Bonds

IN-4232

Otoño 2023
Overview
Motivation
What is a bond and what are its features?
Who issues bonds?
Corporate bonds versus Sovereign bonds
Bonds and the risk of default
Valuing bonds
Spot rates, term structure, yield curve
Macaulay and modified duration and convexity of a bond
Real and nominal interest rates
Forward rates

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Motivation
Investment in physical capital requires money. Sometimes firms can
retain and accumulate earnings to cover the costs of investment, but
often they need to raise extra cash from investors.

▪ Equity Capital
▪ Banks (Short-term loans)
▪ Debt Capital (Bonds)

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What is a Bond and What are its Features?
A bond is a security (instrumento de deuda) that obligates the issuer to
make interest and principal payments to the holder on specific dates:

▪ Maturity: Due date on which a bond must be paid in full

▪ Face value (or par): The amount used to compute interest payments.
▪ Coupon rate: Determines the amount of each coupon payment,
expressed as an Annual Percentage Rate (APR)

𝐶𝑜𝑢𝑝𝑜𝑛 𝑟𝑎𝑡𝑒 𝑥 𝐹𝑎𝑐𝑒 𝑣𝑎𝑙𝑢𝑒

𝐶𝑜𝑢𝑝𝑜𝑛 =
𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑐𝑜𝑢𝑝𝑜𝑛 𝑝𝑎𝑦𝑚𝑒𝑛𝑡𝑠 𝑝𝑒𝑟 𝑦𝑒𝑎𝑟

Bonds differ in several aspects:

▪ Issuer
▪ Maturity
▪ Rating
▪ Priority in case of default

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5
6
7
Characteristics of a Bond

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 Industry Overview

Fixed-Income Market Participants

Investors:
Issuers:
Intermediaries: ▪ Governments
▪ Governments
▪ Primary Dealers ▪ Pension Funds
▪ Corporations
▪ Other Dealers ▪ Insurance Companies
▪ Commercial Banks
▪ Investment Banks ▪ Commercial Banks
▪ States
▪ Credit-rating Agencies ▪ Mutual Funds
▪ Municipalities
▪ Credit Enhancers ▪ Hedge Funds
▪ SPVs
▪ Liquidity Enhancers ▪ Foreign Institutions
▪ Foreign Institutions
▪ Individuals

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Who Issues Bonds?

Corporations (CMPC, CODELCO)

Banks

Central Banks (FED, BCCH)

Governments (Government of Chile)

Municipalities or States (State of California)

Agencies (Fannie Mae)

International organizations (World Bank)

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Domestic Bonds

Domestic bonds are bonds denominated in the currency of the country in

which it is issued, and where the entire process (from issuance to
redemption) is regulated under that country's laws.

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International Bonds

International bonds are commonly divided into two categories,

foreign bonds and Eurobonds.

Foreign bonds: Bonds issued by a borrower from a country other

than the one in which the bond is sold. The bond is denominated
in the currency of the country in which it is marketed. Example are
Yankee bonds, Samurai bonds, Huaso bonds.

Eurobonds: Bonds are in a currency not native to the country

where it is issued, usually that of the issuer, but sold in another
national market. For example, dollar or yen denominated bonds
sold outside the U.S. or Japan (not just in Europe).

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Corporate Bonds versus Sovereign Bonds

Usually, corporate bonds are more complex securities than government

bonds:

• A corporation may not be able to come up with the money to pay its
debts, so investors have to worry about default risk.
• Corporate bonds are also less liquid than government bonds: they are
not as easy to buy or sell, particularly in large quantities or on short
notice.
• Some corporate bonds give the borrower an option to repay early;
others can be exchanged for the company´s common stock.

All of these complications affect the spread of corporate bond rates over
interest rates on government bonds of similar maturities.

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Repayment Schemes

Bonds with a bullet payment

▪ Zero-coupon bonds: Pay no coupon prior to maturity
▪ Coupon bonds: Pay a stated coupon at periodic intervals prior to
maturity
▪ Floating-rate bonds: Pay a variable coupon, reset periodically to a
reference rate

Bonds without a bullet payment

▪ Perpetual bonds: Pay a stated coupon at periodic intervals
▪ Annuity or self-amortizing bonds: Pay a regular fixed amount each
payment period. Principal repaid over time rather than at maturity.

