Professor Chinco

FIN3000
Principles of Finance
Chapter 6
Today’s topics
How bonds work

Pricing bonds

Yield to maturity

Yield curve

What determines bond yields?

How bonds work
What is a bond?
Bond is an asset that pays a fixed series of cash flows at regularly spaced intervals.

Person who sells the bond is called the “issuer”.

Regular cash flows from bond are called “coupon payments”.

At time of last coupon payment, bond pays out “face value” + coupon payment.

e.g., a 2-year bond with a $100 face value and a 2% annual coupon rate would have payouts:

Year 1: Coupon rate x Face value = $2

2% $100

Year 2: Coupon rate x Face value + Face value = $102

2% $100 $100
Bonds are loans
Person who buys the bond is lending money to the issuer.

Price of bond is size of the loan.

Coupon payments are the interest payments.

**Note** Coupon rate is different from the discount rate

used in present value formulas.
Basic bond/loan types
Pure discount: The principal amount is repaid at some
future date, without any periodic interest payments. (e.g.,
Treasury bills, zero coupon bonds)

Interest-only: Borrower pays interest each period and repay

the entire principal at some future date. (e.g., corporate
bonds, treasury bonds)

Amortized: Borrower repays principle of the loan over time.

The process of providing for a loan to be paid off by
making regular principal reductions is called amortizing
the loan. (e.g., mortgages, auto loans)
Why would a company issue bonds
rather than borrow from a bank?

Corporate bonds offer company

1) lower interest rate and
2) less bank oversight.

Bank loans are

1) easier to restructure later and
2) less of an administrative hassle to get in the
first place.
Pricing bonds
Present discounted value
Price of bond is present discounted value of its future cash flows:

c x F c x F (1 + c) x F
Price = ————— + ————— + … + ———————————
(1+r1)1 (1+r2)2 (1+rT)T

Ft = face value; size of bond

ct = coupon rate; fraction of face value paid each period
Tt = maturity; number of periods bond lasts for
rt = discount rate applied to cash flows at time t
Discount rates at different
horizons
Price of bond is present discounted value of its future cash flows:

c x F c x F (1 + c) x F
Price = ————— + ————— + … + ———————————
(1+r1)1 (1+r2)2 (1+rT)T

In general, market will apply different discount rates to cash flows arriving
at different future times. e.g., r5 ≠ r7.

y = yield to maturity. Answer to question: “Suppose you discounted cash flows

at every horizon at the exact same rate. What would that rate have to be in
order to price the bond correctly?” Different bonds will have different yields.
Class problem
Consider a 2-year coupon bond with an annual coupon rate of 4% and a face
value of $100.

If the 1-year discount rate is 3% and the 2-year discount rate is 5%, then
what is the current price of the bond?

c x F (1+c) x F
Price = —————— + —————————
(1+r1)1 (1+r2)2

$4 $104
= —————— + —————— = $98.21
(1+3%)1 (1+5%)2
Class problem
Consider a 2-year coupon bond with an annual coupon rate of 4% and a face
value of $100.

If the 1-year discount rate is 3% and the 2-year discount rate is 5%, then
what is the current price of the bond?

c x F (1+c) x F
Price = —————— + —————————
(1+r1)1 (1+r2)2

$4 $104
= —————— + —————— = $98.21
(1+3%)1 (1+5%)2
Class problem
Consider a 2-year coupon bond with an annual coupon rate of 4% and a face
value of $100.

If the 1-year discount rate is 3% and the 2-year discount rate is 5%, then
what is the current price of the bond?

c x F (1+c) x F
Price = —————— + —————————
(1+r1)1 (1+r2)2

$4 $104
= —————— + —————— = $98.21
(1+3%)1 (1+5%)2
Class problem
Consider a 2-year coupon bond with an annual coupon rate of 4% and a face
value of $100.

If the 1-year discount rate is 3% and the 2-year discount rate is 5%, then
what is the current price of the bond?

c x F (1+c) x F
Price = —————— + —————————
(1+r1)1 (1+r2)2

$4 $104
= —————— + —————— = $98.21
(1+3%)1 (1+5%)2
Yield to
maturity
Yield to maturity
Price of bond is present discounted value of its future cash flows.

c x F c x F (1 + c) x F
Price = ————— + ————— + … + ———————————
(1+y1)1 (1+y2)2 (1+yT)T

In general, market will apply different discount rates to cash flows arriving
at different future times. e.g., r5 ≠ r7.

y = yield to maturity. Answer to question: “Suppose you discounted cash flows

at every horizon at the exact same rate. What would that rate have to be in
order to price the bond correctly?” Different bonds will have different yields.
Class problem
Consider a 3-year coupon bond with an annual coupon rate of 8% and a face value of $1,000.

