COMM 371 - Lecture 7 - Fixed Income

COMM371/COEC371 – Investment Theory
Lecture 7
Fixed Income Securities
Instructors
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Alberto Mokak Teguia
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Definition and Overview of Fixed-Income Securities
A fixed-income security is a security that promises cash flows of

fixed amounts at fixed dates.
The fixed-income market is rather large. In the US:
Category Issuer Market Cap. % of Total

Treasury Treasury 22.58 trillion 42.7
Mortgage-Related Federal/Private 12.20 trillion 23.0
Corporate Corporations 10.01 trillion 19.0
Municipal Local Governments 4.06 trillion 7.7
Federal Agency Federal Agencies 1.43 trillion 2.7
Asset Backed Financial Institutions 1.59 trillion 3.0
Money Market Corporations, Financial Institutions 1.01 trillion 1.9
Total 52.94 trillion 100.0
As of 2021Q4. Source: Securities Industry and Financial Markets Association (SIFMA).
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Fixed-Income is an Important Asset Class

In the US:
Market cap: Fixed-Income vs Equity (in trillions)

Year 2015 2016 2017 2018 2019 2020
Bonds 37.898 39.097 40.411 42.221 44.071 50.113
Stocks 25.068 27.352 32.121 30.436 33.891 40.720
Source: SIFMA & World Bank.
Fixed-Income Market Average Daily Trading Volume in 2021

(in billions)
Jan Feb Mar Apr May Jun
1,105.4 1,113.9 1,084.8 867.2 951.2 991.1
Jul Aug Sep Oct Nov Dec
878.6 891.2 915.7 1,022.9 1,054.2 854.1
Source: SIFMA.
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Fixed-Income Markets Trends
Source: SIFMA (as of December 2021)
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Fixed-Income Markets Trends

Source: SIFMA (as of December 2021)
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Fixed-Income Terminology
We frequently refer to fixed-income securities as bonds.
A zero-coupon bond (or zero) promises a single cash flow, face

value (or par value), at some future date, maturity.
A coupon bond promises a periodic cash flow, coupon, and the

face value at maturity. The coupon rate is the ratio of the
coupon to the face value. Coupon payments are typically
semiannual for US bonds and annual for European bonds.
The time to maturity is the length of time until maturity.
For notational simplicity, from now on, we assume that bonds

have a face value of $100 (unless otherwise stated). This is
equivalent to expressing bond prices as a percentage of face
value.
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Examples of Bonds
Cash flows of a zero-coupon bond with 3 years to maturity.
Cash Flow 0 0 100
r r r -
Year 1 2 3
Cash flows of a bond with coupon rate 8.5%, annual coupon

payments, and 4 years to maturity.
Cash Flow 8.5 8.5 8.5 108.5
r r r r -
Year 1 2 3 4
Cash flows of a bond with coupon rate 10%, semiannual coupon

payments, and 2 years to maturity.
Cash Flow 5 5 5 105
r r r r -
Year 0.5 1 1.5 2
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Treasury Securities
Fixed-income securities generally involve default risk, the risk
that the issuer will not meet the cash flow obligations.
The only fixed-income securities that involve virtually no default

risk are US Treasury securities. We will focus on these securities
because they are the simplest to value.
The US Treasury issues three types of securities:

– Treasury Bills (T-Bills): Maturities up to 1 year. No coupon.
– Treasury Notes (T-Notes): Maturities between 1 and 10 years.
Semiannual coupon.
– Treasury Bonds (T-Bonds): Maturities greater than 10 years.
Semiannual coupon.
The US Treasury allows buyers of T-notes and T-bonds to

exchange them for the individual coupons and face value. These
zero-coupon bonds can be traded and are called Treasury
Strips (T-Strips).
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Term Structure of Spot Rates
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Generally speaking, asset valuations are driven by news about (i)

cash flow growth and (ii) discount rates.
With fixed-income securities, there is no cash flow uncertainty (in

the absence of default). Therefore, we can focus on discount
rates.
We know, from standard discounting, that the present value of $1

received t years from now is
1
dt = ,
(1 + rt )t
where rt is the annual interest rate for year t, also referred to as

the t-year spot rate, and dt is the discount factor.
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In general, the interest rate depends on the length of the time

period when the cash flow is due.
Example: If you buy a 5-year GIC (guaranteed investment

certificate) from a bank, then your rate of return is typically higher
than for a 1-year certificate.
Therefore, to value fixed-income securities, which typically

involve cash flows realized at multiple times in the future, it is
essential to know the spot rate for each maturity.
The term structure of spot rates represents the spot rates as a

function of maturity.
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Example: Bond Valuation Using the Term Structure
Calculate the price of a bond that has a face value of $100,

maturity of 5 years, and pays a 5% coupon annually. The term
structure is described by: r1 = 0.75%, r2 = 1.85%, r3 = 2.75%,
r4 = 3.25%, and r5 = 3.70%.
We discount each cash flow by the interest (spot) rate for the
appropriate maturity:
5 5 5 5 105
Price = + + + +
1.00751 1.01852 1.02753 1.03254 1.03705
= $106.35
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The Yield Curve

We can represent the term structure of interest rates graphically.
Such a representation is called the yield curve.
The term structure of spot rates (or yield curve) represents
the spot rates as a function of maturity. The yield curve from the
previous example is presented below.
Yield Curve
4.0%
3.5%
Spot Rate
3.0%
2.5%
2.0%
1.5%
1.0%
0.5%
0.0%
0 1 2 3 4 5 6
Year
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Facts about the Term Structure
The term structure can have many shapes.

