1,800
rates fall, bond prices rise.
$1,600 Straight bond
But the price of the callable
bond (orange line) is limited $1,400 Call price $1,060
by the call price.
Bond price
$1,200
$1,000
$800
Callable bond
$600
$400
$200
$0
5% 7% 9% 11% 13% 15% 17% 19%
Interest rate
Figure 5.10 shows the risk of a call to the bondholder. The blue line is the value of a 30year,
6.5 percent coupon straight, that is, noncallable bond; the orange line is the value of a bond
with the same coupon rate and maturity, but callable at $1,060 (i.e., 106 percent of face value).
At very high interest rates, the risk of call is negligible, and the values of the bonds are nearly
identical. As rates fall, the noncallable bond steadily increases in value, but because call
becomes more likely in this region, the value of the callable bond is limited by its call price.
Recognizing this pattern, bond investors calculate yield to call rather than yield to maturity
for bonds at high risk of being called. The yield to call is calculated like yield to maturity with
time until call replacing time until maturity, and the call price replacing face value.
Example 5.9
yield to CAll
Suppose a 8.5% coupon, 30year maturity bond (making annual coupon payments) sells for $1,040
and is callable in 10 years at a call price of $1,060. We would calculate its yield to maturity and
yield to call on our calculators as follows:
In Excel, we could solve for these rates as: yield to call YIELD(DATE(2000,1,1),
DATE(2010,1,1),.085,104,106,1) and yield to maturity YIELD(DATE(2000,1,1),
DATE(2030,1,1),.085,104,100,1). The yield to call is higher because the firm has to
pay a premium to call the bonds.
Check Point 5.9 Find the yield to call and yield to maturity of the bond in Example 5.9 if it pays its cou
pons semiannually.
Most callable Canadian corporate bonds have a special call feature known as the Canada call
or the Doomsday call. With a Canada call, the call price is not set in advance but is determined
at the time of the call. The call price is calculated to generate a specific yield, with par value as
the minimum price. A typical Canada call provision states that the call price, referred to as the
Canada yield price, must offer an equivalent yield of a Government of Canada bond of the same
maturity plus an additional prestated amount, for default risk.
With the Canada call, the call price increases as interest rates fall, making it less attractive to
call the bond. By contrast, the call price for a conventional call provision is fixed and if interest
rates fall enough, it becomes profitable for the issuer to call the bond. You wont be surprised to
learn that bonds with a Canada call are rarely called.
Example 5.10
CAlCulAting the CAnAdA yield PriCe
A Cameco 4.7 percent bond due September 16, 2015, is callable (redeemable) at any time at the
greater of the Canada Yield Price and par. The Canada Yield is the yield to maturity for a Government
of Canada bond with the same maturity date as the Cameco bond. To determine the Canada Yield
Price (or call price), the remaining cash flows of the Cameco bond are discounted at the Canada
Yield plus .22 percent.
Suppose the Cameco bond is trading for $1,031.40 on September 16, 2010, giving a yield
to maturity of 4 percent. The coupon rate is greater than the bonds yield. Should the bond be
called and replaced with bonds carrying a lower coupon rate? If equivalentmaturity Canada bonds
are yielding 3.7 percent, the Canada Price must be calculated with a yield of .037 1 .0022,
or 3.92 percent, making the call price $1,035.10. (The Cameco bond is 5 years to maturity, with
10 coupon payments of $23.50 remaining to be paid. On your calculator, set FV 1,000,
PMT 47/2 23.5, n 10, i 3.92/2 1.96, and compute PV.). The call price is greater than the
current market price, and the bond wont be called.