If the yield to maturity is 8%, what is the current price of the bond?
c x F c x F (1+c) x F
Price = —————— + ————— + —————————
(1+y)1 (1+y)2 (1+y)3

$80 $80 $1,080

= —————— + —————— + ——————— = $1,000
(1+8%)1 (1+8%)2 (1+8%)3

If the yield to maturity is 9%, what is the current price of the bond?

$80 $80 $1,080

Price = —————— + —————— + ——————— = $975.69
(1+9%)1 (1+9%)2 (1+9%)3
Class problem
Consider a 3-year coupon bond with an annual coupon rate of 8% and a face value of $1,000.

If the yield to maturity is 8%, what is the current price of the bond?
c x F c x F (1+c) x F
Price = —————— + ————— + —————————
(1+y)1 (1+y)2 (1+y)3

$80 $80 $1,080

= —————— + —————— + ——————— = $1,000
(1+8%)1 (1+8%)2 (1+8%)3

If the yield to maturity is 9%, what is the current price of the bond?

$80 $80 $1,080

Price = —————— + —————— + ——————— = $975.69
(1+9%)1 (1+9%)2 (1+9%)3
Class problem
Consider a 3-year coupon bond with an annual coupon rate of 8% and a face value of $1,000.

If the yield to maturity is 8%, what is the current price of the bond?
c x F c x F (1+c) x F
Price = —————— + ————— + —————————
(1+y)1 (1+y)2 (1+y)3

$80 $80 $1,080

= —————— + —————— + ——————— = $1,000
(1+8%)1 (1+8%)2 (1+8%)3

If the yield to maturity is 9%, what is the current price of the bond?

$80 $80 $1,080

Price = —————— + —————— + ——————— = $975.69
(1+9%)1 (1+9%)2 (1+9%)3
Class problem
Consider a 3-year coupon bond with an annual coupon rate of 8% and a face value of $1,000.

If the yield to maturity is 8%, what is the current price of the bond?
c x F c x F (1+c) x F
Price = —————— + ————— + —————————
(1+y)1 (1+y)2 (1+y)3

$80 $80 $1,080

= —————— + —————— + ——————— = $1,000
(1+8%)1 (1+8%)2 (1+8%)3

If the yield to maturity is 9%, what is the current price of the bond?

$80 $80 $1,080

Price = —————— + —————— + ——————— = $975.69
(1+9%)1 (1+9%)2 (1+9%)3
Class problem
Consider a 3-year coupon bond with an annual coupon rate of 8% and a face value of $1,000.

If the yield to maturity is 8%, what is the current price of the bond?
c x F c x F (1+c) x F
Price = —————— + ————— + —————————
(1+y)1 (1+y)2 (1+y)3

$80 $80 $1,080

= —————— + —————— + ——————— = $1,000
(1+8%)1 (1+8%)2 (1+8%)3

If the yield to maturity is 9%, what is the current price of the bond?

$80 $80 $1,080

Price = —————— + —————— + ——————— = $975.69
(1+9%)1 (1+9%)2 (1+9%)3
Class problem
Consider a 3-year coupon bond with an annual coupon rate of 8% and a face value of $1,000.

If the yield to maturity is 8%, what is the current price of the bond?
c x F c x F (1+c) x F
Price = —————— + ————— + —————————
(1+y)1 (1+y)2 (1+y)3

$80 $80 $1,080

= —————— + —————— + ——————— = $1,000
(1+8%)1 (1+8%)2 (1+8%)3

If the yield to maturity is 9%, what is the current price of the bond?

$80 $80 $1,080

Price = —————— + —————— + ——————— = $975.69
(1+9%)1 (1+9%)2 (1+9%)3
Price vs. yield
1500

Bond Price
1275

1050

825

600
0% 3% 6% 9% 12%

Yield-to-Maturity
Yield vs. coupon rate
If yield to maturity = coupon rate, then par value = bond
price. Priced “at par”; called a “par bond”.

If yield to maturity > coupon rate, then par value > bond
price. Why? The discount provides yield above coupon
rate. Priced “below par”; called a “discount bond”.

If yield to maturity < coupon rate, then par value < bond
price. Why? Higher coupon rate causes value above par
Priced “above par”; called a “premium bond”.
Yield curve
What is the yield curve?

A “yield curve” summarizes the pricing of bonds of

different maturity by plotting the yields on zero coupon
bonds of different maturities.

It depicts the “term structure of interest rates.”

https://stockcharts.com/freecharts/yieldcurve.php
Normal vs inverted yield curve

Normal – upward-sloping; long-term yields are higher than

short-term yields.