– It generally slopes up. This means that spot rates for long
maturities are generally higher than for short maturities.
– However, it can also be hump shaped, inverted hump shaped, or
downward sloping.
– Upward sloping term structures are associated with periods of
economic expansion.
– Downward sloping term structures are associated with periods of
economic slowdown/recession.
Interest rates of different maturities tend to move together.
Spot rates, both for short and long maturities, move substantially
over time. A fascinating animation of the US yield curve from
1953 to 2019 can be found here.
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Current Canada Term Structure
Source link
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Current US Term Structure
Source link
Additional source: US Daily Treasury Yield Curve Rates
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Monetary Policy & Term Structure of Interest Rates
What forces determine the term structure of interest rates?
How does the term structure link to the real economy? How is it
affected by policy decisions?
The central bank manages the short term interest rate through
the overnight Fed funds rate.
Answer provided by the expectations theory.
The expectations theory provides a relationship between

short-term and long-term interest rates.
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Expectations Theory: Example

Recall from an earlier example, the term structure of spot rates
was given by: r1 = 0.75%, r2 = 1.85%, r3 = 2.75%, r4 = 3.25%,
and r5 = 3.70%.
What can we say about (expectations of) future interest rates
based on this information? Specifically, what is the market’s
expectation of the 1-year interest rate in one year from now?
Insight: consider a 2-year bond and compare it to a two-year
rolling investment using 1-year bonds. In other words, we can go
from time t to time t + 2 in two different ways, that is, (i) in one
step or (ii) in two successive steps as depicted below:
[t→t + 2] vs [t→t + 1→t + 2]

Future interest rates are not known now, but the market has
expectations about them.
Key point: current spot rates are linked to the market’s
expectations about future spot rates.
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Expectations Theory: Graphical Illustration
We can infer expected future interest rates from the current

term structure of interest rates.
Notation: rN,t is the interest rate applied to N years out prevailing

at time t
rT,0
r3,0
r2,0 r2,1
r1,0 r1,1
t=0 t=1 t=2 t=3 t=T
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Expectations Theory: Example (continued)
Consider two investment opportunities for one dollar.
Option A: Buy a 2-year zero-coupon bond in year t

– Annual rate of return on the 2-year bond is r2,t
– In year t + 2, the investment will be worth (1 + r2,t )2 dollars.
Option B: Buy a 1-year bond in year t and use the proceeds to

buy a 1-year bond in year t + 1
– Annual rate of return on the 1-year bond bought at t is r1,t .
– Expected annual rate of return on the 1-year bond bought at t + 1
e
is denoted by r1,t+1 .
– In year t + 2, the investment is expected to be worth
e
(1 + r1,t )(1 + r1,t+1 ) dollars.
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Expectations Theory: Example (continued)
In expectation, the investment should be worth the same amount

irrespective of which option we use, option A or option B:
(1 + r2,t )2 = (1 + r1,t )(1 + r1,t+1

e
)
The expected annual rate of return on the 1-year bond at t + 1 is

given by
e (1 + r2,t )2
r1,t+1 = − 1 = 2.96%.
(1 + r1,t )
e
The expected rate r1,t+1 is also called the (implied) forward rate.
Similarly, the 1-year forward rate at t + 2 can be determined by:

(1 + r3,t )3
(1 + r3,t )3 = (1 + r2,t )2 (1 + r1,t+2
e e
) ⇒ r1,t+2 = − 1 = 4.57%.
(1 + r2,t )2
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Expectations Theory: Generalization

Upon re-arrangement, we get
1/2
(1 + r2,t )2 = (1 + r1,t )(1 + r1,t+1
e e
) ⇒ r2,t = (1 + r1,t )(1 + r1,t+1 ) −1
The same relationship leads to the following approximation

e
r1,t + r1,t+1
2 e e
1 + 2r2,t + r2,t = 1 + r1,t + r1,t+1 + r1,t r1,t+1 ⇒ r2,t ≃
2
The expectations theory says that long-term rates are

(geometric) averages of one-period forward rates.
N-year interest rate is expressed as an average of the current

one-year rate and one-year forward rates
1/N
e e
1 + rN,t = (1 + r1,t )(1 + r1,t+1 ) · · · (1 + r1,t+N−1 )
or, in terms of an approximation, as

e
r1,t + r1,t+1 e
+ r1,t+2 e
+ · · · + r1,t+N−1
rN,t ≃
N
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Expectations Theory and the Yield Curve
Consider the one-year spot rate r1,0 , the two-year spot rate r2,0 ,
e
and the one-year forward rate r1,1
Upward sloping yield curve