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Valuation
Cashflow:
▪ Maturity (T)
Example. A 3-year bond with principal of $1,000
▪ Coupon (c) and annual coupon payment of 5% has the
▪ Principal (F) following cashflow:

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Valuation
Components of Valuation
▪ Time value of principal and coupons
▪ Risks
– Inflation
– Credit
– Timing (callability)
– Liquidity
– Currency

For Now, Consider Riskless Debt Only

▪ Government debt (is it truly riskless?)
▪ Consider risky debt later

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Valuation

The value of a bond is the present value of its cash flows

𝑇
𝑐 𝐹
𝑉0 = ෍ +
(1 + 𝑟0,𝑡 )𝑡 (1 + 𝑟0,𝑇 )𝑇
𝑡=1

Where:

𝑉0 = 𝑀𝑎𝑟𝑘𝑒𝑡 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑏𝑜𝑛𝑑 𝑖𝑛 𝑝𝑒𝑟𝑖𝑜𝑑 0

𝐹 = 𝐹𝑎𝑐𝑒 (𝑝𝑟𝑖𝑛𝑐𝑖𝑝𝑎𝑙) 𝑣𝑎𝑙𝑢𝑒
𝑟0,𝑡 = 𝐷𝑖𝑠𝑐𝑜𝑢𝑛𝑡 𝑟𝑎𝑡𝑒 𝑜𝑛 𝑝𝑒𝑟𝑖𝑜𝑑 𝑡 𝑎𝑡 𝑝𝑒𝑟𝑖𝑜𝑑 0
T = 𝑀𝑎𝑡𝑢𝑟𝑖𝑡𝑦 𝑑𝑎𝑡𝑒
𝑐 = 𝐶𝑜𝑢𝑝𝑜𝑛 𝑝𝑎𝑦𝑚𝑒𝑛𝑡

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Valuation of Discount Bonds
Suppose that in December 2019 you decide to buy €100 face value of a
8.5% bond maturing in December 2023. Each December until the bond
matures you are entitled to an interest payment of €8.50. This amount is
the bond’s coupon. When the bond matures in 2023, the issuer of the
bond pays you the final €8.50 interest, plus the principal payment of the
€100 face value.

What is the present value of these payments? It depends on the

opportunity cost of capital, which in this case equals the rate of return
offered by other similar bond. In December 2019, other similar bond
offered a return of about 3.0%.

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Valuation of Discount Bonds
Pure Discount Bond
▪ No coupons, single payment of principal at maturity
▪ Bond trades at a “discount” to face value
▪ Also known as zero-coupon bonds or STRIPS*
▪ Valuation is straightforward application of NPV

𝐹
𝑃0 = 𝑇
1 + 𝑟0,𝑇
▪ Note: (P0, r0,T, F) is “over-determined”; given two, the third is
determined

Now What If r Varies Over Time?

▪ Different interest rates from one year to the next
▪ Denote by r0,t the spot rate of interest now for a cashflow in year t
*Separate Trading of Registered Interest and Principal Securities
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Valuation of Discount Bonds
If r Varies Over Time
▪ Denote by Rt the one-year spot rate of interest in year t

𝐹
𝑃0 =
1 + 𝑅1 1 + 𝑅2 ∙∙∙ 1 + 𝑅𝑇
▪ But we don’t observe the entire sequence of future spot rates today!

𝐹 𝐹
𝑃0 = = 𝑇
1 + 𝑅1 1 + 𝑅2 ∙∙∙ 1 + 𝑅𝑇 1 + 𝑟0,𝑇
𝑟0,𝑇 ≡ Today’s T-year spot rate

▪ Today’s T-year spot rate is an “average” of one-year future spot rates

▪ (P0, F, r0,T) is over-determined

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Valuation of Discount Bonds
Example:
Assume STRIPS are traded at the following prices:

For the 5-year STRIPS, we have

1 1
0.797 = 5 ⇒ 𝑟0,5 = 1 − 1 = 4.64%
1 + 𝑟0,5 0.797 5

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Valuation of Discount Bonds
Suppose We Observe Several Discount Bond Prices Today
F
P0,1 = → 𝑟0,1
1 + 𝑅1
F
P0,2 = → 𝑟0,2
1 + 𝑅1 1 + 𝑅2
F
P0,3 = → 𝑟0,3
1 + 𝑅1 1 + 𝑅2 1 + 𝑅3
⋮
F
P0,T = → 𝑟0,𝑇
1 + 𝑅1 1 + 𝑅2 ⋯ 1 + 𝑅𝑇

𝑃0,1 ; 𝑃0,2 ; ⋯ ; 𝑃0,𝑇 → 𝑟0,1 ; 𝑟0,2 ; ⋯ ; 𝑟0,𝑇

Term Structure of Interest Rates

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Valuation of Discount Bonds
Term Structure Contain Information About Future Interest Rates

𝑟0,𝑡

Maturity (t)

▪ What are the implications of each of the two term structures?

