FINA 2303 Chapter 6 Bonds Part1 Spring 2023

FINA 2303 Spring 2023
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Bonds (Part 1)
Bond is (debt) security sold by governments and corporations to raise money
from investors today in exchange for a promised future payment.
The bond certificate indicates

 Principle or par value
 Coupon rate
 Maturity date
Ekkachai Saenyasiri Page 1 2/25/2023

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Coupon

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Bonds usually pay fixed coupon (interest) payments at fixed interval (usually
every six months) and pay the par value at maturity.
$$$
0 1 2 …. Maturity
Corporation
Cash
Investors
Securities (Bonds, IPOs)
c c c c c c + par
0 1 2 …. Maturity
Date

______________________________________________________
Par value =Facevalue

= the notional amount of the bond, which is paid to bondholders at
maturity (assume $1,000 if not told otherwise)
Couponinterest rate = % APR of par value of the bond that will paid out
periordically(generally fixed rate)
Maturity date = the Final repayment date of the bond.
$C $C $C $C $C $C+ $Par
0 1 2 …. Maturity
Date

______________________________________________________
Why study bond markets?
https://www.sifma.org/wp-content/uploads/2020/09/US-Fact-Book-2021-SIFMA.pdf

______________________________________________________

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Global Bond Market Outstanding – Market Value

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Global Equity Markets Capitalization – Market Value

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Bond ratings
Investment Grade Junk Bonds

(speculative, high yield)
Moody’s Aaa Aa A Baa Ba B Caa C
S&P AAA AA A BBB BB B CCC D
Bond ratings are designed to reflect the probability of a bond issue going into
default.
The ratings also reflect the bondholder’s ability to lay claim to the firm’s assets
in the event of bankruptcy

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Source: S&P Default, Transition, and Recovery: 2019 Annual Global Corporate Default Study and Rating Transitions
______________________________________________________

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https://www.macrotrends.net/2016/10‐year‐treasury‐bond‐rate‐yield‐chart

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U.S. Treasury Securites
Three types of U.S. Treasury securities are currently traded in financial markets:
 Treasury bills (T-bills) – original maturities from 4, 13, 26 and 52 weeks 

zero coupon
 Treasury notes (T-Notes) - original maturities from two to ten years (2, 3,
5, 7 and 10 years)  coupon bonds
 Treasury bonds (T-Bonds) - original maturities of more than ten years 

coupon bonds

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Bond Valuation
$C $C $C $C $C $C+ $Par
0 1 2 3 4 …. n PV = C/(1+r)n
The value of a bond is the present value both of couponsto be received

and the par value of the bond.
n C  Par
Intrinsic value of bond = Pr ice   t 

 t 1 1  r   1  r 
n
 C C C C  Par
Pr ice      ....   
 1  r  1  r  1  r  1  r n  1  r n
2 3
  1 
 1   
  (1  r ) n    FaceValue
Pr ice   C  
 r  1  r n
; when r = rate of return of bond
 
 
r = YTM = Yield to Maturity
n = number of coupons
to be received
______________________________________________________
.
Yield to Maturity (YTM)
  1 
 1   
  (1  r ) n    FaceValue
Pr ice   C  
 r  1  r n
 
 
  1 
 1  
n 
 (1  YTM )   FaceValue
Pr ice   C    
 YTM  1  YTM n
YTM = IRR of bond
 
 
YTM is the discount rate that sets

“PV of payments from bond = Current market price of the bond”

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Example: Suppose a firm decides to issue 20-year bonds with a par value of $1,000 and
annual coupon payments. Suppose that YTM = 12% APR
If the firm decides to offer a 12% coupon interest (APR), what would be a fair price for
these bonds.
Coupon = coupon rate  par value = 12%  $1,000 = $120 per year
$120 $120 $120 $120 $120 $120+ $1,000
0 1 2 3 4 …. 20
1 𝑃𝑎𝑟 1 1000
.
Bond Price 𝐶 120 1000
𝑟 1 𝑟 0.12 1 0.12
If “coupon rate = YTM”, bond will be sold for par value