5.7 suMMAry
1. What are the differences between the bonds coupon bonds. The bond payments discounted at the bonds yield
rate, current yield, and yield to maturity? to maturity equal the bond price. You may also start with
A bond is a longterm debt of a government or corpora the bond price and ask what interest rate the bond offers.
tion. When you own a bond, you receive a fixed interest This interest rate that equates the present value of bond
payment each year until the bond matures. This payment payments to the bond price is the yield to maturity.
is known as the coupon. The coupon rate is the annual Because present values are lower when discount rates are
higher, price and yield to maturity vary inversely.
www.mcgrawhill.ca/olc/brealey
the maturity of the bonds held. Consequently, a higher 5. Why do investors pay attention to bond ratings and
yield on a longerterm bond implies that investors expect demand a higher interest rate for bonds with low
future shortterm interest rates to rise. However, the ratings?
expectations theory ignores interest rate risk, which Investors demand higher promised yields if there is a high
arises from the fact that bond prices rise when market probability that the borrower will run into trouble and
rates fall, and fall when market rates rise. Longterm default. Credit risk implies that the promised yield to
bonds exhibit greater interest rate risk than shortterm maturity on the bond is higher than the expected yield.
bonds. According to the liquiditypreference theory, long The additional yield investors require for bearing credit
term bonds earn extra return to compensate for interest risk is called the default premium. Bond ratings measure
rate risk, resulting in higher yields on longterm bonds the bonds credit risk.
and a tendency for the yield curve to be upward sloping.
Key Terms
accrued interest 133 default premium or junk bond 150
bond 131 credit spread 150 premium bond 138
clean bond price 133 dirty bond price 133 rate of return 140
coupon 131 discount bond 138 real return bond 146
coupon rate 131 face value 131 yield curve or term structure
current yield 137 Fisher effect 147 of interest rates 145
default (or credit) interest rate risk 148 yield to maturity 138
risk 150 investment grade 150
Basic
*1. Bond Yields. A 30year Canada bond is issued with par value of $1,000, paying interest of $60 per year. If
market yields increase shortly after the bond is issued, what happens to the bonds www.mcgrawhill.ca/olc/brealey
a. coupon rate
b. price
c. yield to maturity
d. current yield
2. Bond Yields. If a bond with par value of $1,000 and a coupon rate of 6 percent is selling at a price of $970,
is the bonds yield to maturity more or less than 6 percent? What about the current yield?
*3. Bond Yields. A bond with par value $1,000 has a current yield of 7.5 percent and a coupon rate of 8 percent.
What is the bonds price if it pays interest annually?
*4. Bond Pricing. A 6year Circular File bond pays interest of $75 annually and sells for $950. What is its
coupon rate, current yield, and yield to maturity?
5. Bond Pricing. If Circular File (see previous problem) wants to issue a new sixyear bond at face value, what
coupon rate must the bond offer?
6. Bond Yields. A BCE bond has 10 years until maturity and a coupon rate of 8 percent payable annually, and
sells for $1,050.
a. What is the current yield on the bond?
b. What is the yield to maturity?
7. Coupon Rate. General Matters outstanding bond issue has a coupon rate of 7 percent and a current yield
of 7.6 percent, and it sells at a yield to maturity of 9.25 percent. The firm wishes to issue additional bonds
to the public at par value. What coupon rate must the new bonds offer in order to sell at par?
8. Financial Pages. Turn back to Figure 5.2. What is the current bid yield of the Canada 5.5 percent, June 1,
2010 maturity? What price would you have had to pay to buy the bond that day?
*9. Rate of Return. You bought a 10year, 5 percent coupon bond for $1,000 and sold it 1 year later for $1,100.
What is the rate of return on your investment if the bond pays interest annually?
*10. AfterTax Rate of Return. Refer to problem 9. If your marginal tax rate is 30 percent, and 50 percent of
capital gains are taxable, what is the aftertax rate of return on your bond investment?
Intermediate
*11. Bond Prices and Returns. One bond has a coupon rate of 8 percent, another a coupon rate of 12 percent.
Both bonds have 10year maturities and sell at a yield to maturity of 10 percent. If their yields to maturity
next year are still 10 percent, what is the rate of return on each bond? Does the higher coupon bond give a
higher rate of return? Assume the bonds pay annual interest.