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Valuation of Discount Bonds
Term Structure Contain Information About Future Interest Rates
𝐹
𝑃0,1 =
1 + 𝑅1
𝐹
𝑃0,2 =
1 + 𝑅1 1 + 𝑅2
𝑃0,1 𝐹 1 + 𝑅1 1 + 𝑅2
= = 1 + 𝑅2
𝑃0,2 1 + 𝑅1 𝐹
▪ Implicit in current bond prices are forecasts of future spot rates!
▪ These current forecasts are called one-year forward rates
▪ To distinguish them from spot rates, we use new notation:
𝑡
𝑃0,𝑡−1 1 + 𝑟0,𝑡
= 1 + 𝑓𝑡 = 𝑡−1
𝑃0,𝑡 1 + 𝑟0,𝑡−1
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Valuation of Discount Bonds
Term Structure Contain Information About Future Interest Rates

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Valuation of Discount Bonds
More Generally:
▪ Forward interest rates are today’s rates for transactions between two
future dates, for instance, t1 and t2.
▪ For a forward transaction to borrow money in the future:
– Terms of transaction is agreed on today, t = 0
– Loan is received on a future date t1
– Repayment of the loan occurs on date t2
▪ Note: future spot rates can be (and usually are) different from current
corresponding forward rates

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Valuation of Discount Bonds
Example:
As the CFO of a multinational, you expect to repatriate $10MM from a
foreign subsidiary in one year, which will be used to pay an international
loan one year afterwards. Not knowing the interest rates in one year, you
would like to lock into a lending rate one year from now for a period of one
year. What should you do?

The current interest rates are:

t 1 2
r0,t 5% 7%

Strategy:
• Borrow $9.524MM now for one year at 5%
• Invest the proceeds $9.524MM for two years at 7%

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Valuation of Discount Bonds
Example (cont):

Outcome (in millions of dollars):

Position Year 0 Year 1 Year 2

1-Y Bond Borrowing 9.524 -10.000 0
2-Y Bond Investing -9.524 0 10.904
Funds repatriation 0 10.000 0
Total 0 0 10.904

▪ The locked-in 1-year lending rate one year from now is 9,04%, which
is the one-year forward rate for Year 2

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 Valuation of Discount Bonds
Example:
Suppose that discount bond prices are as follows:

t 1 2 3 4
P0,t 0,9524 0,8900 0,8278 0,7629
r0,t 0,05 0,06 0,065 0,07

A customer would like to have a forward contract to borrow $20MM three

years from now for one year. Can you (a bank) quote a rate for this
forward loan?

All you need is the forward rate f4 which should be your quote for the
forward loan
4
1 + 𝑟0,4 1,07 4
𝑓4 = 3 − 1 = 1,065 3 − 1 = 8,51%
1 + 𝑟0,3

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Valuation of Discount Bonds
Example (cont):

Strategy:
▪ Buy 20.000.000 of 3 year discount bonds, costing

20.000.000 ∙ 0,8278 = $16.556.000

▪ Finance this by (short) selling 4 year discount bonds of amount

16.556.000
= $21.701.403
0,7629
▪ This creates a liability in year 4 in the amount $21.701.403
▪ Aside: A shortsale is a particular financial transaction in which an
individual can sell a security that s/he does not own by borrowing the
security from another party, selling it and receiving the proceeds, and
then buying back the security and returning it to the orginal owner at a
later date, possibly with a capital gain or loss.

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Valuation of Discount Bonds
Example (cont):
▪ Cashflows from this strategy (in million dollars):

Year Years Year Year

Position 0 1-2 3 4
Long 3-Y Bond -16.556 0 20.000 0
Short 4-Y Bond 16.556 0 0 -21.701
Total 0 0 20.000 -21.701

▪ The yield for this strategy or “synthetic bond return” is given by:

21.701.403
− 1 = 8,51%
20.000.000
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Valuation of Coupon Bonds
Coupon Bonds
▪ Intermediate payments in addition to final principal payment
▪ Coupon bonds can trade at discounts or premiums to face value
▪ Valuation is straightforward application of NPV (how?)

Example:
▪ 3-year bond of $1,000 par value with 5% coupon

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Valuation of Coupon Bonds
Valuation of Coupon Bonds

𝑐 𝑐 𝑐+𝐹
𝑉0 = + +…+
1+𝑅1 1+𝑅1 1+𝑅2 1+𝑅1 ∙∙∙ 1+𝑅𝑇
▪ Since future spot rates are unobservable, summarize them with "y"
𝑐 𝑐 𝑐+𝐹
𝑉0 = + +…+
1+𝑦 1+𝑦 2 1+𝑦 𝑇
▪ y is called the yield-to-maturity (YTM; rendimiento al vencimiento)
of a bond
▪ It is a complex average of all future spot rates
▪ There is usually no closed-form solution for y; numerical methods
must be used to compute it (Tth-degree polynomial)
▪ (V0, y, c) is over-determined; any two determines the third
▪ For pure discount bonds, the YTM’s are the current spot rates
▪ Graph of coupon-bond y against maturities is called the yield curve
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Yield to Maturity
The Yield to maturity (YTM) of a bond is the internal rate of return (IRR,
overall interest rate) earned by an investor who buys the bond today at
the market price, assuming that the bond will be held until maturity, and
that all coupon and principal payments will be made on schedule.
The YTM is often given in terms of Annual Percentage Rate (A.P.R.), but
more usually market convention is followed.