Inverted – downward-sloping; long-term yields are lower

than short-term yields.

Market crashes are often preceded by inverted yield curve

What determines
bond yields?
Bond yields are affected by…

Interest-rate risk

Default risk

Taxability

Liquidity

Inflation risk
Interest-rate risk
Suppose you buy a bond at par today. Then, overnight, yields shift
upwards by 1% at all horizons. Your bond will suddenly be priced
below par tomorrow morning.

Its cash flows haven’t changed. But it will be priced differently

because the market is discounting those cash flows at a higher rate.

Interest-rate risk is the name for the uncertainty generated by this

phenomenon.

Long-term bonds have more interest-rate risk than short-term bonds.

Low-coupon bonds have more interest-rate risk than high-coupon bonds.
Bond rates of return
Rate of return is defined as

Coupon(t+1) + [Price(t+1) - Price(t)]

Return(t+1) = —————————————————————————————————————
Price(t)

Price(t) = How much you paid for the bond

Price(t+1) = How much you can sell the bond for next period
Coupon(t+1) = Coupon payment delivered by bond next period

Answers question: “Suppose you bought a bond today. If you sold it

tomorrow, what would be your gain on each dollar invested?”
Class problem
Suppose you buy a bond today for $963.80. Next period, the bond
pays a $21.86 coupon and its price increases from $963.80 to
$1,380.50 because yields have fallen.
What rate of return did you earn on this bond purchase?

$21.86 $1,380.50 $963.80

Coupon(t+1) + [Price(t+1) - Price(t)]
Return(t+1) = ————————————————————————————————————— = 45.5%
Price(t)
$963.80
Class problem
Suppose you buy a bond today for $963.80. Next period, the bond
pays a $21.86 coupon and its price increases from $963.80 to
$1,380.50 because yields have fallen.
What rate of return did you earn on this bond purchase?

$21.86 $1,380.50 $963.80

Coupon(t+1) + [Price(t+1) - Price(t)]
Return(t+1) = ————————————————————————————————————— = 45.5%
Price(t)
$963.80
Class problem
Suppose you buy a bond today for $963.80. Next period, the bond
pays a $21.86 coupon and its price increases from $963.80 to
$1,380.50 because yields have fallen.
What rate of return did you earn on this bond purchase?

$21.86 $1,380.50 $963.80

Coupon(t+1) + [Price(t+1) - Price(t)]
Return(t+1) = ————————————————————————————————————— = 45.5%
Price(t)
$963.80
Class problem
Suppose you buy a bond today for $963.80. Next period, the bond
pays a $21.86 coupon and its price increases from $963.80 to
$1,380.50 because yields have fallen.
What rate of return did you earn on this bond purchase?

$21.86 $1,380.50 $963.80

Coupon(t+1) + [Price(t+1) - Price(t)]
Return(t+1) = ————————————————————————————————————— = 45.5%
Price(t)
$963.80
Default risk
Suppose you buy a 3-year coupon bond with a face value of $100 and an annual
coupon rate of 5%.

The bond is scheduled to pay $5 in year 1, $5 in year 2, and $105 in year 3.

But, if the bond issuer defaults after the first 2 payments, then you will
receive $5 in year 1, $5 in year 2, and $0 in year 3.

Default risk is the name for the uncertainty generated by this possibility.

If the bond was priced at par under the assumption that there was no default
risk, then it will be priced below par in the presence of default risk.
Bond ratings
Standard & Poors and Moody’s are the most widely used bond ratings
agency. Fitch is distant third.

Investment-grade
High Grade Medium Grade
Standard & Poor’s AAA AA A BBB
Moody’s Aaa Aa A Baa

Speculative-grade
High yield
Low Grade Junk
Standard & Poor’s BB B CCC CC C D
Moody’s Ba B Caa Ca C C
How ratings are described
Standard &
Moody' s Poor's
The strongest rating; ability to repay interest and principal is very
Aaa AAA
strong
Aa AA Very strong likelihood that interest and principal will be repaid

A A Strong ability to repay, but some vulnerability to changes in

circumstances

Baa BBB Adequate capacity to repay; more vulnerability to changes in economic

circumstances

Ba BB Considerable uncertainty about ability to repay

B B Likelihood of interest and principal payments over sustained periods is

questionable
Caa CCC
Bonds in the Caa/CCC and Ca/CC classes may already be in default or in
Ca CC danger of imminent default
C-rated bonds offer little prospect for interest or principal on the debt
C C
ever to be repaid
Default rates by bond rating
Yields by bond rating
Yield spreads between corporate Baa
and Aaa bonds
Today’s topics
How bonds work

Pricing bonds

Yield to maturity

Yield curve

What determines bond yields?