12. Accrued Interest. The July 15, 2011, quoted price of a bond with a coupon rate of 4.5 percent, payable
semiannually, maturing on March 1, 2015, is 990. If you buy the bond on July 15, 2011, what is the total
price you must pay for the bond?
*13. Bond Returns.
a. If the BCE bond in problem 6 has a yield to maturity of 8 percent 1 year from now, what will its
price be?
b. What will be your rate of return if you buy it today and sell it in one year?
c. If the inflation rate during the year is 3 percent, what is the real rate of return on the bond?
14. Bond Pricing. A Metallico bond carries a coupon rate of 8 percent, payable semiannually, has 9 years until
maturity, and sells at a yield to maturity of 9 percent.
a. What interest payments do bondholders receive each year?
*b. At what price does the bond sell?
c. What will happen to the bond price if the yield to maturity falls to 7 percent?
15. Bond Pricing. A 30year maturity bond with $1,000 face value makes annual coupon payments and has a
coupon rate of 9.75 percent. What is the bonds yield to maturity if the bond is selling for
a. $900
b. $1,000
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*c. $1,100
16. Bond Pricing. Repeat the previous problem if the bond makes semiannual coupon payments.
17. Bond Pricing. Fill in the table below for the following zerocoupon bonds. The face value of each bond is
$1,000.
Price Maturity (Years) Yield to Maturity
$300 30
$300 8%
10 10%
18. Consol Bonds. Perpetual Life Corp. has issued consol bonds with coupon payments of $60. (Consols pay
interest forever and never mature. They are perpetuities.) If the required rate of return on these bonds at the
time they were issued was 6 percent, at what price were they sold to the public? If the required return today
is 10 percent, at what price do the consols sell?
*19. Bond Pricing. Sure Tea Co. has issued 9 percent annual coupon bonds, which are now selling at a yield to
maturity of 10 percent and current yield of 9.8375 percent. What is the remaining maturity of these
bonds?
20. Bond Pricing. Large Industries bonds sell for $1,065.95. The bond life is 9 years, and the yield to maturity
is 7 percent. What must be the coupon rate on the bonds? Coupons are paid semiannually.
*21. Bond Prices and Yields.
a. Several years ago, Castles in the Sand, Inc., issued bonds at face value at a yield to maturity of 65 percent.
Now, with 8 years left until the maturity of the bonds, the company has run into hard times, and the
yield to maturity on the bonds has increased to 14 percent. What has happened to the price of the bond?
Coupons are paid semiannually.
b. Suppose that investors believe that Castles can make good on the promised coupon payments, but that
the company will go bankrupt when the bond matures and the principal comes due. The expectation is
that investors will receive only 80 percent of face value at maturity. If they buy the bond today, what yield
to maturity do they expect to receive?
*22. Bond Returns. You buy an 8 percent coupon, paid annually, 10year maturity bond for $980. A year later,
the bond price is $1,050.
a. What is the yield to maturity on the bond today? What is it in one year?
b. What is your rate of return over the year?
23. Bond Returns. You buy an 8 percent annual coupon, 10year maturity bond when its yield to maturity is
9 percent. A year later, the yield to maturity is 10 percent. What is your rate of return over the year?
24. Rate of Return. A 2year maturity bond with $1,000 face value makes annual coupon payments of $65 and
is selling at face value. What will be the rate of return on the bond if its yield to maturity at the end of the
year is
a. 6 percent
b. 8 percent
c. 10 percent
25. Rate of Return. A bond that pays coupons annually is issued with a coupon rate of 4 percent, maturity of
30 years, and a yield to maturity of 8 percent. What rate of return will be earned by an investor who pur
chases the bond and holds it for 1 year if the bonds yield to maturity at the end of the year is 9 percent?
*26. Rate of Return. Five years ago you purchased an 8 percent coupon bond for $975. Today you sold the bond
for $1,000. What is your rate of return on the bond in each of the following situations:
a. All coupons were immediately spent when received.
b. All coupons were reinvested in your bank account, which pays 1 percent interest until the bond is sold.
c. All coupons were reinvested at 8.64 percent until the bond is sold.