– upward sloping means that r2,0 > r1,0
e e
– since r2,0 is an average of r1,0 and r1,1 , this implies that r1,1 > r1,0
Flat yield curve

– flat means that r2,0 = r1,0
e e
– since r2,0 is an average of r1,0 and r1,1 , this implies that r1,1 = r1,0
Downward sloping yield curve

– downward sloping means that r2,0 < r1,0
e e
– since r2,0 is an average of r1,0 and r1,1 , this implies that r1,1 < r1,0
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Term-Structure Theories
Expectations Theory: Investing in long-maturity bonds returns
the same, on average, as investing in short-maturity bonds and
rolling over.
– Long rates reflect expectations of future short rates.
– Term structure slopes up ⇒ Market expects rates to rise.
– Term structure slopes down ⇒ Market expects rates to fall.
Liquidity Preference Theory: Investors prefer short-maturity
bonds.
– The risks of long-term and short-term bonds are not equivalent.
– Short-term bonds provide more liquidity than long-term bonds: they
offer greater price certainty and trade in more active markets.
– Investors that have preferences for greater liquidity will accept
lower rates of return offered by short-term bonds compared to
longer-term bond returns
– The risk premium required by long-term bonds will make the yield
curve upward sloping - even if investors expect no increases in the
future rates
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Monetary Policy and the Term Structure
The Fed manages the one-period interest rate (Fed funds rate).
Expectations theory implies that today’s yield curve reflects the

market’s expectations of future Fed actions regarding the Fed
funds rate.
There is a clear link between the yield curve and monetary

policy. The expectations theory is a way to think about that
important link.
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Fed Funds Rate, Inflation, and Interest Rate
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Fed’s Reaction Function
In the US, the Fed seems to set the Fed funds rate using the
following rule (Taylor rule):
rt = a + b(πt − π ∗ ) + c(yt − yt∗ )
rt is the Fed funds rate
(yt − yt∗ ) is the deviation of the economic activity from the “full
employment” level
πt is the actual inflation rate and π ∗ is the target rate
a, b, c > 0
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Fed’s Reaction Function

For every percentage point increase (decrease) in inflation, the
Fed will increase (decrease) the Fed funds rate by b percentage
drt
points (i.e., the derivative dπ t
= b)
For every percentage point increase (decrease) in output, the
Fed will increase (decrease) the Fed funds rate by c percentage
drt
points (i.e., the derivative dyt
= c)
From the September 22, 2021 press release by the Board of

Governors of the Federal Reserve System:
“The Committee seeks to achieve maximum employment and inflation at the rate
of 2 percent over the longer run. With inflation having run persistently below this
longer-run goal, the Committee will aim to achieve inflation moderately above 2
percent for some time so that inflation averages 2 percent over time and
longer-term inflation expectations remain well anchored at 2 percent. The
Committee expects to maintain an accommodative stance of monetary policy
until these outcomes are achieved.”
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Real vs. Nominal Interest Rates
Real vs. nominal dollars
Nominal dollars are “regular" dollars.
Real dollars are dollars adjusted for inflation.
One nominal dollar received next year is
1
1+π
real dollars, where π is the inflation rate during the year.
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Real vs. Nominal Rates
Nominal rate (i): 1 dollar now gives (1 + i) nominal dollars next

year.
Real rate (r ): 1 dollar now gives (1 + r ) real dollars next year.

Relation between i and r :
– 1 dollar now gives (1 + i) nominal dollars next year, i.e.,
(1 + i)/(1 + π) real dollars.
– Therefore,
1+i
1+r = .
1+π
OK to use either real or nominal dollars. However:
– If use real dollars, have to use real rate.
– If use nominal dollars, have to use nominal rate.
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Inflation-Indexed Bonds
Inflation fluctuates in time and changes in inflation affect real

payoffs.
How can an investor protect against inflation?

Use inflation-indexed bonds.
– U.K. since the 1980’s
– Canada Real Return Bonds
– U.S. since 1997
How do they work? The principal is adjusted based on inflation

so that the real payoff stays the same.
Canada Real Return Bonds
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Why Changes in Interest Rates are Important
They affect valuation of assets, in particular the ones with

long-term cash flows (value vs growth stocks)
They affect the cost of doing business (debt)
They affect discretionary spending
They affect availability of margin and, to some degree, demand

for risky assets
They have different effect on existing vs new bonds
Note the higher inflation typically leads to higher interest rates

(why?)
Who is better/worse off when interest rates increase/decrease?
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Bond Valuation
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Valuation of Zero-Coupon Bonds
Consider a zero-coupon bond with T years to maturity.

The PV of the bond’s cash flows is
100
PV = = $100 × dT ,
(1 + rT )T
where rT is the T -year spot rate and dT is the discount factor.

