BF2 - Lecture4 - Bond Prices and Yields

Introduction Bond Characteristics Bond Pricing Bond Yield Bond Prices over Time Default Risk
Lecture 4
Chapters 14. Bond Prices and Yields
Associate Professor Dr. Phan Dinh Khoi
Faculty of Finance and Banking

School of Economics
Can Tho University
Oct 24 2023
Phan Dinh Khoi Business Finance 2 - Lecture 4 1 / 42

Outline
1 Introduction
2 Bond Characteristics
3 Bond Pricing
4 Bond Yield
5 Bond Prices over Time
6 Default Risk

A debt security is a claim on a specific periodic stream of

income. Debt securities are often called fixed-income
securities because they promise either a fixed stream of
income or one that is determined according to a specific
formula.
Bonds are the basic debt security. Bond pricing explains how
bond prices are set in accordance with market interest rates
and why bond prices change with those rates.
Given these properties, we look at some measures of bond
returns such as yield to maturity, yield to call,
holding-period return, and realized compound rate of
return.
We also discuss how bond prices evolve, tax rules affect
debt securities, credit risk, and its instruments affect
bond pricing.

Definitions
A bond is a security that is issued in connection with a

borrowing arrangement in which the borrower issues a bond to
the lender for some amount of cash. Therefore, the bond is
the ”IOU” of the borrower.
The arrangement obligates the issuer to make specified
payments to the bondholder on specified dates.
A typical coupon bond obligates the issuer to make
semiannual payments of interest to the bondholder for the life
of the bond. These are called coupon payments.
When the bond matures, the issuer repays the debt by paying
the bond’s par value or face value.
The coupon rate of the bond determines the interest
payment: The annual payment is the coupon rate times the
bond’s par value.

Definitions of terms
The contract between the issuer and the bondholder is called

the bond indenture which includes the coupon rate,
maturity rate, and par value.
Normally, bonds are issued with coupon rates set just high
enough to induce investors to pay for pay par value to buy the
bond. Sometimes, zero-coupon bonds are issued.
A zero coupon bond makes no coupon payment for the
bondholder but the par value at the maturity date.
These bonds are issued at prices considerably below par value
as the investor’s return comes solely from the difference
between the issue price and the payment of the par value.
par value - the amount at the maturity date

Treasury Bonds and Notes
Bonds and Notes can be purchased directly from the Treasury.

Treasury notes are issued with maturity ranging between 1 to
10 years
Treasury bonds’ maturity ranges from 10 to 30 years.
Both make semiannual coupon payments
Denominations
As small as $100
mệnh giá
Usually bonds are sold in denominations of $1000
<1 bills
1- 10 notes
10> bonds

sell buy

Coupon rate is 2.5%

Par value is typically $1000
Bond pays interest of $25 per year into two semiannual
payments of $12.5
Payments are made in May and November
Bid and Asked are quoted as a percentage of par value.
Bid price is 97.9922% of par value or $979.922 for
bondholders who want to sell the bond to a dealer.
Asked price is 98.0234% of par value or $980.234 for
bondholders who want to buy the bond from a dealer.
The minimum increment in price is called tick size which is
calculated by 1/128. Therefore, the bond is selling for
983/128 percent of its par value.

The Asked Yield is the yield to maturity on the bond based on

the asked price.
The yield to maturity measures the average rate of return to
an investor who purchases the bond for the asked price and
holds it until maturity.
Bonds are traded in both primary and secondary markets.
Therefore, the bond prices quoted on the websites are not
actually the price that investors pay for the bond.
Because the quoted price does not include the interest rate
that accrues between coupon payment dates.

Accrued Interest and Quoted Bond Prices
If a bond is purchased between coupon payments, the buyer must

pay the seller for accrued interest as the prorated share of the
upcoming semiannual coupon.
For example
If 30 days have passed since the last coupon payment, and
there are 182 days in the semiannual coupon period, the seller
is entitled to a payment of accrued interest rate of 30/182 of
the semiannual coupon.
The sale, or invoice, price of the bond would equal the stated
price plus the accrued interest. 365 / 2 = 182
semi annualy
The accrued interest is calculated as: tick size to calculate the
interest rate have pay
Annual coupon payment Days since last coupon
× (1)
2 Days separating coupon payments

Corporate Bonds
Corporations borrow money by issuing corporate bonds. Although

corporate bonds are publicly traded on different channels, most
bonds are traded over-the-counter in a network of dealers via many
electronic quotation systems and flat forms.
The bond listing often includes the coupon, maturity, price,
yield to maturity, and ratings by service providers.
Bonds with A ratings are safer than those with B ratings.
Higher ratings provide lower yields to maturity.