*27. Rate of Return. Looking back at the previous question, use the yieldtomaturity method to compute the
rate of return on your bond investment.
28. Bond Pricing. Are the following statements true or false? Provide simple examples to support your
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assessment.
a. If interest rates rise, bond prices rise.
b. If the bonds yield to maturity is greater than its coupon rate, the price is greater than the bonds face
value.
c. Highcoupon bonds of a given maturity sell for lower prices than otherwise identical lowcoupon
bonds.
d. If interest rates change, the price of a highcoupon bond changes proportionately more than the price of
a lowcoupon bond of the same maturity and default risk.
e. A investor who owns a 10 percent, 5year Canada bond is wealthier if interest rates rise from 4 percent
to 5 percent.
29. Internet. Use historical yieldtomaturity data from the Bank of Canada Web site at www.bankofcanada.ca
to look at bonds of different types. Go to www.bankofcanada.ca/en/rates/bondlook.htm and follow the
instructions. Download 60 months of yieldtomaturity data for longterm corporate bonds (series V122518),
longterm provincial bonds (V122517), and longterm Canada bonds (series V122544), and put the data into
a spreadsheet. Calculate the average spreads of the corporate and provincial bonds over the Canada bonds.
Graph the yields to maturity over time. What do you see? Does it make sense?
30. Yield Curve. The following table shows the prices of strips of Canada bonds in November 2008. Each strip
makes a single payment of $100 at maturity.
Maturity Price ($)
June 2010 96.94
June 2012 91.04
June 2015 80.58
June 2019 65.43
June 2025 45.75
a. Calculate the annually compounded, yield to maturity (spot interest rate) for each bond.
b. Is the term structure upward or downward sloping?
31. Bond Pricing. Diamond Corporation is planning a bond issue with an escalating coupon rate. The annual
coupon rate will be 4 percent for the first 3 years, 5 percent for the subsequent 3 years, and 6 percent for the
final 3 years. If bonds of this risk are yielding 5 percent, estimate the bonds current price.
32. Interest Rate Risk. Consider three bonds with 8 percent coupon rates, all selling at face value. The short
term bond has a maturity of 4 years, the intermediateterm bond has maturity of 8 years, and the longterm
bond has maturity of 30 years.
a. What will happen to the price of each bond if their yields increase to 9 percent?
b. What will happen to the price of each bond if their yields decrease to 7 percent?
c. What do you conclude about the relationship between time to maturity and the sensitivity of bond prices
to interest rates?
*33. Bond Risk. A bonds credit rating provides a guide to its risk. Longterm bonds rated AA currently offer
yields to maturity of 8.5 percent EAR. Arated bonds sell at yields of 8.8 percent EAR. If a 10year bond
with a coupon rate of 8 percent, paid semiannually, is downgraded by DBRS from AA to A rating, calculate
the likely effect on the bond price.
34. Internet. Free online yieldtomaturity and credit spread data for Canadian corporate bonds with different
debt ratings is not available. However, old US data is available at www.bondsonline.com/Todays_Market/
Corporate_Bond_Spreads.php. You will see a table showing credit spreads for corporate bonds of different
risk over comparableterm US government bonds from 2006. The spreads are measured in basis points,
where 1 basis point equals .01 (1/100) percentage point. Using the data in the table, estimate the required
rate of return on a 10year debt issue by a US company with A2/Arated debt. What if its debt had a
B2/B rating? The current yield to maturity on US Treasury bonds is available at www.bondsonline.com/
Todays_Market/Composite_Bond_Yields_table.php.
35. Internet. From www.globeinvestor.com/servlet/Page/document/v5/data/bonds, find five different corpo
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rate bonds and find Government of Canada bonds with similar terms to maturity. Look up their ratings at
either www.dbrs.com or www.standardpoor.com. Compare the bonds yields to maturity to comparable
term Government of Canada bonds. Do the yields make sense relative to their bond ratings?