This is the price of the bond.
Example: The 4-year spot rate is 3%. Compute the price of a
zero-coupon bond with 4 years to maturity.
100
Price = = $88.85.
(1 + 3%)4
A zero-coupon bond always sells at a “discount" (below face

value).
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Valuation of Coupon Bonds

Consider a bond with annual coupon rate c% (i.e., annual
coupon payments of c), and T years to maturity.
c c 100 + c
PV = + 2
+ ··· +
1 + r1 (1 + r2 ) (1 + rT )T
= c × d1 + c × d2 + · · · + (100 + c) × dT .

Example: The 1-year spot rate is 2%, the 2-year spot rate is
2.45%, and the 3-year spot rate is 2.75%. Compute the price of a
bond with annual coupon rate 4%, and 3 years to maturity.
4 4 104
Price = + + = $103.60
1 + 2% (1 + 2.45%)2 (1 + 2.75%)3
A coupon bond may sell at a discount (below face value), at par

(at face value), or at a premium (above face value).
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Semiannual Coupon Payments

Consider a bond with semiannual coupon rate c% (i.e.,
semiannual coupon payments of c/2), and T periods to maturity.
By convention, the period spot rates (r1 , r2 ,...,rT ) are quoted as
semiannual APRs.
c c c
2 2 100 + 2
PV = r1 + + ··· +
r2 2
.
rT T
1+ 2 1+ 1+
2 2

Example: Suppose that r1 = 2%, r2 = 2.4%, r3 = 2.8%, and
r4 = 3.2%. Compute the price of a bond with semiannual coupon
rate 3%, and 2 years to maturity.
1.5 1.5 1.5 101.5

Price = + + + = $99.64
1 + 1% (1 + 1.2%) (1 + 1.4%) (1 + 1.6%)4
2 3
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Example
Find the price of a bond with a quarterly coupon at 8% (annualized)

rate and 1 year to maturity. The quarterly spot rates (quarterly APRs)
are r1 = 1% (one-quarter), r2 = 1.5% (two-quarter), r3 = 2%
(three-quarter), and r4 = 2.5% (four-quarter).
2 2 2 102
Price = .01
+ .015 2
+ .02 3
+ = $105.44
1+ 4 (1 + 4 ) (1 + 4 ) (1 + .025
4 )
4
If the bond instead has a maturity of 2 years, can we still

compute the price with the given information?
Practice question for the expectations hypothesis: What is the

expected semi-annual APR in 2 quarters from now?1
1 Answer: 3.52%
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Obtaining Spot Rates
So far, we took the spot rates as given. But, the market does not
give us spot rates directly. Instead, we can observe prices of
bonds with different coupon rates and different maturities.
So, the important question is: How do we obtain spot rates?
Recall that the price of a zero-coupon bond with T years to
maturity is
100
PTzc = = 100 × dT .
(1 + rT )T
Therefore, we can obtain

– the discount factor dT , by dividing the price by 100
– the T -year spot rate, by
1
1 1 T
dT = ⇒ rT = − 1.
(1 + rT )T dT
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Example: Calculating the Term Structure of Interest

Rates
Suppose that the prices for zero coupon bonds of maturities 1, 2,

and 3 years are P1 = $98.50, P2 = $96, P3 = $92.50. Using
annual compounding, find the discount factors and spot rates
(annual APRs) for maturities of 1, 2 and 3 years.
98.5 96
Discount factors: d1 = 100 = .985, d2 = 100 = .96,
d3 = 92.5
100 = .925
1
11 1
12
Spot rates: r1 = .985 − 1 = 1.52%, r2 = .96 − 1 = 2.06%,
1
1
3
r3 = .925 − 1 = 2.63%
What is the price of a coupon bond with a maturity of 3 years and

annual coupon rate of 10%?2
2 $121.20
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Valuation via Zero-Coupon Bonds

Recall that the price of a coupon bond is
c c 100 + c
Price = + 2
+ ··· +
1 + r1 (1 + r2 ) (1 + rT )T
= c × d1 + c × d2 + · · · + (100 + c) × dT .
The price depends on the spot rates.
But we obtained the spot rates from the prices of zero-coupon

bonds.
Therefore, we implicitly obtained the price of a bond from the

prices of zero-coupon bonds.
Knowing the prices of zero-coupon bonds pins down the

term structure of interest rates, and therefore allows us to
compute the prices of all bonds.
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Valuation via Zero-Coupon Bonds: An Example

Consider a coupon bond with an annual coupon rate of 10% and
3 years to maturity.
Cash flows are
Cash Flow r 10 10 110
r r r -
Year 0 1 2 3
Suppose that the prices of zero-coupon bonds with maturities 1,