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Suppose interest rate falls immediately after we issued the bonds. YTM drops to 10%.
What would happen to the bond’s intrinsic value?
When YTM = 10%. Coupon = coupon rate  par value = 12%  $1,000 = $120
  1 
 1  
  (1  r ) n 
   Par
Bond price   C  
 1  r 
n
 r
 
 
  1 
 1  
  20 
(1  0.10)   1000
Bond price = 120    = 1,021.628 + 148.644 = 1,170.27

 0. 10 
 1  0.10  20
 
 
Note: If interest rate falls, bond price rises.

If the coupon rate > YTM, bond will be sold for a premium (higher than par value)
Given your required return = 10%, the max price you will pay for this bond is $1,170.27

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What if YTM = 14%
Coupon = coupon rate  par value = 12%  $1,000 = $120

  1  
 1  
  (1  r ) n  
   Par
Bond price   C  
 1  r 
n
 r
 
 
  1 
 1  
20 
  (1  0.14)    1000
120 
Bond price= =  0 .14 
1  0 .14 20 794.77 + 72.76 = 867.53
 
 
 
Note:
If interest rate rises, bond price falls.
If the coupon rate <YTM, bond will be sold for a discount (lower than par value)
Given your required return = 14%, the max price you will pay for this bond is $867.53

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Example: When YTM = 10% and coupon rate is 12% and paid semi-annually.
Coupon Rate  Par Value 12%  1,000

Coupon = = = = $60 paid every six months
2 2
Discount rate = 5% per six month, n = 40
$60 $60 $60 $60 $60 $60+ $1,000
0 0.5 1 1.5 2 …. 20
  1 
 1  
  
 (1  0.05)  
40
1000
Bond price =  60   = 1,029.545 + 142.046 = 1,171.59
 1  0.05
0.05 40

 
 

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Example: When YTM = 14% and coupon rate is 12% and paid semi-annually.

Coupon = = = = $60 paid every six months.
2 2
Discount rate = 7% per six months, n = 40
$60 $60 $60 $60 $60 $60+ $1,000
0 0.5 1 1.5 2 …. 20
  1 
 1  
  
 (1  0.07)  
40
1000
Bond price =  60   = 799.903 + 66.78 = 866.68
 1  0.07 
0.07 40

 
 

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Zero-Coupon Bonds
(Pure Discount Bonds)
/
𝐵𝑜𝑛𝑑 𝑃𝑟𝑖𝑐𝑒 1 𝑌𝑇𝑀
Suppose that we have four zero-coupon risk-free bonds are trading at prices
below. Face value = $100. Each bond has different maturity date as follow
Maturity (Years) Price

Bond #1 1 96.62
Bond #2 2 92.45
Bond #3 3 87.63
Bond #4 4 83.06
Compute YTM (the rate of return from each bond)

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96.62 100
Bond #1 96.62  3.5%
t =0 t =1 per year
92.45 100
Bond #2 92.45  4.0%
t =0 t =2 per year
87.63 100
Bond #3 87.63  4.5%
t =0 t =3
per year
83.06 100
Bond #4 83.06  4.75%
t =0 t =4
per year

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Zero-Coupon Yield Curve
From the example above

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Given the yield curve in the previous page, what is the price of a 1-year risk-free zero-
coupon bond with a face value of $500?
Given the law of one price, the rate of return of this risk-free bond must be the same as
the rate of return of all other zero-coupon risk-free bonds with the same maturity  3.5%
𝐹𝑎𝑐𝑒 𝑉𝑎𝑙𝑢𝑒
𝐵𝑜𝑛𝑑 𝑃𝑟𝑖𝑐𝑒
1 𝑌𝑇𝑀
𝐵𝑜𝑛𝑑 𝑃𝑟𝑖𝑐𝑒 = 483.10

