Banking & Finance: Chapter 6 – Valuing Bonds

6.1 Bond pricing

 SEE CHAPTER 2 (financial markets, bond markets)

 Suppose you want to buy this Ahold Delhaize bond, The nominal value of on
denomination is $1,000.
o $994.4, issued price
o $17.5, coupon percentage
o $1,000 + $17.5 = $1,017.5, you’ll receive at the end of these 7 year

PRICE COUPON COUPON COUPON COUPON FACE VALUE + COUPON

 Bond
o Security that obligates the issuer to make specified payments to the
bondholder
 Price
o The price to be paid by the buyer, usually expressed as a % of face value
 Face value
o Payment at the maturity date. Also called par value, principal value or nominal
value
 Coupon
o The interest payments made to the bondholder
 Coupon rate
o Annual interest payment as a percentage of face value
 EXERCISE
o Face value = $1,000
o Annual coupon rate = 7.5%
o Maturity = 4 years
o Annual interest rate = 3.0%
o ANSWER
 PV price = sum of all the PV of the CF = $1,167.27
 Year 1 = $75
 Year 2 = $75
 Year 3 = $75
 Year 4 = $1,075
 Still pay more than the face value, because market interest would be
3.0% instead of the now 7.5%
 Bond = level stream of payments (PV annuity) + final repayment (single CF PV)
 PV = PVcoupons + PV face value
  EXERCISE
o Face value = $1,000
o Annual interest rate = 2%
o ANSWER
 PV price = $926.94
 Year 1 = $4.5
 Year 2 = $4.5
 Year 3 = $4.5
 Year 4 = $4.5
 Year 5 = $1,004.5

6.2 Interest rates and bond prices

 The coupon rate is NOT the same as the discount rate used to calculate the price of
the bond
 The coupon rate (cpn) tells us what cash flows the bond will produce
 The discount rate (r) is the interest rate at which the cash flows can be (re)invested
 EXERCISE
o Maturity = 3 years
o Face value = $1,000
o Cpn = 1.25%
o R = 10%
o ANSWER
 PV price = $782.40
 Relationship between “bond prices” and “r”
o R goes down  bond prices go up
o R goes up  bond prices go down
 If the cpn = r  price of the coupon = 100%
6.3 Yield to maturity (YTM)

 YTM is defined as the “r” that makes the PV equal to its price
 E.g. 4 year bond with par value of $1,000 which is priced at 100% and has a cpn of
7.5%
o What is the YTM? 7.5%
 Par bond 
o priced at 100%
o cpn = r
o YTM = cpn
 Discount bond
o priced at < 100%
o cpn > r
o YTM > cpn
 Premium bond
o priced at > 100%
o cpn < r
o YTM < cpn

6.4 Bond rates of returns (ROR)

 If interest rates fall then ROR > YTM

o Interest rates go down, bond prices go up
 If interest rates rise then ROR < YTM
o If interest rates go up, bond prices go down
 EXERCISE
o Coupon income = $21.875
o Price beginning = $963.8
o Price now = $1,350.5
o ANSWER = ROR = 45.5%
6.5 The yield curve

 If long-term bonds offer higher yields, why would you buy short-term bonds
o LT bonds are more sensitive to interest rate shifts  higher price fluctuations
o ST investors can profit if interest rates rise, reinvest at higher rates
 Investing and trading is all about expectations and confidence, you can be wrong!!!!!
 Treasury Inflation Protected Securities (TIPS)
o Nominal payments linked to inflation
o Real cash flows are fixed

6.6 Corporate bonds and the risk of default

 Default or credit risk

o The risk that a bond issuer may default on its bonds
 Default premium
o The additional yield on a bond that investors require for bearing credit risk
 Investment grade
o Bonds rated Baa or above by Moody’s or BBB or above by Standard & Poor’s
 Junk bonds
o Bond with a rating below Baa or BBB
 Protection against default risk
o Seniority
 Subordinated versus senior dept
o Security
 Collateral to secure the dept, lenders have a first claim on specified
assets
o Protective covenants
 Conditions imposed to protect lenders against unreasonable risks
 Types of corporate bonds
o Plain-vanilla bonds
 Standard bonds have fixed rate coupons
o Zero-coupon bonds
 Only repay principal at maturity, coupon = 0%
o Floating-rate bonds
 Coupon is not fixed but variable
o Convertible bonds
 Can be exchanged for equity