2, and 3 years, are 95, 88, and 80, respectively.
The price of the coupon bond is
Price = 10 × d1 + 10 × d2 + 110 × d3
= 10 × 0.95 + 10 × 0.88 + 110 × 0.8
= $106.30
But what ensures that this “PV rule price" is the actual market
price? Why does the PV rule work?
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Synthetic Replication
We can construct a portfolio of the three zero-coupon bonds, that

has the same cash flow as the coupon bond.
Cash Flow of
Year Portfolio of Zeros
Coupon Bond
1 10 0.1 one-year zeros
2 10 0.1 two-year zeros
3 110 1.1 three-year zeros
The portfolio of the zero-coupon bonds synthetically replicates

the coupon bond. It is a replicating portfolio for the coupon
bond.
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Arbitrage
We have two portfolios with the same cash flows (both the
amounts and timing of cash flows is the same):
– The coupon bond.
– The replicating portfolio.
The market value of the replicating portfolio is
0.1 × $95 + 0.1 × $88 + 1.1 × $80 = $106.3
The market value of the coupon bond (the bond’s price) has to
be the same. Otherwise, there would exist an arbitrage.
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Arbitrage
Arbitrage is defined as making money without incurring any risk.
Suppose that a trader offers the coupon bond at $105. Then we

can
– buy the coupon bond at $105
– sell the replicating portfolio at $106.3
The cash flows in years 1, 2, and 3 cancel out, and we are left
with a gain of $106.3-$105=$1.3 today.
In financial markets, arbitrage opportunities cannot prevail.
Absence of arbitrage implies that the price of the coupon bond

has to be $106.3.
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What Did we Learn?
The spot rates can be obtained from the prices of zero-coupon

bonds.
Once we obtain the interest rates, then we can obtain the prices
of all bonds.
Any bond can be synthetically replicated by a portfolio of

zero-coupon bonds.
Absence of arbitrage implies that a bond must have the same

price as its replicating portfolio. This is the price given by the PV
rule.
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Using Coupon Bonds Instead of Zero-Coupon Bonds
We used zero-coupon bonds to

– obtain spot rates.
– obtain prices of other bonds.
– synthetically replicate other bonds.
Instead of zero-coupon bonds, we can use coupon bonds.
The advantage of using coupon bonds is that some coupon

bonds are very liquid, and thus their quoted prices are very
accurate.
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Bootstrapping
Bootstrapping is a procedure to obtain spot rates from the prices

of coupon bonds.
Example. Consider three bonds with the following

characteristics:
Maturity Coupon Rate

Price
(Period) (Semiannual)
1 0% 98
2 0% 95
3 8% 102
Determine the 6-month (1st period), 1-year (2nd period), and

18-month (3rd period) spot rates, expressed as semiannual
APRs.3
3 Answer: r1 = 4.082%, r2 = 5.196%, r3 = 6.650%
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Synthetic Replication of a Zero-Coupon Bond
Example. Consider two bonds with the following characteristics

available for trading:
Coupon Rate
Maturity Price
(Annual)
2 4% 96.37
2 8% 103.74
Goal: Generate a cash flow of $100 one year from now.
Questions:
(i) How do we synthetically create the one-year zero by trading
in the two-year bonds?
(ii) How much will this synthetic one-year zero cost? That is,
what is the no-arbitrage price of what I want?
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Suppose that portfolio consists of x1 units of the first bond and x2
units of the second.
Cash flows are:
Year Portfolio Zero-Coupon Bond

1 4x1 + 8x2 100
2 104x1 + 108x2 0
We need to solve the system of equations
4x1 + 8x2 = 100

104x1 + 108x2 = 0
The solution is x1 = −27 and x2 = 26.

We need to sell 27 units of the first bond and buy 26 units of the
second.
How do we replicate a 2-year zero coupon bond?
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Having synthetically replicated the zero-coupon bond, we can

compute its price.
The market value of the replicating portfolio is
−27 × 96.37 + 26 × 103.74 = 95.25.
The price of the zero-coupon bond has to be 95.25. Otherwise,

there would exist an arbitrage opportunity.
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Yield to Maturity
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Yield to Maturity – Definition

The yield to maturity (YTM) of a bond is the single discount rate
that equates the PV of the bond’s cash flows to the bond’s price.
For a bond with annual coupon rate c% and T years to maturity,
the YTM y is given by
c c 100 + c
Price = + + ··· + .
1+y (1 + y )2 (1 + y )T
Using the finite annuity formula, we get

1 1 100
Price = c 1− + .
y (1 + y )T (1 + y )T
Example: If c = 6, T = 3, and the price is $109, then

6 6 106
109 = + + .
1+y (1 + y )2 (1 + y )3
Solving numerically (e.g., EXCEL “Solver”), we get y = 2.83%.
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Facts About YTM
The relation between a bond’s YTM and coupon rate tells us how the
bond’s price compares to the face value.
If the YTM is greater than the coupon rate, then the bond sells at
a discount (below face value).
If the YTM is equal to the coupon rate, then the bond sells at par
(at face value).
If the YTM is smaller than the coupon rate, then the bond sells at
a premium (above face value).
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Relation Between YTM and Spot Rates

