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The Current I-Bond Composite Rate = 1.74% (through October 31, 2010 - this includes a 0.20% fixed rate and 0.77% variable rate). I-bond rates changes every six months. The I-bond rate is based on a combination of two separate rates: a fixed rate of return and a semi-annual inflation rate. The fixed rate is announced by the Treasury each May and November, and this rate remains effective throughout the life of the I-bond. In addition, a semi-annual inflation rate based on the Consumer Price Index for all Urban consumers (CPI-U) is announced at the same time. The inflation rate is a variable rate which changes every six months over the life of the I-bond. The fixed rate and the semi-annual inflation rate are combined each May and November to determine the I-bond's earnings rate for the next six months. The semi-annual inflation rate announced each May measures the inflation from the previous October through March while the infl ation rate announced in November measures the inflation from the previous April through September. The Department of Labor's Bureau of Labor Statistics publishes the CPI-U on a monthly basis. You must hold I-bonds for a minimum of 1 year, but you can hol d them up to the maximum term limit of 30 years. If you sell the I-bond between 1 year and 5 years, there is a 3 month interest penalty for withdrawals. I-bonds are guaranteed by the United States government. You can't loose your principle and will earn a set variable interest rate which changes and is set every 6 months. As of January 1, 2008, the annual limitation on purchases of I -bonds is set at $5,000 per Social Security Number. Under these new rules, an individual can buy a maximum of $5,000 worth o f electronic and paper bonds I-bonds a single calendar year, or a total of $10,000. Previously to this change the limit had been $60,000 ($30,000 of electronic and paper I-bonds each). Electronic I-Bonds can be purchased directly at TreasuryDirect. Paper I-Bonds can be purchased at most local financial institutions. To do so, you must fill out a purchase order and pay for the I-Bond. The I-Bond will then be mailed to you within three weeks. I-Bonds can also be purchased through employer-sponsored payroll savings plans. Contact your employer to see if I-Bonds are available where you work. There is also a new payroll feature at TreasuryDirect which allows you to send funds to your TreasuryDirect account through a direct deposit deduction. I-Bonds can be purchased and owned by U.S. citizens, residents, or worker of any age with a valid U.S. social security number.

The earnings from I-Bonds are exempt from state and local income taxes. 3) If you qualify.20%) and a semi-annual variable inflation rate (currently 0. but the earnings rate is never less than zero.0020 x 0.I-Bond Fixed Rate History I-Bonds are made up of two components: a fixed rate and a variable rate.0174 Composite rate = 1. you can exclude all or part of the interest on I -Bonds from your income as long as the money is used are for eligible college educational institutions.0077) + (0.000 0154] Composite rate = [0. Details are available in IRS Publication 550.0174154] Composite rate = 0. When the inflation rate is less than zero. "Investment Income and Expenses." . 1. or until the time your redeem the I-Bond.74% earnings rate for I-bonds purchasesd from May 2010 through October 2010 applies to their first six months after issue. the I-bond's earnings rate will be less than its fixed rate. 2. these income taxes can be deferred while you still own the bond. I Bond Tax Advantages The I-Bond comes with a few tax advantages. This is how the composite rate for I-bonds issued from May 2010 through October 2010 was calculated: Fixed rate = 0.77%).20% fixed rate of return with the 1.74% The 1. While I-Bond interest is taxed at the Federal level.0154 + 0. Below is the history of the fixed interest rate for I-Bonds: I-Bond Rate Calculation The I-bond rate is calcualted using a combination of the fixed rate (currently 0.20% Semiannual inflation rate = 0. The earnings rate combines a 0.74% annualized rate of inflation as measured by the Consumer Price Index for all Urban Consumers (CPI-U).0020 + 0. That means that Federal taxes can be deferred for up to thirty years.0020 + (2 x 0.0077)] Composite rate = [0. The fixed rate remains with the bond the entire period while the fixed rate is adjusted with inflation every six months.77% Composite rate = [Fixed rate + (2 x Semiannual inflation rate) + (Fixed rate x Semiannual inflation rate)] Composite rate = [0. These together make the Ibond's interest rate.