In a number of major markets (such as gilts) the convention is to quote

annualized yields with semi-annual compounding; thus, for example, an
annual effective yield of 10.25% would be quoted as 10.00%, because
1.05 x 1.05 = 1.1025.

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Example

Suppose the following zero-coupon bonds are trading at the prices

shown below per $100 face value. Determine the corresponding yield to
maturity for each bond.

Maturity (in years) 1 2 3 4

Price 96.62 92.46 87.64 87.64
Yield to maturity (y) 3.50% ? 4.50% ?

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Amortization Bonds

Consider an amortization bond maturing in two years with a semiannual

payments of $1.000. Assume that the APR is 10% with semiannual
compounding.

How can we value this security?

▪ Brute force discounting

1000 1000 1000 1000
𝑉0 = + + + = $3.545,95
(1+0,1/2) (1+0,1/2)2 (1+0,1/2)3 (1+0,1/2)4

▪ Recognize the stream of cash flows as an annuity

𝑐 1 1000 1
𝑉0 = 1− = 1− = $3.545,95
𝑦/𝑚 (1 + 𝑦/𝑚)𝑁 0,1/2 1 + (0,1/2 4

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Pricing Bonds using Excel

2.25% coupon bond, 6.25% coupon bond,

maturing July 31, 2018 maturing May 2030
Settlement date 23-Sep-20 23-Sep-20
Maturity date 23-Sep-26 15-May-38
Annual coupon rate 0.0225 0.0625
Yield to maturity 0.0079 0.02183
Redemption value (% of face value) 100 100
Coupon payments per year 2 2
Price 108.5 161.5

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Valuation of Discount Bonds

What is the price of a bullet bond if we have a monthly rate?

𝑐 1 𝐹
𝑉0 = 1− +
𝑦/𝑚 (1 + 𝑦/𝑚)𝑇 (1 + 𝑦/𝑚)𝑇

The annualized yield equals:

𝑦 ∗ = (1 + 𝑦/𝑚)𝑚 −1

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Exercise

a) Find the price of a 10% Government coupon bond that pays annual
coupons, matures in exactly 2 years, and has a face value of $1,000.
The yield to maturity is 4.09% compounded annually.

b) A 10-year U.S. Treasury bond with a face value of $10,000 pays a

coupon of 5.5% (2.75% of face value every six months). The
semiannually compounded interest rate is 5.2% (a six month discount
rate of 5.2/2=2.6%)

• What is the present value of the bond?

• Generate a graph or table showing how the bond´s present value
changes for semiannually compounded interest rates between 1% and
15%.

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Time Series of U.S. Treasury Security Yields

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 Interest Rate Sensitivity Zero Coupon Bonds
Why do zero-coupon bond prices change? … Interest rates change!

𝐹
𝑉0 =
(1 + 𝑟)𝑇

The price of a zero-coupon bond maturing in one year from today with face
value $100 and an APR of 10% is:

100
𝑉0 = 1
= $90,91
(1 + 0,10)

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Zero-Coupon Bonds
What is the price of a zero-coupon bond?

𝐹
𝑉0 =
(1 + 𝑟)𝑇

The Yield to Maturity (y) is the one discount rate that sets the present
value of the promised bond payments equal to the current market price
of the bond.
1ൗ
𝐹 𝑇
𝑦=𝑟= −1
𝑉0

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Interest Rate Sensitivity of Zero Coupon
Bonds
What is the natural thing to do?

𝐹
𝑉0 =
(1 + 𝑟)𝑇

𝜕𝑉0 − 𝑇+1
⇒ = −𝐹𝑇 1 + 𝑟 < 0 (Negative slope in r)
𝜕𝑟

𝜕2 𝑉0 − 𝑇+2
⇒ = 𝐹𝑇 𝑇 + 1 1 + 𝑟 > 0 (Convex function of r)
𝜕𝑟 2

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Coupon Bond Prices and Interest Rates

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Coupon Bond Prices and Interest Rates

• Bond prices and interest rates must move in opposite

directions.

• When bond prices fall, interest rates (that is, yields to maturity)
must rise. When interest rates rise, bond prices must fall.

• A change in interest rates has only a modest impact on the

value of near-term cash flows but a much greater impact on the
value of distant cash flows.

• Thus the price of long-term bonds is affected more by changing

interest rates than the price of short-term bonds.