Consider a bond with annual coupon rate c% and T years to
maturity. Its price is
c c 100 + c
Price = + + ··· + .
1 + r1 (1 + r2 )2 (1 + rT )T
The YTM is given by

c c 100 + c
Price = + 2
+ ··· + .
1+y (1 + y ) (1 + y )T
Comparing the two equations:

– YTM is a complicated average of the spot rates corresponding to
the years 1, .., T .
– YTM is simple only if the bond is zero-coupon (c = 0). It is then
equal to the T -year spot rate.
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Semiannual Coupon Payments
When coupon payments are semiannual, the YTM is generally

quoted as a semiannual APR.
For a bond with semiannual coupon rate c% and T years to
maturity, the YTM (y ) is given by
c c
2 2 100 + 2c
Price = y + + ··· +
y 2
2T .
1+ 2 1+ 1 + y2
2
Using the finite annuity formula, we get

c1 1 100
Price = y 1 − + .
22 (1 + y2 )2T (1 + y2 )2T
For T-strips, T-notes, and T-bonds, the YTM is quoted as a

semiannual APR, and is given by the above formula.
55/77
Uses and Misuses of YTM
Main use of YTM: As an alternative way to quote the price of a

bond.
Misuse 1: As a measure of the bond’s return.
Misuse 2: As a tool for choosing between different bonds.
56/77
YTM and Return: Zero-Coupon Bonds

The YTM of a zero-coupon bond is the spot rate corresponding
to the bond’s time to maturity.
This is the return from investing in the bond and holding it until
maturity.
But it is not the return for any other investment horizon!
Example: Consider a zero-coupon bond with 3 years to maturity and

YTM 3%.
The return from investing in the bond and holding it for 3 years is
3%.
However, the return from investing in the bond and selling it after
one year is unknown today.
– The return depends on the bond’s price in one year.
– The price in one year depends on the 2-year spot rate that will
prevail in one year. This spot rate is unknown today.
57/77
YTM and Return: Coupon Bonds
The YTM of a coupon bond is the return of

1. investing in the bond,
2. holding it until maturity, and
3. reinvesting the coupons at a rate equal to the YTM.
Problem 1: The YTM is not the return for any investment horizon
other than maturity. This is for the same reason as for
zero-coupon bonds.
Problem 2: The YTM is not the return even for investment horizon
equal to maturity. This is because the future spot rates, at which
the coupons will be reinvested, may be different than the YTM.
In general, YTM is not a return.
58/77
YTM as a Tool for Comparing Bonds
Using the YTM for comparing bonds is correct only when the
bonds have the same coupon and time to maturity. In all other
cases it can be very misleading.
Suppose, for instance, that the bonds have different time to

maturity.
– Recall that the YTM is at best the return of investing until maturity.
– Therefore, by comparing YTMs we compare returns for different
investment horizons.
The correct way to compare bonds is simply to compute the PV

of their cash flows.
If bonds have the same coupon and time to maturity, why could
they have different YTMs?
59/77
CFA Problem
Bonds of Zello Corporation with par value of $1,000 sell for $960,
mature in 5 years, and have 7% annual coupon rate paid
semiannually. Calculate:
Current yield
Yield to maturity (to the nearest percent, i.e., 3%, 4%, etc.)
Current yield is the bond’s annual coupon payment divided by the

bond price. It measures the cash flow income provided by the bond
as a percentage of its price and ignores any prospective capital gains
and losses. Formula for the current yield:
Annual Income
Current Yield =
Current Bond Price
1, 000 × 7%
= = 0.0729 = 7.29%
960
60/77
CFA Problem
Calculate the yield to maturity y (to the nearest percent)
35 35 35 1035
960 = y + y 2 + ... + y 9 +
(1 + 2 ) (1 + 2 ) (1 + 2 ) (1 + y2 )10

35 1 1000
= y 1− y 10 +
2 (1 + 2 ) (1 + y2 )10
YTM has to be greater than 7% because the bond sells at a discount.

Let’s compute the bond’s price at YTM = 8% and at YTM = 9%.
Price(YTM = 8%) = $959.45

Price(YTM = 9%) = $920.87
So YTM is 8%.
61/77
Corporate Bonds
62/77
Definition
Corporate bonds are bonds issued by corporations.
Corporate bonds involve default risk, the risk that the

corporation fails to pay the promised cash flows.
The price of a corporate bond depends on:

– promised cash flows
– spot rates
– likelihood of default
– risk premium associated with default/recovery rate.
63/77
Historical default rates (US)

This graph plots the annual value-weighted percentage default rates for bonds issued by domestic
non financial firms for the 1866–2008 period.
Source: Giesecke et al. (2011): “Corporate Bond Default Risk: A 150-year

Perspective," Journal of Financial Economics.
64/77
Bond Ratings
Corporate bonds are rated by rating agencies, such as

Moody’s, Standard and Poor’s (S&P), etc.
Ratings provide an indication of the likelihood of default.