if you purchased a bond with a par value of $100 for $95. allowing us to see the percentage return: So. he or she must calculate the yield of a bond he or she wants to buy. Because the comparison of the bond price to its par value is a factor that affects the actual current yield. investors can modify the current yield formula by adding the result of the current yield to the gain or loss the price gives the investor: [(Par Value ± Bond Price)/Years to Maturity].unless of course the investor pays par value for the bond.92 and it paid a coupon rate of 5%. you should know how to calculate yield. this yield calculates what percentage the actual dollar coupon payment is of the price the investor pays for the bond. this is how you'd calculate its current yield: Notice how this calculation does not include any capital gains or losses the investor would make if the bond were bought at a discount or premium. The modified current yield formula then takes into account the discount or premium at which the investor bought the bond. This is the full calculation: . So if you want to know what your bond investment will earn. The required yield of a bond is usually the yield offered by other plain vanilla bonds that are currently offered in the market and have similar credit quality and maturity. Calculating Current Yield A simple yield calculation that is often used to calculate the yield on both bonds and the dividend yield for stocks is the current yield. In other words.Advanced Bond Concepts: Yield and Bond Price The general definition of yield is the return an investor will receive by holding a bond to maturity. To correct this. the above formula would give a slightly inaccurate answer . The current yield calculates the percentage return that the annual coupon payment provides the investor. on the other hand. Required yield. Let's proceed and examine these calculations. Once an investor has decided on the required yield. is the yield or return a bond must offer in order for it to be worthwhile for the investor. The multiplication by 100 in the formulas below converts the decimal into a percentage.

If you do. markets is the clean price.92 instead of $100) gives the investor more of a gain on the investment. they are most often referring to the yield to maturity (YTM). but usually the figure quoted in U. is whether you buy the bond between coupon payments.Let's re-calculate the yield of the bond in our first example. remember to use the dirty price in place of the market price in the above equation. however. which matures in 30 months and has a coupon payment of $5: The adjusted current yield of 6. when investors and analysts refer to yield. we would calculate its current yield with the following formula: Calculating Yield to Maturity The current yield calculation we learned above shows us the return the annual coupon payment gives the investor.S.000 that matures in two years and can be currently purchased for $925. For such a bond. One thing to note. The dirty price is what you will actually pay for the bond. which is the interest rate by which the present values of all the future cash flows are . Now we must also account for other factors such as the coupon payment for a zero-coupon bond. but this percentage does not take into account the time value of money or.21% because the bond's discounted price ($95. the yield calculation would be as follows: n = years left until maturity If we were considering a zero-coupon bond that has a future value of $1. which has only one coupon payment.84% is higher than the current yield of 5. For this reason. the present value of the coupon payments the investor will receive in the future. more specifically.

bond prices decrease. To demonstrate this method. YTM is the return the investor will receive from his or her entire investment. If you don't have such a program. As market interest rates increase. which is the interest rate that we are solving for. the par value and capital gains in relation to the price that is paid. remember to think of YTM as the yield a bondholder receives if he or she reinvested all coupons received at a constant interest rate. Discount bond: Coupon rate is less than market interest rates. Thirdly. The charted relationship between bond price and required yield appears as a negative curve: This is due to the fact that a bond's price will be higher when it pays a coupon that is higher than prevailing interest rates. An easy way to think of YTM is to consider it the resulting interest rate the investor receives if he or she invests all of his or her cash flows (coupons payments) at a constant interest rate until the bond matures. we first need to review the relationship between a bond's price and its yield. as a bond's price increases. In general. If we . however.equal to the bond's price.01% change in interest rates. is an interest rate that must be calculated through trial and error. the PVBP measures the degree to which a bond's price will change when there is a 0. It is the return that an investor gains by receiving the present values of the coupon payments. The second concept we need to review is the basic price-yield properties of bonds: Premium bond: Coupon rate is greater than market interest rates. By taking into account factors such as the bond's coupon rate and credit rating. This relationship is measured using the price value of a basis point (PVBP). Such a method of valuation is complicated and can be time consuming. yield decreases. you can use an approximation method that does not require any serious mathematics. so investors (whether professional or private) will typically use a financial calculator or program that is quickly able to run through the process of trial and error. The yield to maturity.