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Macaulay Duration
Macaulay duration is the weighted average maturity of cash flows.
𝑇 𝑇
𝑡 × 𝑃𝑉𝑡 1 𝐶𝐹𝑡
𝑀𝑎𝑐𝐷 = ෍ = 𝑇 ෍𝑡 × 𝑡
𝑃𝑉 σ𝑡=1 𝐶𝐹𝑡 Τ 1 + 𝑦 𝑡 1+𝑦
𝑡=1 𝑡=1

Year(t) 1 2 3 4
Cash payment (Ct) 8,5 8,5 8,5 108,5
PV(Ct) at 3% 8,25 8,01 7,78 96,4 PV=120.44
Fraction of total value [PV(Ct)/PV] 0,069 0,067 0,065 0,8
Year x Fraction of total value [t x PV(Ct)/PV] 0,069 0,133 0,194 3,202 Duration=3.6

For a standard bond the Macaulay duration will be between 0 and the
maturity of the bond. It is equal to the maturity if and only if the bond is a
zero-coupon bond. 96,4

8,25 8,01 7,78

𝑀𝑎𝑐𝐷

𝑡
120,44

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Exercise
The duration of a bond that makes an equal payment each year in a
perpetuity is (1+r)/r. Prove it.

1 2 3 𝑡
+ + + ⋯ + +⋯
(1 + 𝑟) (1 + 𝑟)2 (1 + 𝑟)3 (1 + 𝑟)𝑡
𝑀𝑎𝑐𝐷 =
1 1 1 1
+ + + ⋯ + +⋯
(1 + 𝑟) (1 + 𝑟)2 (1 + 𝑟)3 (1 + 𝑟)𝑡
2
1 1 1 1
(1 + 𝑟) + + + ⋯ + +⋯
(1 + 𝑟) (1 + 𝑟)2 (1 + 𝑟)3 (1 + 𝑟)𝑡
𝑀𝑎𝑐𝐷 =
1
𝑟
2
1
(1 + 𝑟) (1 + 𝑟)
𝑟
𝑀𝑎𝑐𝐷 = =
1 𝑟
𝑟

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 Exercise
What is the duration of a common stock (in function of r and g) whose
dividends are expected to grow at a constant rate in a perpetuity?

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Modified Duration
In contrast to Macaulay duration, modified duration is a price sensitivity
measure, defined as the percentage derivative of price with respect to
yield.
1 𝜕𝑉
ModD(y) ≡ −
𝑉 𝜕𝑦

It is not so difficult to prove that:

𝑀𝑎𝑐𝐷 𝑀𝑎𝑐𝐷 k = number of coupon

ModD = = 𝑌𝑇𝑀 payments per year
(1+𝑦) (1+ 𝑘 )

The near-equality of the values for Macaulay and modified duration can
be a useful aid to intuition. For example a standard 10-year coupon bond
will have Macaulay duration not dramatically less than 10 years and from
this we can infer that the modified duration (price sensitivity) will also be
not dramatically less than 10%. Similarly, a 2-year coupon bond will have
Macaulay duration somewhat below 2 years, and modified duration
somewhat below that number.
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Estimate Duration of a Bond using Excel

2.25% coupon bond, 6.25% coupon bond,

maturing Sep 23, 2026 maturing May 2038
Settlement date 23-Sep-20 23-Sep-20
Maturity date 23-Jul-26 15-May-38
Annual coupon rate 0.0225 0.0625
Yield to maturity 0.0079 0.02117
Coupon payments per year 2 2
Duracion 5.66 12.25
Modified Duration 5.64 12.12

The formulas entered here are: =DURACION(D3,D4,D5,D6,D7)

:=DURACION.MODIF(D3,D4,D5,D6,D7)

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Convexity
Convexity is a measure of the sensitivity of the duration of a bond to
changes in interest rates, the second derivative of the price of the bond
with respect to interest rates (duration is the first derivative). In general,
the higher the convexity, the more sensitive the bond price is to the
change in interest rates.

1 𝑑 2 𝑉(𝑦)
𝐶≡
𝑉 𝑑𝑦 2
𝑇
1 𝐶𝐹𝑡
𝐶= 2
×෍ 𝑡× 𝑡+1 × 𝑡
𝑉× 1+𝑦 1+𝑦
𝑡=1

Prove that:

𝑑𝑀𝑜𝑑𝐷
𝐶= 𝑀𝑜𝑑𝐷2 −
𝑑𝑦

51
Application of Duration and Convexity

The first and second-order approximation of bond price movements due

to rate changes uses the convexity:

1 𝑑𝑉 𝑦 1 𝑑2 𝑉 𝑦 1 2
∆𝑉 = 𝑉 × ∆𝑦 + 2
× ∆𝑦 +⋯
𝑉 𝑑𝑦 𝑉 𝑑𝑦 2

1 2
∆𝑉 ≈ 𝑉 −𝑀𝑜𝑑𝐷 × ∆𝑦 + 𝐶𝑜𝑛𝑣𝑒𝑥𝑖𝑡𝑦 × ∆𝑦
2

When ∆y is small:

∆𝑉 ≈ 𝑉 −𝑀𝑜𝑑𝐷 × ∆𝑦

It could be good enough...