36. Real Rate of Interest. You have been told that the yield to maturity on 3month Treasury bills is 4 percent
and the current inflation rate is 2 percent. Estimate the real rate of interest.
37. Real Returns. Suppose that you buy a 1year maturity bond for $1,000 that will pay you $1,000 plus a
coupon payment of $60 at the end of the year. What real rate of return will you earn if the inflation rate is
*a. 2 percent
b. 4 percent
c. 6 percent
d. 8 percent
38. Real Returns. Now suppose that the bond in the previous problem is a real return bond with a coupon rate
of 4 percent. What will the cash flow provided by the bond be for each of the four inflation rates? What will
be the real and nominal rates of return on the bond in each scenario?
39. Real Returns. Now suppose the real return bond in the previous problem is a twoyear maturity bond. What
will be the bondholders cash flows in each year in each of the inflation scenarios?
40. Yield to Call. A 6.25 percent 15year bond, paying interest annually, can be called at 110 percent of par
value in 10 years. The bond currently sells for $1,048.
a. What is the yield to maturity?
b. What is the yield to call?
41. Canada Call Price. A 7 percent corporate bond with 6 years to maturity has a Canada call. The bonds yield
to maturity is 4.8 percent. The call price must offer an equivalent yield to a Canada bond plus .35 percent.
Currently, sixyear Government of Canada bonds are yielding 4 percent. Assume coupons are paid
annually.
a. What is the current bond price?
b. What is the current call price?
42. Canada Call. When ABC Company originally issued its callable 5.5 percent, 10year bond, it was rated AA
and priced to sell at par. The bond is callable at the price that offers an equivalent yield to a Canada bond
plus .15 percent. At that time, the credit spread over 10year Canada bonds was .25 percent. The bond pays
interest annually.
a. What was the call price at issue?
Now, 5 years later, the bond rating agencies have raised the bond rating to AAA and the bonds yield to
maturity is 5 percent. Equivalentmaturity Canada bonds are yielding 4.9 percent.
b. What is the current call price?
c. Would ABC Company consider calling the bond now?
Challenge
43. Interest Rate Risk. Suppose interest rates increase from 8 percent to 9 percent. Which bond will suffer the
greater percentage decline in price: a 30year bond paying annual coupons of 8 percent, or a 30year zero
coupon bond? Can you explain intuitively why the zero exhibits greater interest rate risk even though it has
the same maturity as the coupon bond?
44. AfterTax Rate of Return. Using the information in problem 26, calculate your aftertax rate of return on
your bond investment assuming that your marginal tax rate is 35 percent. You pay tax on the interest when
it is received.
45. Bond Prices and Yields. Big Time Company is planning to raise $15 million by selling 10year bonds.
The bond rating agency has advised the company that the bonds will have an A rating. Currently, the
difference between the yield to maturity of Arated corporate bonds over similarmaturity Government of
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Canada bonds is 150 basis points (1 basis point equals .01 percentage points). If 10year Canada bonds are
currently priced to yield 5 percent, what coupon rate should Big Time select if the new issue is to sell at par
value.
46. Standard & Poors. Go to Market Insight (www.mcgrawhill.ca/edumarketinsight) and find the bond rat
ing of BCE (BCE) and Agrium (AGU) in the Financial Highlights section. Which has the higher bond
rating (i.e., S&P Issuer Credit Rating)? What are the main business activities of each of these companies?
Compare their ability to pay their interest obligations by calculating the ratio of EBIT to interest payments.
The higher this times interest earned ratio, the greater a companys ability to make its interest payments.
Also, calculate both companies indebtedness, as measured by the ratio of debt to equity. The higher the
times interest earned and the lower the indebtedness, the more likely a company will be able to make its debt
payments. Are the debt ratings consistent with the calculated ratios?
longterm provincial bonds (V122517), and longterm Canada bonds (series V122544), and put the data into
a spreadsheet. Calculate the average spreads of the corporate and provincial bonds over the Canada bonds.