3. Guess and Check: Now for the tough part: solving for ³i. When a bond is priced at par.21% because the bond is priced at $95. 2. 1. Rather than pick random numbers. In total. we can start by considering the relationship between bond price and yield.025*100).50.92.50 (0. If the bond is priced above par (at a . The calculation can be presented as: OR Example 1: You hold a bond whose par value is $100 but has a current yield of 5.´ or the interest rate. plus the future value of $100.were to add the present values of all future cash flows. The bond matures in 30 months and pays a semi-annual coupon of 5%. you would receive five payments of $2. Determine the Cash Flows: Every six months you would receive a coupon payment of $2. the interest rate is equal to the coupon rate. Plug the Known Amounts into the YTM Formula: Remember that we are trying to find the semi-annual interest rate. we would end up with the market value or purchase price of the bond. as the bond pays the coupon semiannually.

we can make another table showing the prices that result from a series of interest rates that go up in increments of 0. If at this point we did not find that 6.92. You can see why investors prefer to use special programs to narrow down the interest rates .1% instead of 1. which gives a price of $95. we can calculate a number of bond prices by plugging various annual interest rates that are higher than 5% into the above formula.the calculations required to find YTM can be quite numerous! Calculating Yield for Callable and Puttable Bonds Bonds with callable or puttable redemption features have additional yield calculations.0% and 7.8%. so the annual interest rate we are seeking (like the current yield) must be greater than the coupon rate of 5%. In our case. and 7%. the bond is priced at a discount from par.92 when we have an interest rate of 6. Below we see the bond prices that result from various interest rates that are between 6.01% increments. the coupon rate is greater than the interest rate. A callable bond's valuations must account for the issuer's ability to call the bond on the call date and the puttable . Here is a table of the bond prices that result from a few different interest rates: Because our bond price is $95. Now that we have found a range between which the interest rate lies. we would have to make another table that shows the interest rates in 0.premium).0%: We see then that the present value of our bond (the price) is equal to $95. our list shows that the interest rate we are solving for is between 6%. which gives a price of $98.0%.8% gives us the exact price that we are paying for the bond. Now that we know this.

Yield to call is the rate that would make the bond's present value equal to the full price of the bond. Essentially. To calculate yield to put. The yield for callable bonds is referred to as yield-to-call. which is commonly used by conservative investors when calculating their expected yield. For both callable and puttable bonds. . Yield to put (YTP) is the interest rate that investors would receive if they held the bond until its put date. these yield figures do not account for bonds that are not redeemed or are sold prior to the call or put date. and then use these figures to estimate the expected yield. The lowest yield calculated is known as yield to worst. Unfortunately. With lending a large asset. its calculation requires two simple modifications to the yield-to-maturity formula: Note that European callable bonds can have multiple call dates and that a yield to call can be calculated for each. the same modified equation for yield to call is used except the bond put price replaces the bond call value and the time until put date replaces the time until call date. the lender m ay have been able to generate income from the asset should they have decided to use it themselves. and the yield for puttable bonds is referred to as yield-to-put. The period until the first call is referred to as the call protection period. Now you know that the yield you receive from holding a bond will differ from its coupon rate because of fluctuations in bond price and from the reinvestment of coupon payments. In addition. the lender could have invested the funds instead of lending them out. Yield to call (YTC) is the interest rate that investors would receive if they held the bond until the call date. you are now able to differentiate between current yield and yield to maturity. astute investors will compute both yield and all yield-tocall/yield-to-put figures for a particular bond. Interest Rate Interest is charged by lenders as compensation for the loss of the asset's use. In the case of lending money. Using the simple interest formula: Simple Interest = P ( principal ) x I (annual interest rate) x N (years) Borrowing $1. or yield curve.bond's valuation must include the buyer's ability to sell the bond at the pre-specified put date. In our next section we will take a closer look at yield to maturity and how the YTMs for bonds are graphed to form the term structure of interest rates.000 at a 6% annual interest rate for 8 months means that you would owe $40 in interest (1000 x 6% x 8/12).