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Spot Rates, Term Structure, Yield Curve
A spot rate is the interest rate on a T-year loan that is to be made today

▪ r =5% indicates that the current rate for a one-year loan today is 5%.
1

▪ r =6% indicates that the current rate for a two-year loan today is 6%.
2

• Spot rate= YTM on default-free zero coupon bonds

The term structure of interest rates is the series of spot rates r1, r2, r3, …
relating interest rates to investment term

The yield curve is just a plot of the term structure: interest rates against
investment term (maturity)

53
Term Structure of Risk-Free U.S. Interest
Rates

54
But the slope is not always positive …

55
Exercise
You have estimated spot rates as follows:

r1=5%, r2=5.4%, r3=5.7%, r4=5.9%, r5=6%

1) What are the discount factors for each date (that is, the present value of
$1 paid in year t )?
2) Calculate the PV of the following bonds assuming annual coupons: i)
5%, two year bond; ii) 5% five year bond; and iii) 10%, five year bond.
3) Explain intuitively why the yield to maturity on the 10% bond is less than
that on the 5% bond.
4) What should be the yield to maturity on a five year zero coupon bond?
5) Show that the correct yield to maturity on a five year annuity is 5.75%.
6) Explain intuitively why the yield on the five-year bonds described in part
3) must lie between the yield on a five-year zero-coupon bond and a
five-year annuity.

56
Explaining the Term Structure
Suppose that you held a portfolio of one-year U.S. Treasuries. Here are
three possible reasons why you might decide to hold on to them, despite
their low rate of return:

Expectations Theory of the Term Structure

Introducing Risk

Inflation and Term Structure

57
Expectations Theory of the Term Structure
Suppose that the one-year interest rate is: r1=5%
The two-year interest rate is: r2=7%
The extra return that you earn for that second year is:

1.072
− 1 = 0.09
1.05

Would you be happy to earn that extra 9% for investing for two years
rather than one?

The answer depends on how you expect interest rates to change over the
coming year.

If you are confident that in 12 months’ time one-year bonds will yield more
than 9%, you would do better to invest in a one-year bond.

58
Term Structure
Models of the Term Structure
▪ Expectations Hypothesis
▪ Liquidity Preference
▪ Preferred Habitat
▪ Market Segmentation
▪ Continuous-Time Models
– Vasicek, Cox-Ingersoll-Ross, Heath-Jarrow-Morton

Expectations Hypothesis
▪ Expected Future Spot = Current Forward

E 0 [R k ] = fk

59
Term Structure
Liquidity Preference Model
▪ Investors prefer liquidity
▪ Long-term borrowing requires a premium
▪ Expected future spot < current forward

E[R k ] < fk
E[R k ] = fk - Liquidity Premium

60
Inflation and Term Structure
Which of the following strategies is more risky?

Invest in a succession of one-year Treasuries, rolled over annually, or

invest one in 20-year strips?

The answer depends on how confident you are about future inflation.

If you buy the 20-year strips, you know exactly how much money you will
have at year 20, but you do not know what that money will buy.

On the other hand you do not know future short-term interest rates, but
you do know that future interest rates will adapt to inflation.

61
Real and Nominal Interest Rate
Most bonds like U.S. Treasury bonds promise a fixed nominal rate of
interest. The real interest rate that you receive is uncertain and depends
on inflation. But, you can buy an indexed bond that makes cash
payments linked to inflation.

Assume someone buys a $1 bond in period t while the interest rate is it. If
redeemed in period, t+1, the buyer will receive (1+it) dollars. But if the
price level has changed between period t and t+1, then the real value of
the proceeds from the bond is therefore

1 + 𝑟𝑡+1 = (1 + 𝑖𝑡 )/(1 + 𝜋𝑡+1 )

This implies that:

𝑖𝑡 ≈ 𝑟𝑡+1 + 𝜋𝑡+1

62
 Forward Rates
A forward rate is a rate agreed upon today, for a loan that is to be made in
the future. Not necessarily equal to the future spot rate.

▪ f2,1= 7%
▪ indicates that we could contract today to borrow money at 7% for one year,
starting two years from today.

63
General Forward

Forward rates are entirely determined by spot rates (and vice-versa) .