Graph the yields to maturity over time. What do you see? Does it make sense?
30. Yield Curve. The following table shows the prices of strips of Canada bonds in November 2008. Each strip
makes a single payment of $100 at maturity.
Maturity Price ($)
June 2010 96.94
June 2012 91.04
June 2015 80.58
June 2019 65.43
June 2025 45.75
a. Calculate the annually compounded, yield to maturity (spot interest rate) for each bond.
b. Is the term structure upward or downward sloping?
31. Bond Pricing. Diamond Corporation is planning a bond issue with an escalating coupon rate. The annual
coupon rate will be 4 percent for the first 3 years, 5 percent for the subsequent 3 years, and 6 percent for the
final 3 years. If bonds of this risk are yielding 5 percent, estimate the bonds current price.
32. Interest Rate Risk. Consider three bonds with 8 percent coupon rates, all selling at face value. The short
term bond has a maturity of 4 years, the intermediateterm bond has maturity of 8 years, and the longterm
bond has maturity of 30 years.
a. What will happen to the price of each bond if their yields increase to 9 percent?
b. What will happen to the price of each bond if their yields decrease to 7 percent?
c. What do you conclude about the relationship between time to maturity and the sensitivity of bond prices
to interest rates?
*33. Bond Risk. A bonds credit rating provides a guide to its risk. Longterm bonds rated AA currently offer
yields to maturity of 8.5 percent EAR. Arated bonds sell at yields of 8.8 percent EAR. If a 10year bond
with a coupon rate of 8 percent, paid semiannually, is downgraded by DBRS from AA to A rating, calculate
the likely effect on the bond price.
34. Internet. Free online yieldtomaturity and credit spread data for Canadian corporate bonds with different
debt ratings is not available. However, old US data is available at www.bondsonline.com/Todays_Market/
Corporate_Bond_Spreads.php. You will see a table showing credit spreads for corporate bonds of different
risk over comparableterm US government bonds from 2006. The spreads are measured in basis points,
where 1 basis point equals .01 (1/100) percentage point. Using the data in the table, estimate the required
rate of return on a 10year debt issue by a US company with A2/Arated debt. What if its debt had a
B2/B rating? The current yield to maturity on US Treasury bonds is available at www.bondsonline.com/
Todays_Market/Composite_Bond_Yields_table.php.
35. Internet. From www.globeinvestor.com/servlet/Page/document/v5/data/bonds, find five different corpo
www.mcgrawhill.ca/olc/brealey
rate bonds and find Government of Canada bonds with similar terms to maturity. Look up their ratings at
either www.dbrs.com or www.standardpoor.com. Compare the bonds yields to maturity to comparable
term Government of Canada bonds. Do the yields make sense relative to their bond ratings?
36. Real Rate of Interest. You have been told that the yield to maturity on 3month Treasury bills is 4 percent
and the current inflation rate is 2 percent. Estimate the real rate of interest.
37. Real Returns. Suppose that you buy a 1year maturity bond for $1,000 that will pay you $1,000 plus a
coupon payment of $60 at the end of the year. What real rate of return will you earn if the inflation rate is
*a. 2 percent
b. 4 percent
c. 6 percent
d. 8 percent
The yield to maturity at the start of the year was 4.6 percent. However, because interest rates rose during the
year, the bond price fell and the rate of return is below the yield to maturity.
5.5 By the end of this year, the bond will have only one year left until maturity. It will make only one more pay
ment of coupon plus face value, so its price will be $1,055/1.046$1,008.60. The rate of return is
therefore
$55 1 ($1, 008.60 2 $1, 016.83)
.046, or 4.6%
$1, 016.83
5.6 The coupon payment is .083$1,000, or $80, before tax. The tax on the coupon interest is .43$80, or $32.
A capital gain of $1,2152$1,200$15 is made. The capital gains tax is .53.43$15, or $3. The beforetax
rate of return is
$80 1 ( $1, 215 $1, 200 )
.0792, or 7.92%
$1, 200
The aftertax rate of return is
$80 2 $32 1 ( $1, 215 2 $1, 200 ) 2 $3
.05, or 5.0%
$1, 200
5.7 The general level of (nominal) interest rates in July 1990 was much higher than in 2007. This suggests that
investors were expecting much higher inflation in 1990 than in 2007. The inflation rate in 1990 was about
5 percent and was about 2.5 percent in 2007.