the disparity between the two types of interest calculations grows.70.1 ] Borrowing $1. The interest owed when compounding is taken into consideration is higher.Using the compound interest formula: Compound Interest = P (principal) x [ ( 1 + I(interest rate) N (months) . though.000 at a 6% annual interest rate for 8 months means that you would owe $40. As the lending time increases. . because interest has been charged monthly on the principal + accrued interest from the previous months. For shorter time frames. the ca lculation of interest will be similar for both methods.

Actual/Actual Day Count (Non-leap year) Actual/Actual Day Count (Leap year) Bond Price 30/360 Day Count Accrued Interest (AI) Adjusted Current Yield Current Yield Key Rate Duration Macaulay Duration .Below is our formula cheat sheet for bond analysis.

Modified Duration Yield Yield to Call Yield to Put Zero Coupon Bond Price .

. which is a series of fixed payments at set intervals over a fixed period of time. If the bond's price is higher than its par value. In this section. however. given the bond's coupon rate in comparis to on the average rate most investors are currently receiving in the bond market. Usually the required yield on a bond is equal to or greater than the current prevailing interest rates. or required yield M = value at maturity.) The first payment of an ordinary annuity occurs one interval from the time at which the debt security is acquired. refer to Understanding the Time Value of Money. it will sell at a premium because its interest rate is higher than current prevailing rates. or par value The succession of coupon payments to be received in the future is referred to as an ordinary annuity.Bond Pricing Printer friendly version (PDF format) It is important for prospective bond buyers to know how to determine the price of a bond because it will indicate the yield received should the bond be purchased. For bond pricing. The calculation assumes this time is the present. Calculating bond price is simple: all we are doing is discounting the known future cash flows. you are calculating the maximum price you would want to pay for the bond. which uses the basic present value (PV) formula: C = coupon payment n = number of payments i = interest rate. Bonds can be priced at a premium. (Coupons on a straight bond are paid at ordinary annuity. we will run through some bond price calculations for various types of bond instruments. this interest rate is the required yield. If the bond's price is lower than its par value. the price of a bond is the sum of the present values of all expected coupon payments plus the present value of the par value at maturity. When you calculate the price of a bond.) Here is the formula for calculating a bond's price. Remember that to calculate present value (PV) which is based on the assumption that each payment is re-invested at some interest rate once it is received--we have to know the interest rate that would earn us a known future value. discount. Fundamentally. or at par. the bond will sell at a discount because its interest rate is lower than current prevailing interest rates. (If the concepts of present and future value are new to you or you are unfamiliar with the calculations. Required yield or required rate of return is the interest rate that a security needs to offer in order to encourage investors to purchase it.

(For more on calculating the time value of annuities. The farther into the future a payment is to be received. however. Because these payments are paid at an ordinary annuity. ) By incorporating the annuity model into the bond pricing formula. we arrive at the following formula: . but unlike the bond-pricing formula we saw earlier. This PV-of-ordinaryannuity formula replaces the need to add all the present values of the future coupon. two and three.You may have guessed that the bond pricing formula shown above may be tedious to calculate. the less it is worth today . it doesn't require that we add the value of each coupon payment. The following diagram illustrates how present value is calculated for an ordinary annuity: Each full moneybag on the top right represents the fixed coupon payments (future value) received in periods one. It calculates the sum of the present values of all future cash flows.is the fundamental concept for which the PV-of-ordinaryannuity formula accounts. see Anything but Ordinary: Calculating the Present and Future Value of Annuities and Understanding the Time Value of Money. we can use the shorter PV-of-ordinary-annuity formula that is mathematically equivalent to the summation of all the PVs of future cash flows. which requires us to also include the present value of the par value received at maturity. as it requires adding the present value of each future coupon payment. Notice how the present value decreases for those coupon payments that are further into the future the present value of the second coupon payment is worth less than the first coupon and the third coupon is worth the lowest amount today.