Corporate Bonds

Call provisions on Corporate Bonds
Callable bonds
Some corporate bonds are issued with call provisions that

allow the issuer to repurchase the bond at a specified call
price before the maturity date.
These callable bonds are designed to protect the issuer from
fluctuations in interest rates relative to coupon rates.
Callable bonds come with a period of call protection, an initial
time during which the bonds are not callable. These are called
deferred callable bonds.
To compensate investors for risk, callable bonds are issued
with higher coupons and promised higher yields to maturity
than noncallable bonds. to be active in cash flow that company want
to keep the money
(not have to pay a large money at the
maturity date for specific company plans)
Puttable bonds
Puttable bonds give the bondholders the option to extend the

bond at the put date.
IF the bond’s coupon rate exceeds current market yields, the
bondholder will choose to extend the bond’s life.
If the bond’s coupon rate is low, it will be optional for the
bondholder.
extend

Floating-rate bonds
make interest payments that are tied to some measure of current

market rates.
For instance, the rate might be adjusted to the current T-bills
rate plus 2%.
This arrangement means that the bond always pays
approximately current market rates.

Preferred Stocks
Referred stock is considered to be equity but it is often included in

the category of fixed-income assets. Similar to bonds, preferred
stocks promise to pay a specified stream of dividends. However,
unlike bonds, failure to pay dividends does not cause bankruptcy.
Preferred stocks pay a fixed dividend hence it is not
considered tax-deductible expenses for the firm.
However, when a corporation buys preferred stocks of other
firms, its effective tax rate is reduced.
Other Types of Bonds include
Bonds issued by domestic corporations.
Bonds issued by international corporations.

Bond value and Price
Bonds pay coupon and principal payments in the future.

Therefore, the price an investor would be willing to pay for a
claim to those payments depends on the value to be received
in the future compared to that of today.
To value a bond, we discount its expected cash flow by the
approximate discount rate.
Bond value = Present value of coupon + Present value of par
T
X Coupon Par value
Bond value = + (2)
(1 + r )t (1 + r )t
t=1
Alternatively, the bond price is

Price = Coupon × Annuity factor(r,T) + Par value × PV factor(r,T)

Bond pricing between Coupon Dates
As bonds are normally purchased between coupon days, in this

case, we apply the same principle with adjustments as follows:
Compute the present value of each remaining payment then
sum up.
Adjust for the fractional period remaining until each payment.
It is actually the invoice price.
Invoice price = Flat price + Accrued interest

Bond pricing between Coupon Dates
For the 2.5% coupon May 2046 maturity in Figure 14.1, the
invoice price can be calculated in Spreadsheet 14.1, and likewise
for the others.
Figure: Sheet 14.1 Bond pricing

Bond Prices and Yields
Figure: 14.3 The inverse relationship between bond prices and yields

Yield to Maturity
The bf Yield to Maturity is defined as the interest rate that

makes the present value of a bond’s payment equal to its
prices.
The YTM allows investors to measure the average rate of
return over the bond’s life.
To calculate YTM, we solve the bond price equation for the
interest rate given the bond’s price.
T
X Coupon Par value
Bond value = + (3)
(1 + r ∗ )t (1 + r ∗ )t
t=1
Example 14.6 Yield to maturity

Yield to Calls
Callable bonds are subject to the Yield to Calls. Figure 14.4

illustrates the risk of call to the holder.
Figure: 14.4 Callable bond prices vs straight debts

Yield to Calls
Given a non-callable bond BN with par value $1000, an 8%

coupon rate, and 30-year time to maturity as a function of the
market interest rate.
▶ If interest rates fall, the bond price can rise substantially.
Given also a callable bond BC with the same coupon rate and
maturity date but it is callable at 110% at par value.
▶ If interest rates fall, the bond price can rise up to the call
price, $1100.
To calculate the yield to call, we apply the same formula for the
YTM with some adjustments:
time to call replaces time to maturity
call price replaces par price
▶ This calculation is called ”yield to first call”

Yield to Calls
Figure: Example 14.7 Yield to call vs Yield to maturity

Realized Compound Return versus Yield to Maturity
Figure: 14.5 Growth of invested funds

Realized Compound Return versus Yield to Maturity
Yield to maturity will equal the rate of return realized over the
bond’s life if all coupons are reinvested at an interest rate equal to
the bond’s yield to maturity.
If the reinvestment rates are not equal to the bond’s yield to
maturity, the conventional yield to maturity will not equal
realized coupon return.
In an economy with future interest rate uncertainty, bond
investors are subject to two sources of risk.
▶ When interest rates rise, bond prices fall, and the
portfolio value is reduced.
▶ reinvested coupon income will compound more
rapidly at high rates.
The reinvestment rate risk is said to offset the impact of price
risk.