. %
If investors pay 483.09 for this bond at time 0, the investor will get 3.5% rate of return
until maturity
If the amount you pay for the bond = PV of CFs from the bond (483.09)  your rate of
return will be the same as the discount rate (3.5%).
Note that if you buy five zero-coupon risk-free bonds with face value 100  5 × 96.62 = 483.1
You will pay in total the same price as one zero-coupon risk-free bonds with face value 500

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Example: Suppose your firm decides to issue 1-year zero coupon bonds with a
par value of $1,000. What would be a fair price of these bonds if YTM = 5%?
How about 10% or 20%?
$1,000
0 1
,
When required return = 5%, 𝐵𝑜𝑛𝑑 𝑃𝑟𝑖𝑐𝑒 = 952.380
%
,
%
,
%
When interest rate falls, bond price rises

When interest rate rises, bond price falls

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Key Points
 Coupon, par value and maturity date do not change over time. These terms
are determined at the beginning when the bond is sold by issuer.
 Bond price changes when YTM changes in opposite direction
 If YTM< coupon rate, then bond price > par value. Premium
 If YTM = coupon rate, then bond price = par value. Par
 If YTM > coupon rate, then bond price < par value. Discount

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Bondholders’Expected Rate of Return

(Yield to Maturity, YTM)
Yield to maturity is the rate of return implied by the current bond price.
Given market value of bond  we can compute YTM

 we can compute the rate of return if we buy the bond at
the market price
Assume that
a) no default
b) the bond is held to maturity

______________________________________________________
  1 
 1  
n
 (1  YTM )  
 C  
Par
MarketValuebond    Compute for YTM,
 YTM  1  YTM n
given bond price, C, Par, n
 
 
Compute for the rate of return (YTM) that equates the present value of the future cash
flows (interest and par value) with the market price of the bond.
YTM of a bond is the IRR of that bond
-Price $C $C $C $C $C $C+ $Par
0 1 2 …. Maturity
Date

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Example: Suppose we paid $899 for a $1,000 par 10% coupon bond with 8 years to
maturity and semi-annual coupon payments. What is the yield to maturity of this bond?
Quoted price = 89.9  bond price is quoted per $100 face value
  1 
 1  
n
 (1  YTM )  
 C  
Par
MarketValuebond  
 YTM  1  YTM n
 
 
  
  
 1 1 
  YTM 16  
  (1 ) 
 2  1000
50  16

899= 
YTM   YTM 
2  1 
   2 
 
 
$50 = the coupon paid every half year  so we have to use half year rate of return  YTM/2
Solve for YTM using trial and error.

______________________________________________________
Note that this bond is sold at discount  YTM must be higher than coupon rate
If the discount rate = 13% per year
  1 
 1  
16 
Bond price =  50   (1  0.065)    1000 = 853.48
 
 1  0.065
16
0.065

 
 
853.48 < 899
This implies that 13% discount rate is too high.

______________________________________________________
If the discount rate = 10% per year
  1 
 1  
  (1  0.05)16  
Bond Price =  50     1000 = 1,000

 1  0.05
0 . 05 16

 
 
1,000 > 899
This implies that 10% discount rate is too low.

______________________________________________________
If discount rate = 12% per year and coupons are semi-annual
  1 
 1  
  (1  0.06)  
16
1000
Bond price =  50    = 899 = market price of the bond

 1  0.06 
0.06 16

 
 
𝑌𝑇𝑀
6%
2
The YTM of this bond is 12% per year  YTM = 12%
Use financial calculator
FV = 1000, PMT = 50 per 6 months, n = 16, PV = -899  I/Y = 6% per 6 months

 YTM = 6% * 2 = 12% per year

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Bond Prices & Interest Rates
Reminder
𝐹𝑉
PV
1 𝑟
1 𝑃𝑎𝑟
Bond Price 𝐶
𝑟 1 𝑟
Bond prices move inverselyto interest rates.
 If interest rate increases, the value of the bond decreases.
 If interest rate decreases, the value of the bond increases.
If you expect interest rates to fall tomorrow, what should you do today?