4.05). a coupon rate of 10%. each semi-annual coupon payment will be $50 ($1. because investors can make a larger return in the market. Here are the steps we have to take to calculate the price: 1. Determine the Semi-Annual Yield: Like the coupon rate. In other words. who could find higher interest elsewhere in the prevailing rates. and a required yield of 12%. Determine the Number of Coupon Payments: Because two coupon payments will be made each year for ten years. the required yield of 12% must be divided by two because the number of periods used in the calculation has doubled. we will have a total of 20 coupon payments. If we left the required yield at 12%. In our example we'll assume that coupon payments are made semi-annually to bond holders and that the next coupon payment is expected in six months.000 X 0.000 to be paid in ten years. 3.12/2). The bond must sell at a discount to attract investors. divide the coupon rate in half. the bond price is less than its par value because the required yield of the bond is greater than the coupon rate. the required semiannual yield is 6% (0. The coupon rate is the percentage off the bond's par valu As e. Determine the Value of Each Coupon Payment: Because the coupon payments are semiannual. we have determined that the bond is selling at a discount. Example 1: Calculate the price of a bond with a par value of $1. a result. they need an extra incentive to invest in the bonds. Therefore. . Plug the Amounts Into the Formula: From the above calculation. 2.Let's go through a basic example to find the price of a plain vanilla bond. our bond price would be very low and inaccurate.

Therefore. Therefore. Determine the Yield: The required yield of 6% must also be divided by two because the number of periods used in the calculation has doubled.000 and a required yield of 6%. which represents the frequency of coupon payments. 1. or the number of times a year the coupon is paid. Determine the Number of Periods: Unless otherwise indicated. F would have a value of one. F would be two. Should a bond pay qu arterly payments. This is because the interest on a zerocoupon bond is equal to the difference between the purchase price and maturity value. so the 6% required yield must be adjusted to the equivalent of its semi-annual coupon rate. the number of periods for zero-coupon bonds will be doubled. there is no coupon payment until maturity.Accounting for Different Payment Frequencies In the example above coupons were paid semi-annually. A simple modification of the above formula will allow you to adjust interest rates and coupon payments to calculate a bond price for any payment frequency: Notice that the only modification to the original formula is the addition of "F". so the zero coupon bond maturing in five years would have ten periods (5 x 2). and if the bond paid semi-annual coupons. Here's a simple example: Example 2(a): Let's look at how to calculate the price of a zero-coupon bond that is maturing in five years. Plug the amounts into the formula: . You simply calculate the present value of the par value at maturity. Because of this. 3. but we need a way to compare a zero-coupon bond to a coupon bond. which are required if the coupon payments occur more than once a year. F would equal four. the required yield of most zerocoupon bonds is based on a semi-annual coupon payment. for bonds paying annual coupons. has a par value of $1. The yield for this bond is 3% (6% / 2). Pricing Zero-Coupon Bonds So what happens when there are no coupon payments? For the aptly-named zero-coupon bond. so we divided the interest rate and coupon payments in half to represent the two payments per year. You may be now wondering whether there is a formula that does not require steps two and three outlined above. 2. the present value of annuity formula is unnecessary.