5.8 At an interest rate of 4.6 percent, the 3year bond sells for $1,024.69. If the interest rate jumps to 10 percent,
the bond price falls to $888.09, a decline of 13.3 percent. The 30year bond sells for $1,144.89 when the
interest rate is 4.6 percent, but its price falls to $575.79 at an interest rate of 10 percent, a much larger per
centage decline of 49.7 percent.
5.9 The semiannual coupon is $42.50. The number of payments will be 20 if the bond is called after 10 years,
or 60 if it is held until maturity. Therefore, use these inputs:
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For Appendix 5A, see the Online Learning Centre at www.mcgrawhill.ca/olc/brealey.
7 Astripped bond, or strip, is a bond that makes only one payment at maturity. Stripped bonds are also called zerocoupon
bonds.
you invested in the twoyear strip, by the end of two years, December 2008, every dollar invested
would grow to $13(1.0402)25$1.082016. By keeping your money invested for the extra year,
your savings grow from $1.0417 to $1.082016, an increase of 3.87 percent (51.082016/1.041721).
This extra 3.87 percent that you earn by investing for two years, rather than one, is called a for
ward interest rate.
A forward interest rate is an interest rate calculated using spot rates. Let r1 be the current
oneyear spot rate and r2 be the current twoyear spot rate. Invest for one year, each dollar grows
to (11r1). Invest for two years in the twoyear bond, your investment grows to (11r2)2. The
extra rate of return that you earn in the second year is the forward rate, f2. In our example,
(1 r2 )2 (1.082016) (5B.1)
f2 5 215 2 1 5 .0387, or 3.87%
(1 r1 ) 1.0417
Twist this equation around and you get an expression for the twoyear spot rate, r2, in terms
of the oneyear spot rate, r!, and the forward rate, f2:
(1r2)25(1r1)3(1f2) (5B.2)
In other words, you can think of the twoyear investment as earning the oneyear spot rate for
the first year and the forward rate for the second year.
Forward rates can be calculated for other years, provided that you have the appropriate spot
rates. For example, if the 5year spot rate, r5, is 6% and the 6year spot rate, r6, is 6.5 percent,
the forward rate for the 6th year, f6, must satisfy this equation:
(1r6)65(1r5)53(1f6) (5B.3)
In other words, the Year 6 forward rate is the extra return for investing for the 6th year. In this
case, f6(1.065)6/(1.06)521, or 9 percent. Generally, the forward rate for the nth year, fn, must
satisfy the following equation:
(1rn)n5(1rn21)n213(1fn) (5B.4)
According the expectations theory, in equilibrium the forward rate, f2, equals the expected
oneyear spot rate, 1r2. The expectations theory implies that the only reason for an upward
sloping yield curve is that investors expect shortterm interest rates to rise. Likewise, the only
reason for a downwardsloping yield curve is that investors expect shortterm rates to fall.
If the expectations theory is correct, you can use the current spot rates to calculate investors
expected future spot rates. For example, suppose the current oneyear spot rate is 3 percent and
the current twoyear spot rate is 6 percent. What is the expected oneyear spot rate for Year 2?
According to the expectations theory,
(1 1 r2 ) 2 (1.06)2
1 r2 f2 21 2 1 .0909, or 9.09%
(1 1 r1 ) 1.03
If shortterm rates are much lower than longterm rates, it may be tempting to borrow short
term. However, the expectations theory tells us to not be fooled. Longterm rates are connected
to shortterm rates. If longterm rates are higher, it must be the case that the market is expecting
interest rates to rise.
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