______________________________________________________
A 5-year 8% semiannual coupon bond is being sold at $1000 (market price = par)  offers 8% YTM.
What if a) interest rates rises to 9% b) interest rates drop to 7%

.
40 = 960.44
. .

______________________________________________________
Example: 20-year bond with a par value of $1,000. YTM = 14% and coupon rate is 12%
paid semi-annually.

2 2
Discount rate = 7% per six months, n = 40
$60 $60 $60 $60 $60 $60+ $1,000
0 0.5 1 1.5 2 …. 20
  1 
 1  
  
 (1  0.07)  
40
1000
Bond price =  60   = 799.903 + 66.78 = 866.68
 1  0.07 
0.07 40

 
 

______________________________________________________
What is the price of 20-year bond 1 years after issued, assume YTM = 14% per year and
coupon rate is 12% paid semi-annually. Par value = 1,000.
Value of the bond, after
issued for 1 year
$60 $60 $60 $60 $60 $60 $60+ $1,000
0 0.5 1 1.5 2 2.5 3 3.5 4 20

2 2
Discount rate = 7% per six months, n = 38  Number of coupons to be received in the future
  1 
 1  
  (1  0.07 ) 38 
  1000
 60  
 1  0.07 
38
Price after issued for 1 year =  0.07 = 791.608+ 76.457 =868.065
 
 
(Price excluded the
coupon on the payout
date)  Clean price
______________________________________________________
What is the price of 20-year bond 2 years after issued, assume YTM = 14% per year and
coupon rate is 12% paid semi-annually. Par value = 1,000.
Value of the bond, after
issued for 2 years
$60 $60 $60 $60 $60+ $1,000
0 0.5 1 1.5 2 2.5 3 3.5 4 20

2 2
Discount rate = 7% per six months, n = 36  Number of coupons to be received in the future
  1 
 1  
  
 (1  0.07)  
36
1000
Price after issued for 2 years =  60    = 782.112 + 87.535 = 869.65
 1  0.07
0.07 36

  (Price excluded the
  coupon on the payout
date)  Clean price

______________________________________________________
From the previous example, assuming that YTM =14% from time 0 to time 1,
what will be your rate of return if you buy the bond at time 0 and sell it at time 1?
+868.065
- 866.68 $60 $60
0 0.5 1 1.5 2 2.5 3 3.5 4 20
Computer IRR (i.e., realized rate of return) of the time line above
PV = -866.68
PMT = 60 per 6 months
n = 2 periods (6 months each)
FV = 868.065
Compute I/Y = 7% per six months 7% *2 = 14% rate of return per year

______________________________________________________
From the previous example, assuming that YTM =14% from time 0 to time 2,
what will be your rate of return if you buy the bond at time 0 and sell it at time 2?
+869.65
- 866.68 $60 $60 $60 $60
0 0.5 1 1.5 2 2.5 3 3.5 4 20
Computer IRR (i.e, realized rate of return) of the time line above
PV = -866.68
FV = 869.65
Compute I/Y = 7% per six months 7% *2 = 14% rate of return per year
If you sell a bond before its maturity date, you can earn the same rate of return
(14%) as the original YTM (14%) only if YTM at the moment you buy is the same
as YTM at the moment you sell.

______________________________________________________
From the previous example, assuming that YTM =16% at time 2, what will be
your rate of return if you buy the bond at time 0 when YTM = 14% and sell it at
time 2 when YTM = 16%?
Compute bond price at time 2.

PMT = 60, n = 36, FV = 1000, I/Y = 16%/2 = 8%  Price at time 2 = 765.656
+765.656
- 866.68 $60 $60 $60 $60
0 0.5 1 1.5 2 2.5 3 3.5 4 20

PV = -866.68
FV = 765.656
Compute I/Y = 4.185% per six months 4.185% * 2 = 8.37% per year
If you sell a bond before its maturity date, your realized rate of return (8.37%)
may differ from the original YTM (14%) when you purchased the bond.