Pricing Bonds between Payment Periods Up to this point we have assumed that we are purchasing bonds whose next coupon payment occurs one payment period away. the total number of days in a year is 366 rather than 365. he or she must be compensated for the interest accrued on the bond over these 60 days. and its next coupon payment is in four months (July 1. one month. if we were to price a bond that pays semi-annual coupons and we purchased the bond today. Determining Day Count To price a bond between payment periods. it's important you know how to calculate price if. 60 days of the payment period (182 . There is actual/actual day count. according to the regular payment-frequency pattern. In these six months there are exactly 182 days. Day count is a way of measuring the appropriate interest rate for a specific period of time. our calculations would assume that we would receive the next coupon payment in exactly six months. so the day count of the Treasury bond would be 122/182. we must also know the number of days in the six-month period of the regular payment cycle. In other words. or 21 days. which is much . (Note that if it is a leap year. This method counts the exact number of days until the next payment. because you won't always be buying a bond on its coupon payment date. For example.) For municipal and corporate bonds. a semi-annual bond is paying its next coupon in three months. 2003).122) have already passed. So far. the next coupon payment would be in 122 days: Time Period = Days Counted March 1-31 = 31 days April 1-30 = 30 days May 1-31 = 31 days June 1-30 = 30 days July 1 = 0 days Total Days = 122 days To determine the day count. 2003. investors would have no way of making money from them and therefore no incentive to buy them. we must use the appropriate day-count convention. you would use the 30/360 day count convention. if you purchased a semi-annual Treasury bond on March 1. the bond still has 122 days before the next coupon payment.You should note that zero-coupon bonds are always priced at a discount: if zero-coupon bonds were sold at par. which means that out of the 182 days in the six -month period. If the bondholder sold the bond today. say. which is used mainly for Treasury securities. Of course.

Time Period = Days Counted March 1-30 = 30 days April 1-30 = 30 days May 1-30 = 30 days June 1-30 = 30 days July 1 = 0 days Total Days = 120 days As a result. the bond prices quoted are often clean prices. What is the interest accrued on the bond? 1. the next coupon payment would be in 120 days. The following example will make this concept more clear." Dirty bond prices include any accrued interest that has accumulated since the last coupon payment while clean bond prices do not. according to the 30/360 day count.000 X 0. Notice that we end up with almost the same answer as the actual/actual day count convention above: both day-count conventions tell us that 60 days have passed into the payment period. As an example.000 and a 7% coupon paid semi-annually. the bond seller must be compensated for the portion of the coupon payment he or she earns for holding the bond since the last payment.7% of the coupon period remains. is equal to six months. which gives a rate of 3. assume the above Treasury bond was actually a semi-annual corporate bond. is expected on June 30.035). Time Period = Days Counted March 1-30 = 30 days April 1-30 = 30 days May 1-30 = 30 days June 1-30 = 30 days Total Days = 120 days There are 120 days remaining before the next coupon payment. divide the coupon rate in half. but because the coupons are paid semi-annually (two times a year). the regular payment period if the bond is 180 days. which means that 66. In newspapers. In this case. because many of the bonds traded in the secondary market are often traded in between coupon payment dates. Each semi-annual coupon payment will then be $35 ($1. Francesca is selling a corporate bond with a face value of $1. Determining Interest Accrued Accrued interest is the fraction of the coupon payment that the bond seller earns for holding the bond for a period of time between bond payments. The seller. 2003. Determine the Semi-Annual Coupon Payment: Because the coupon payments are semi-annual. The bond price's inclusion of any interest accrued since the last payment period determines whether the bond's price is "dirty" or "clean. The next coupon payment after March 1. 2003. This count convention assumes that a year consists of 360 days and each month consists of 30 days. 2. therefore. has accumulated 60 . the day count convention would be 120/180. we will use the 30/360 day-count convention. However. 2003. Determine the Number of Days Remaining in the Coupon Period: Because it is a corporate bond.5% (7% / 2). The amount of the coupon payment that the buyer should receive is the coupon payment minus accrued interest. which.simpler as there is no need to remember the actual number of days in each year and month. Example 3: On March 1.

If the buyer only paid her the clean price. 3. Calculate the Accrued Interest: Accrued interest is the fraction of the coupon payment that the original holder (in this case Francesca) has earned. she would not receive the $11.67. regardless of when its next coupon will be paid. the interest accrued by Francesca is $11. In addition.days worth of interest (180-120). required yield and price as well as the reasons for which bond prices change in the market . both buyers and sellers should understand the amount for which a bond should be sold or purchased.67 to which she is entitled for holding the bond for those 60 days of the 180-day coupon period. It is calculated by the following formula: In this example. Bond price quotes are typically the clean prices. but buyers of bonds pay the dirty. As a result. or full price. the tools you learned in this section will better enable you to learn the relationship between coupon rate. Now you know how to calculate the price of a bond.

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