General Forward Rate Relation:

(1 + 𝑟𝑛+𝑡 )𝑛+𝑡 = (1 + rn )n (1 + 𝑓𝑛,𝑡 )𝑡

Think in this picture for intuition: 𝑃𝑙𝑒𝑎𝑠𝑒 𝑐𝑜𝑛𝑠𝑖𝑑𝑒𝑟: 𝑓k−1,1 ≡ 𝑓𝑘

(1 + r1 ) (1 + f1,2 )2

(1 + r1 ) (1 + 𝑓2 ) (1 + 𝑓3 )

(1 + r2 )2 (1 + 𝑓3 )

Time 0 1 2 3
64
Exercise
Suppose that you borrow $90.91 for one year at 10% and lend $90.91 for two years at
12%. These interest rates are for loans made today; therefore, they are spot interest rates.
The cash flows on your transactions are as follows:

Year(t) Year 1 Year 2 Year 3

Borrow for 1 year at 10% +90.91 -100
Lend for 2 years at 12% -90.91 +114.04
Net cash flow 0 -100 +114.04

Notice that you do not have any net cash outflow today but you have contracted to pay out
money in year 1. The interest rate on this forward commitment is 14.04%. To calculate this
forward interest rate, we simply worked out the extra return for lending for two years rather
than one:

(1 + 𝑟2 )2 1.122
𝑓1,1 = −1= − 1 = 0.1404
(1 + 𝑟1 ) 1.10

65
Exercise

a) You have the following data on spot and forward rates on US treasury
securities:
r0,1=4.12%, f1,1=4.06%, f2,1=4.36%, f3,2=4.29%
For example, the one-year spot interest rate, r0,1, is 4.12%. The one-year forward
rate starting in one year for one year, f1,1, is 4.06%. Construct the term structure
of interest rates from the data above.

b) What is the forward rate f1,4; that is, the forward rate on a four-year loan
starting in one year?

66
Exercise
You are given the following cash flow information about three bonds: A, B, and C:

Cash Flow
Bond Price
1 2 3
A 977,12 100 100 1100
B 1026,35 120 1120
C 245,93 100 100 100

a) Find the spot rates for years one through three.

b) Assume that there also exist three zero coupon bonds of maturities 1, 2, and
3 years, all with a face value of $100. What are the prices of these three
bonds?
c) Find the forward rates: f1;1, f2;1, and f1;2. Recall that ft;k is the forward interest
rate beginning in period t and lasting for k periods.

67
Exercise
a) We can find the three year spot rate by subtracting bond C from bond A to get a three
year zero coupon bond with face value 1000 and price 731,25
To get second year spot rate, we can subtract 1,2 times Bond C from bond B.
We can used the fact that r3 = 11%. Solving for r2 yields 10,5%.
Finally, using our solutions for r2 and r3, we can use any of the bonds to find that r1 =
10%.

b)

c) (1 + 𝑟2 )2
𝑓1,1 = − 1 = 11%
(1 + 𝑟1 )
1/2
(1 + 𝑟3 )3
𝑓1,2 = − 1 = 10,75%
(1 + 𝑟1 )
(1 + 𝑟3 )3
𝑓2,1 = − 1 = 12%
(1 + 𝑟2 )2
68
Introducing Risk
What does the expectation theory leave out? The most obvious answer is
“risk”.

If you are confident about the future level of interest rates, you will simply
choose the strategy that offers the highest return.

If you are less sure of your forecasts, you may well opt for a less risky
strategy even if it means giving up some return.

Remember that the prices of long-duration bonds are more volatile that
prices of short-term bonds.

A sharp increase in interest rates can knock 30% or 40% off the price of
long term bonds.

69
Risky Bonds
Default Risk
▪ It is the possibility that a bond issuer will default, by failing to repay
principal and interest in a timely manner.

Liquidity Risk
▪ It is the risk that a given security or asset cannot be traded quickly
enough in the market to prevent a loss.

Rollover Risk
▪ It is commonly faced by countries and companies when their debt is
about to mature and needs to be rolled over into new debt. If interest
rates rise adversely, they would have to refinance their debt at a higher
rate and incur more interest charges in the future.

70
 Credit Ratings
Credit ratings are opinions about credit risk. They express a credit rating
agency’s opinion about the ability and willingness of an issuer to meet its
financial obligations in full and on time.

Credit ratings can also speak to the credit quality of an individual debt issue,
such as a corporate or municipal bond, and the relative likelihood that the
issue may default.

Ratings are provided by credit rating agencies which specialize in evaluating

credit risk.

▪ Standard & Poor’s

▪ Moody’s
▪ Fitch

71
Credit Ratings and the Risk of Default

72
Corporate Bonds and Default Risk
Non-Government Bonds Carry Default Risk
▪ A default is when a debt issuer fails to make a promised payment
(interest or principal)
▪ Credit ratings by rating agencies (e.g., Moody's and S&P) provide
indications of the likelihood of default by each issuer.
Credit Risk Moody's S&P Fitch

Investment Grade
Highest Quality Aaa AAA AAA
High Quality (Very Strong) Aa AA AA
Upper Medium Grade (Strong) A A A
Medium Grade Baa BBB BBB

Not Investment Grade

Somewhat Speculative Ba BB BB
Speculative B B B
Highly Speculative Caa CCC CCC
Most Speculative Ca CC CC
Imminent Default C C C
Default C D D

73
Credit Ratings Agencies
https://www.spglobal.com/ratings/en/research-insights/topics/coronavirus-special-report
S&P: Coronavirus Impact
Key Takeaways From Our Articles
Published March 18, 2020

Global confirmed cases of COVID-19 now exceed 222,000 people (with 9,100 deaths
and 84,000 recoveries), and the spread outside of China threatens to strain the
capacity of countries' health care systems, even in more-developed economies. In this
light, the economic and credit implications have sharply worsened. In addition to the
human cost, uncertainty about the speed of the spread has sent financial markets into
a tailspin, weighed on business across industries and sectors, and has likely plunged
the global economy into recession.