– Investment grade bonds: Aaa-Baa by Moody’s, or AAA-BBB by
S&P.
– Speculative grade bonds (junk bonds): Ba and below by Moody’s,
or BB and below by S&P.
65/77
S&P Global Ratings credit rating symbols provide a simple, efficient way to
The ABCs of Rating
communicateScales
creditworthiness and credit quality.
S&P Global Ratings Our global rating scale provides a benchmark for evaluating the relative
credit risk of issuers and issues worldwide.
General summary of the opinions reflected by our ratings
AAA Extremely strong capacity to meet financial commitments. Highest rating
Investment
Grade AA Very strong capacity to meet financial commitments
Strong capacity to meet financial commitments, but somewhat susceptible to
A
adverse economic conditions and changes in circumstances
Adequate capacity to meet financial commitments, but more subject
BBB
to adverse economic conditions
BBB- Considered lowest investment-grade by market participants
BB+ Considered highest speculative-grade by market participants
Speculative
Grade Less vulnerable in the near-term but faces major ongoing uncertainties to
BB
adverse business, financial and economic conditions
More vulnerable to adverse business, financial and economic conditions
B
but currently has the capacity to meet financial commitments
Currently vulnerable and dependent on favorable business, financial and
CCC
economic conditions to meet financial commitments
Highly vulnerable; default has not yet occurred, but is expected to be
CC
a virtual certainty
Currently highly vulnerable to non-payment, and ultimate recovery is
C
expected to be lower than that of higher rated obligations
Payment default on a financial commitment or breach of an imputed promise;
D
also used when a bankruptcy petition has been filed or similar action taken
Ratings from ‘AA’ to ‘CCC’ may be modified by the addition of a plus (+) or minus (-) sign to show relative
standing within the major rating categories. 66/77
Value of U.S. Corporate Bonds by Rating

Source: WSJ, September 20, 2018, www.wsj.com
67/77
Price with Default Risk

Recall that the price of a bond with no default risk is given by
c c 100 + c
Price = + + ··· +
1 + r1 (1 + r2 )2 (1 + rT )T
where rt is the t-year spot rate, c% the coupon rate, and T the
years to maturity.
To compute the price in the presence of default risk, we need to

use
– expected cash flows
– risk-adjusted discount rates.
For expected cash flows, we need to estimate the likelihood of

default.
For risk-adjusted discount rates, we can use a risk model such

as the CAPM.
68/77
YTM with Default Risk

Recall that the YTM (y ) of a bond with no default risk is defined
by
c c 100 + c
Price = + 2
+ ··· + ,
1+y (1 + y ) (1 + y )T
where c% is the coupon rate, and T the years to maturity.
The YTM in the presence of default risk is defined by the same

formula.
A bond with default risk has

– lower price
– higher YTM
than an otherwise identical bond with no default risk.
The difference in the YTMs of the two bonds is the default

spread.
69/77
of U.S. corporate debt to GDP. In terms of a moving yearlong average, U.S. nonfinancial-corporate debt
finished 2017 at an unprecedented 45.4% of U.S. nominal GDP. Nevertheless, not only was the U.S.’
high-yield default rate of Q4-2017 at a below-trend 3.3%, but the accompanying average high-yield
US High-Yield Bond Spreads and Default Rates
bond spread of 363 basis points reflected expectations of an even lower default rate nine to twelve
months hence. Moody’s Default Research Group expects the default rate to approximate 2% during early
Source:
2019.Moody’s Analytics, March 15, 2018
Figure 1: Both High-Yield Bond Spread and Moody's Default Research Group Project a Declining Trend for
the Default Rate Into 2019
US High-Yield Bond Spread: basis points (bp) ( L ) US High-Yield Default Rate: %, actual & projected ( R )
2,000
14.25
1,800
13.00
1,600 11.75
10.50
1,400
9.25
1,200
8.00
1,000 6.75
800 5.50
4.25
600
3.00
400
1.75
200 0.50
Dec-93 Dec-95 Dec-97 Dec-99 Dec-01 Dec-03 Dec-05 Dec-07 Dec-09 Dec-11 Dec-13 Dec-15 Dec-17
70/77
Features of Corporate Bonds
Secured vs. Unsecured: Secured bonds are backed by specific

assets.
Senior vs. Subordinated: Senior bonds have priority in being
repaid.
Sinking fund provisions: Issuers have to make regular payments
into a sinking fund, to retire part of the bond issue.
Put provisions: Investors can sell the bonds back to the issuer at
a pre-specified price under pre-specified conditions.
Covenants: Restrictions on issuers’ ability to take actions that
affect the value of the bonds. (Issue additional bonds, make
dividend payments, etc.)
Call provisions: Issuers can retire the bonds at pre-specified
prices on pre-specified dates prior to maturity.
71/77
Application: The Case of the German Twin