______________________________________________________
From the previous example, what will be your rate of return if you buy the bond at
time 0 when YTM = 14% and sell it at maturity date?
+1,000
- 866.68 $60 $60 $60 $60 $60 $60 $60 $60 … $60
0 0.5 1 1.5 2 2.5 3 3.5 4 20
PV = -866.68
FV = 1,000 (at maturity, FV = 1,000 regardless of YTM at that time).
Compute I/Y = 7% per six months  7% * 2 = 14% rate of return per year
If you sell a bond at its maturity date, regardless of the YTM at the maturity date,
your realized rate of return will be the same as the original YTM (14%) when you
purchased the bond.

FINA 2303 Chapter 6 Bonds Part1 Spring 2023

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FINA 2303 Chapter 6 Bonds Part1 Spring 2023

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FINA 2303 Spring 2023

The bond certificate indicates

Ekkachai Saenyasiri Page 1 2/25/2023

Ekkachai Saenyasiri Page 2 2/25/2023

Securities (Bonds, IPOs)

Ekkachai Saenyasiri Page 3 2/25/2023

Par value =Facevalue

Maturity date = the Final repayment date of the bond.

Ekkachai Saenyasiri Page 4 2/25/2023

Why study bond markets?

Ekkachai Saenyasiri Page 5 2/25/2023

Ekkachai Saenyasiri Page 6 2/25/2023

Global Bond Market Outstanding – Market Value

Ekkachai Saenyasiri Page 7 2/25/2023

Global Equity Markets Capitalization – Market Value

Ekkachai Saenyasiri Page 8 2/25/2023

Ekkachai Saenyasiri Page 9 2/25/2023

Investment Grade Junk Bonds

Moody’s Aaa Aa A Baa Ba B Caa C

S&P AAA AA A BBB BB B CCC D

Ekkachai Saenyasiri Page 10 2/25/2023

Ekkachai Saenyasiri Page 12 2/25/2023

Ekkachai Saenyasiri Page 13 2/25/2023

 Treasury bills (T-bills) – original maturities from 4, 13, 26 and 52 weeks 

 Treasury bonds (T-Bonds) - original maturities of more than ten years 

Ekkachai Saenyasiri Page 14 2/25/2023

The value of a bond is the present value both of couponsto be received

YTM is the discount rate that sets

Ekkachai Saenyasiri Page 16 2/25/2023

$120 $120 $120 $120 $120 $120+ $1,000

If “coupon rate = YTM”, bond will be sold for par value

Ekkachai Saenyasiri Page 17 2/25/2023

Note: If interest rate falls, bond price rises.

Ekkachai Saenyasiri Page 18 2/25/2023

What if YTM = 14%

Coupon = coupon rate  par value = 12%  $1,000 = $120

Ekkachai Saenyasiri Page 19 2/25/2023

Coupon Rate  Par Value 12%  1,000

Discount rate = 5% per six month, n = 40

$60 $60 $60 $60 $60 $60+ $1,000

Ekkachai Saenyasiri Page 20 2/25/2023

Coupon Rate  Par Value 12%  1,000

Discount rate = 7% per six months, n = 40

$60 $60 $60 $60 $60 $60+ $1,000

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Maturity (Years) Price

Compute YTM (the rate of return from each bond)

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𝐵𝑜𝑛𝑑 𝑃𝑟𝑖𝑐𝑒 = 483.10

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When interest rate falls, bond price rises

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 Bond price changes when YTM changes in opposite direction

 If YTM = coupon rate, then bond price = par value. Par

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Bondholders’Expected Rate of Return

Given market value of bond  we can compute YTM

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YTM of a bond is the IRR of that bond

-Price $C $C $C $C $C $C+ $Par