The rate of spread and timing of the peak of the outbreak are still highly uncertain. As
the situation evolves, we will update our assumptions and estimates accordingly. As we
expand our analysis of how the outbreak will affect economic conditions and credit, we
will periodically update this article, which is an edited compilation of the key
takeaways from our series.

74
Standard and Poor’s Credit Ratings
Standard and Poor´s web page: http://www.standardandpoors.com

Governments
▪ Argentina (C)
▪ Chile (A)
▪ Spain (A)
Domestic Corporations
▪ Banco de Chile (A)
▪ Banco del Estado de Chile (A+)
International Corporations
▪ Walmart (AA)
Supranational Corporations
▪ Inter-American Development Bank (AAA)

75
Sovereign Ceiling

Although credit rating agencies have gradually moved away from a policy of never rating a
corporation above the sovereign (the ‘sovereign ceiling’), it appears that sovereign credit
ratings remain a significant determinant of corporate credit ratings (Borensztein, Cowan and
Valenzuela, 2013).
76
Credit Spread

The financial term credit spread is the yield spread, or difference in yield
between different securities, due to different credit quality.

The credit spread reflects the additional net yield an investor can earn
from a security with more credit risk relative to one with less credit risk.

The credit spread of a particular security is often quoted in relation to the

yield on a credit risk-free benchmark security or reference rate, typically
either U.S. Treasury bonds

77
Bond Spread by Credit Rating
(As of September 1, 2005)

4.5

4.0

3.5

3.0

2.5

2.0

1.5

1.0

0.5

0.0
AAA AA+ AA AA- A+ A A- BBB+ BBB BBB- BB+ BB BB- B+ B B-

Private US Private Developing Sovereign

78
Yield Spread

The difference between yields on differing debt instruments, calculated

by deducting the yield of one instrument from another. The higher the
yield spread, the greater the difference between the yields offered by
each instrument. The spread can be measured between debt
instruments of differing maturities, credit ratings and risk.

For example,

Spread Corporate Bonds = Yield Corporate Bonds – Yield US Treasury

Bonds

79
Risky Bonds

80
Risky Bonds

81
Corporate Bonds and Default Risk
Decomposition of Corporate Bond Yields
8%

5%

4%

82
Determinants of Bonds Safety
Bond rating agencies base their quality ratings largely on an analysis of the
level and trend of some of the issuer’s financial ratios. Key ratios used are:
Coverage ratios: Ratio of earnings before interest payments and taxes to
interest obligations. Low coverage ratios signal possible cash flow
difficulties.
Leverage ratios: A too-high leverage ratio indicates excessive
indebtedness, signaling the possibility the firm will be unable to earn
enough to satisfy the obligations on its bonds.
Liquidity ratios: Ratio of current assets to current liabilities. This ratio
measures the firm´s ability to pay bills coming due with its most liquid
obligations.
Profitability ratios: Firms with higher ROA and ROE are better able to
raise money in security markets because they offer prospects for better
returns on the firm´s investments.
Cash-flow-to-debt ratio: This is the ratio of total cash flow to outstanding
debt.

83
Altman’s Discriminant Analysis

With the discriminant analysis technique a firm is assigned a score based

on its financial characteristics. If its score exceeds a cut-off value, the
firm is deemed creditworthy.

Altman found the following equations to best separate failing and

nonfailing firms (Z-Score):

Z= 3.3 x (EBIT/Assets) + 1.0x(Sales/Assets) +

0.6 x (Equity/Liabilities) + 1.4 x (Retained earnings/Assets)
+ 1.2 x (Working capital/Assets)

Z-scores below 1.8 indicate vulnerability to bankruptcy, scores between

1.8 and 3.0 are a grey area, and scores above 3.0 are considered safe.

84
Summary

Bonds can be valued by discounting their future cash flows

Bond prices change inversely with yield

Price response of bond to interest rates depends on term to maturity

Measure interest rate sensitivity using duration

▪ Works well for zero-coupon bond, but not for coupon bonds
The term structure implies terms for future borrowing:
▪ Forward rates
▪ Compare with expected future spot rates.

85
86
IG Corporate Bond Yield in Real Terms

87
88