Bonds
72/77
German Twin Bonds

Pastor, L., Stambaugh, R. F., & Taylor, L. A. (2022). Dissecting green returns. Journal of Financial
Economics, 146(2), 403-424.
What does the past performance of green bonds imply about

their future performance?
– Pastor et al. (2021) show that green bonds have higher realized
returns and lower expected returns than brown bonds
– Reasons:
1. Investors have green tastes
2. Greener assets are a better hedge against climate risk
– Green bonds’ lower expected returns reflects a taste premium and
a risk premium
73/77
German Twin Bonds

Economics, 146(2), 403-424.
The case of German “twin” bonds illustrates the inverse relation

between realized returns and expected returns in the context of
climate concerns
Since 2020, the German government has issued green bonds,
along with virtually identical non-green twins
– Green bonds have eco and climate friendly budget expenditures
assigned
The green bonds trade at lower yields, indicating lower expected
returns compared to non-green bonds
– The yield spread between the green and non-green twins, known
as the “greenium” reflects investors’ willingness to accept a lower
return in exchange of holding assets more aligned with their
environmental values
74/77
German Twin Bonds

Economics, 146(2), 403-424.
The difference between the yield of green and non-green bonds

is the greenium
– Investors holding the bonds to maturity, the green bond always has
a lower expected return than the non-green bond
75/77
German Twin Bonds

Economics, 146(2), 403-424.
Given the lower yield of the green bond, one would expect it to
deliver a lower return than its conventional twin
Instead, the green bond delivered a higher realized return in
the sample!
To show this, the authors built a long-short portfolio (buy green
bonds, short non-green bonds)
76/77
German Twin Bonds

Economics, 146(2), 403-424.
Importantly, the positive average return of the long-short portfolio

does not imply that the portfolio’s expected return is positive!
We know with certainty that the portfolio’s expected return is
negative if the bonds are held to maturity
– The green bonds deliver a lower return than the non-green bonds,
as their YTM is lower
How can we reconcile the higher realized return of the
green bond with its lower expected return?
– If investors’ tastes shift toward green assets, they push up the price
of the green bond relative to the non-green bond
– However, the green bond’s outperformance is temporary, as it
comes entirely at the expense of the bond’s future return
77/77

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COMM371/COEC371 – Investment Theory

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Definition and Overview of Fixed-Income Securities

A fixed-income security is a security that promises cash flows of

Category Issuer Market Cap. % of Total

As of 2021Q4. Source: Securities Industry and Financial Markets Association (SIFMA).

Fixed-Income is an Important Asset Class

Market cap: Fixed-Income vs Equity (in trillions)

Source: SIFMA & World Bank.

Fixed-Income Market Average Daily Trading Volume in 2021

Fixed-Income Markets Trends

Source: SIFMA (as of December 2021)

Fixed-Income Markets Trends

A zero-coupon bond (or zero) promises a single cash flow, face

A coupon bond promises a periodic cash flow, coupon, and the

The time to maturity is the length of time until maturity.

For notational simplicity, from now on, we assume that bonds

Cash flows of a bond with coupon rate 8.5%, annual coupon

Cash flows of a bond with coupon rate 10%, semiannual coupon

The only fixed-income securities that involve virtually no default

The US Treasury issues three types of securities:

The US Treasury allows buyers of T-notes and T-bonds to

Term Structure of Spot Rates

Term Structure of Spot Rates

Generally speaking, asset valuations are driven by news about (i)

With fixed-income securities, there is no cash flow uncertainty (in

We know, from standard discounting, that the present value of $1

where rt is the annual interest rate for year t, also referred to as

Term Structure of Spot Rates

In general, the interest rate depends on the length of the time

Example: If you buy a 5-year GIC (guaranteed investment

Therefore, to value fixed-income securities, which typically

The term structure of spot rates represents the spot rates as a

Example: Bond Valuation Using the Term Structure

Calculate the price of a bond that has a face value of $100,

The Yield Curve

Facts about the Term Structure

The term structure can have many shapes.

Interest rates of different maturities tend to move together.

Current Canada Term Structure

Current US Term Structure

Monetary Policy & Term Structure of Interest Rates

What forces determine the term structure of interest rates?

Answer provided by the expectations theory.

The expectations theory provides a relationship between

Expectations Theory: Example

[t→t + 2] vs [t→t + 1→t + 2]

Expectations Theory: Graphical Illustration

We can infer expected future interest rates from the current

Notation: rN,t is the interest rate applied to N years out prevailing

t=0 t=1 t=2 t=3 t=T

Expectations Theory: Example (continued)

Consider two investment opportunities for one dollar.

Option A: Buy a 2-year zero-coupon bond in year t

Option B: Buy a 1-year bond in year t and use the proceeds to

Expectations Theory: Example (continued)

In expectation, the investment should be worth the same amount

(1 + r2,t )2 = (1 + r1,t )(1 + r1,t+1

The expected annual rate of return on the 1-year bond at t + 1 is

Similarly, the 1-year forward rate at t + 2 can be determined by:

Expectations Theory: Generalization

The same relationship leads to the following approximation

The expectations theory says that long-term rates are