As bond pricing provides a fair bond value when its coupon rate
equals the market interest rate. Hence, the investor receives fair
compensation for the time value of money in the form of recurring
coupon payments.
When the coupon rate is lower than the market interest rate,
the coupon payments only will not provide investors as high a
return as they could earn elsewhere.
Investors need some price appreciation on their bonds as
compensation.
Hence, the bond must offer below par value to provide a
”built-in” capital gain on the investment

Figure 14.6 illustrates the price path of two 30-year maturity bonds
at a yield-to-maturity rate of 6%.
Figure: 14.5 Price path of two 30-year maturity bonds

Fair Holding Period Return: An Example
To illustrate built-in gains or losses, suppose a bond was issued

several years ago when the interest rate was 7%. The bond’s
annual coupon rate was set at 7%. Given three years left in the
bond’s life, the interest rate is now 8% per year.
The present value is
$70 × Annuity factor(8%, 3) + $1000 × PV factor(8%, 3) = $974.23
After the next coupon is paid, the bond would sell at

$70 × Annuity factor(8%, 2) + $1000 × PV factor(8%, 2) = $982.17
Capital gain over one year is $7.94.

If the investor had purchased the bond at $974.23, the total
return over the year would equal the coupon payment plus the
capital gain: $70 + $7.94 = $77.94.
▶ This represents a rate of return of $77.94/$947.23 = 8%
Yield to Maturity versus Holding Period Return
Now consider a 30-year bond paying an annual coupon of $80 and

selling at par value of $1000. The bond’s initial yield to maturity is
8%.
If the yield remains at 8% over the year, the bond price will
remain at par value. Therefore, its holding period return will
remain at 8$.
However, if the yield falls below 8%, the bond price will
increase to $1050.
The holding period return is
$80+($1050−$1000)
Holding-period return = $1000 = 0.13 or 13%
▶ The HPR increase as the yield falls.

Zero-coupon Bonds and Treasury Strips
The zero-coupon carries no coupon per annual period and

provides all its return in the form of price appreciation. It
provides only cash flow to bondholders on the maturity date.
The US Treasury issues both short-term zero-coupon bonds
and long-term zero-coupon bonds.
While the short-term zero-coupon bond is called the original
issue discount bond, the long-term zero-coupon bonds are
commonly created from coupon-bearing notes and bonds. It is
often called Treasury Strips.
These zero-coupon bonds are issued under the Treasury
program namely ”Separating Trading of Registered Interest
and Principal of Securities” or STRIPS

The US Treasury bills, for example, are short-term zero

coupon instruments. If the bill has face value of $10,000 then
the Treasury sells it for some amount less than $10,000 and
agrees to repay $10,000 at the maturity date. Hence, all
investor’s return comes in the form of price appreciation.
A bond dealer may ask the Treasury to break down the cash
flows to be paid by the bond into a series of independent
securities. Each one is a claim to one of the repayments of
the original bond. For example, a 10-year coupon would be
”stripped” of its 20 semiannual coupons, and each coupon
payment would range from six months to 10 years.
The final payment of principal would be treated as another
stand-alone zero coupon security.

What would happen to prices of zeros overtime?

Consider a zero with 30 years until maturity, and suppose the
market interest rate is 10% per year.
The price of the bond today is $1000/(1.1.)30 = $57.31.
Next year, with only 29 years to maturity, the price will be
$1000/(1.10)29 = $63.04
▶ Hence, the par value of the bond is now discounted for one less
year, its price has increased by 1-year discount factor.

Figure: 14.7 The price of a 30-year zero-coupon bond over time at a yield
to maturity of 10%

After-Taxe Returns
The tax authorities recognize the ”built-in” price appreciation as a

capital gain. Any additional gains or losses that arise from changes
in market interest rates are treated which is subject to tax by the
International Revenue Service (IRS).
For example, the IRS recognizes $63.04 − $57.31 = $5.73 as a
capital gain hence this amount is subject to tax.
The price of the bond today is $1000/(1.1.)30 = $57.31.
Next year, with only 29 years to maturity, the price will be
$1000/(1.10)29 = $63.04
▶ Hence, the par value of the bond is now discounted for one less
year, its price has increased by 1-year discount factor.
If the interest rate falls to 9.9%, the bond price will be
$1000/(1.099)29 = $64.72, this capital gain
($64.7 − $63.04 = $1.68) is also subject to tax.

Default risk and Bond Pricing
Although bonds promises a fixed flow of income, that income is

not risk-less. While US government bonds may be treated as free
of default risk, this is not true for corporate bonds.
The actual payments on corporate bonds are uncertain as they
depend on the corporate’s financial health.
Bond default risk usually called credit risk is measured by credit
providers namely Moody’s Investor Services, Standard & Poor’s
Corporation, Fitch Investor Services, and so on.
Figure 14.8 provides the bond ratings of these service providers.
Based on credit ratings, bonds can be classified as:
Investment-grade bonds
Speculative-grade bonds or Junk bonds

Altman (1968) suggested an equation to separate default and

non-default bonds as:
EBIT Sales Shareholders’ equity
Z = 3.1 + 1.0 + 0.42
Total assets Assets Total liabilities (4)
Retained earnings Working capital
+0.85 + 0.72
Total assets Total assets
Z-Scores and Zones of discrimination:
Z > 2.90 is considered a ”safe” zone
1.23 < Z < 2.90 is considered a ”grey” zone
Z < 1.23 is considered a ”distress” zone

Figure: 14.9 Discriminant analysis

Figure: 14.11 Yield spreads between corporate and 10-year Treasury

bonds

Credit Default Swap
A credit default swap is defined as an insurance policy on the

default risk of a bond. The CDS seller collects annual
payments for the term of the contract but must compensate
the buyer for loss of bond value in the event of default.
For example, Figure 14.12 illustrates the price of 5-year CDS
contracts on Greek government debt between 2009 and 2010
vs. German government bonds.

Credit Default Swap

QUESTIONS AND ANSWERS

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Introduction Bond Characteristics Bond Pricing Bond Yield Bond Prices over Time Default Risk

Associate Professor Dr. Phan Dinh Khoi

Faculty of Finance and Banking

Phan Dinh Khoi Business Finance 2 - Lecture 4 1 / 42

5 Bond Prices over Time

Phan Dinh Khoi Business Finance 2 - Lecture 4 2 / 42

A debt security is a claim on a specific periodic stream of

Phan Dinh Khoi Business Finance 2 - Lecture 4 3 / 42

A bond is a security that is issued in connection with a

Phan Dinh Khoi Business Finance 2 - Lecture 4 4 / 42

The contract between the issuer and the bondholder is called

par value - the amount at the maturity date

Phan Dinh Khoi Business Finance 2 - Lecture 4 5 / 42

Treasury Bonds and Notes

Bonds and Notes can be purchased directly from the Treasury.

Phan Dinh Khoi Business Finance 2 - Lecture 4 6 / 42

Treasury Bonds and Notes

Phan Dinh Khoi Business Finance 2 - Lecture 4 7 / 42

Treasury Bonds and Notes

Coupon rate is 2.5%

Phan Dinh Khoi Business Finance 2 - Lecture 4 8 / 42

Treasury Bonds and Notes

The Asked Yield is the yield to maturity on the bond based on

Phan Dinh Khoi Business Finance 2 - Lecture 4 9 / 42

Accrued Interest and Quoted Bond Prices

If a bond is purchased between coupon payments, the buyer must

Phan Dinh Khoi Business Finance 2 - Lecture 4 10 / 42

Corporations borrow money by issuing corporate bonds. Although

Phan Dinh Khoi Business Finance 2 - Lecture 4 11 / 42

Phan Dinh Khoi Business Finance 2 - Lecture 4 12 / 42

Call provisions on Corporate Bonds

Some corporate bonds are issued with call provisions that

Call provisions on Corporate Bonds

Puttable bonds give the bondholders the option to extend the

Phan Dinh Khoi Business Finance 2 - Lecture 4 14 / 42

Call provisions on Corporate Bonds

make interest payments that are tied to some measure of current

Phan Dinh Khoi Business Finance 2 - Lecture 4 15 / 42

Referred stock is considered to be equity but it is often included in

Phan Dinh Khoi Business Finance 2 - Lecture 4 16 / 42

Bond value and Price

Bonds pay coupon and principal payments in the future.

Alternatively, the bond price is

Phan Dinh Khoi Business Finance 2 - Lecture 4 17 / 42

Bond pricing between Coupon Dates

As bonds are normally purchased between coupon days, in this

Invoice price = Flat price + Accrued interest

Phan Dinh Khoi Business Finance 2 - Lecture 4 18 / 42

Bond pricing between Coupon Dates

Figure: Sheet 14.1 Bond pricing

Phan Dinh Khoi Business Finance 2 - Lecture 4 19 / 42

Bond Prices and Yields

Phan Dinh Khoi Business Finance 2 - Lecture 4 20 / 42

The bf Yield to Maturity is defined as the interest rate that

Example 14.6 Yield to maturity

Phan Dinh Khoi Business Finance 2 - Lecture 4 21 / 42

Callable bonds are subject to the Yield to Calls. Figure 14.4

Figure: 14.4 Callable bond prices vs straight debts

Phan Dinh Khoi Business Finance 2 - Lecture 4 22 / 42

Given a non-callable bond BN with par value $1000, an 8%

Phan Dinh Khoi Business Finance 2 - Lecture 4 23 / 42

Figure: Example 14.7 Yield to call vs Yield to maturity

Phan Dinh Khoi Business Finance 2 - Lecture 4 24 / 42