Chap 014

CHAPTER 14
Bond Prices and Yields
INVESTMENTS | BODIE, KANE, MARCUS

McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.
14-2
Bond Characteristics
• Bonds are debt. Issuers are
borrowers and holders are creditors.
– The indenture is the contract between

the issuer and the bondholder.
– The indenture gives the coupon rate,
maturity date, and par value.

14-3
Bond Characteristics
• Face or par value is typically $1000; this is
the principal repaid at maturity.
• The coupon rate determines the interest

payment.
– Interest is usually paid semiannually.
– The coupon rate can be zero.
– Interest payments are called “coupon
payments”.

14-4
U.S. Treasury Bonds
• Bonds and notes may be

•Note maturity
purchased directly from
is 1-10 years
the Treasury.
• Denomination can be as
•Bond maturity small as $100, but
is 10-30 years $1,000 is more common.
• Bid price of 100:08
means 100 8/32 or
$1002.50
14-5
Accrued Interest
A bond with coupon rate of 8% is quoted as
$990. Face value is $1,000, and interest is
paid semiannually. The 30 days have passed
since the last coupon payment and there are
182 days in the semiannual coupon period.
what would you pay for this bond?

14-6
Accrued Interest
The quoted price does not include the
interest that accrues between coupon
payment dates.
The sale/invoice price = the stated/quoted
price/flat price/clean price + accrued interest

14-7
Corporate Bonds
Callable bonds can be repurchased before
the maturity date. When the bond is called,
the holder must forfeit it for the call price.
When might the firm call the bond?
Callable bond vs Non callable bonds

14-8
Corporate Bonds
Convertible bonds can be exchanged for
shares of the firm’s common stock.
• conversion ratio is the number of shares for
which each bond may be exchanged.
• market conversion value is the current
value of the shares for which the bonds
may be exchanged.
• conversion premium is the excess of the
bond’s value over its conversion value
14-9
Corporate Bonds
Suppose a convertible bond is issued at par
value of $1,000 and, conversion price is $25
per share. The current stock price is $20 per
share.
• conversion ratio is …
• market conversion value is….
• conversion premium is…
Convertible vs Noncovertible
14-10
Corporate Bonds
• Puttable bonds give the bondholder the
option to retire or extend the bond.
When will the bondholder extend it?

When will the bondholder retire it?

14-11
Corporate Bonds
• Puttable bonds give the bondholder the
option to retire or extend the bond.
• Floating rate bonds have an adjustable

coupon rate

14-12
Preferred Stock
• Dividends are paid in

•Equity perpetuity.
•Fixed income • Nonpayment of dividends
does not mean
bankruptcy.
• Preferred dividends are
paid before common.
• No tax break.
14-13
Innovation in the Bond Market

(At home)
• Inverse Floaters
• Asset-Backed Bonds
• Catastrophe Bonds
• Indexed Bonds
–Treasury Inflation Protected
Securities (TIPS).

14-14
Table 14.1 Principal and Interest Payments

for a Treasury Inflation Protected Security

14-15
Bond Pricing

T
PB = C + P a r V a luT e
t =1 (1 + r )
t
(1 + r )
PB = Price of the bond
Ct = interest or coupon payments
T = number of periods to maturity
r = semi-annual discount rate or the semi-annual
yield to maturity

14-16
Bond Pricing

T
PB = C + P a r V a luT e
t =1 (1 + r )
t
(1 + r )

14-17
Example 14.2: Bond Pricing
Price of a 30 year, 8% coupon bond.

Market rate of interest is 10%.
60
$40 $1000
Price =  +
t =1 (1.05) (1.05)
t 60
Price = $810.71

14-18
• Prices and yields (required rates of

return) have an inverse relationship
Calculate the price of the 30-year, 8%
coupon bond for a market interest rate of 3%
per half-year. Compare the capital gain for
the 1-percent interest rate decline to the loss
incurred when the rate increases from 4% to
5%.

14-19
Figure 14.3 The Inverse Relationship

Between Bond Prices and Yields

14-20
• Prices and yields (required rates of

return) have an inverse relationship
• The bond price curve (Figure 14.3) is
convex.

14-21
Sensitivity of the bond’s price to interest rate

volatility/interest rate risk
volatility/interest rate risk vs maturity

14-22
The longer the maturity, the more

sensitive the bond’s price to changes in
market interest rates.

14-23
Yield to Maturity
• Interest rate that makes the present
value of the bond’s payments equal
to its price is the YTM.
Solve the bond formula for r

T
PB = C + P a rV a luT e
t =1 (1 + r )
t
(1 + r )

14-24
Yield to Maturity Example

Suppose an 8% coupon, 30 year bond
is selling for $1276.76. What is its
average rate of return?

60
$40 1000
$ 1 2 7 6 .7 6 = +
(1 + r ) (1 + r )
t 60
t =1
r = 3% per half year

Bond equivalent yield = 6%
EAR = ((1.03)2)-1=6.09%
14-25
YTM vs. Current Yield

YTM Current Yield
• The YTM is the bond’s • The current yield is the
internal rate of return. bond’s annual coupon
• YTM is the interest rate payment divided by the
that makes the present
value of a bond’s bond price.
payments equal to its • For bonds selling at a
price. premium, coupon rate >
• YTM assumes that all current yield>YTM.
bond coupons can be
reinvested at the YTM • For discount bonds,
rate. relationships are reversed.

14-26
Yield to Call
Callable bonds
Call price
• Bond with par value $1,000, an 8%
coupon rate, and a 30-year time to
maturity
• Bond that has the same coupon rate and
maturity date but is callable at 110% of par
value, or $1,100
• YTM vs YTC
14-27
Figure 14.4 Bond Prices: Callable and Straight

Debt

14-28
Yield to Call
• If interest rates fall, price of straight bond
can rise considerably.
• The price of the callable bond is flat over a
range of low interest rates because the
risk of repurchase or call is high.
• When interest rates are high, the risk of
call is negligible and the values of the
straight and the callable bond converge.

14-29
Realized Yield versus YTM

If all coupons are reinvested at an interest rate
equal to the bond’s yield to Maturity, what is the
realized yield?
greater than the bond’s yield to Maturity, what is
the realized yield?
less than the bond’s yield to Maturity, what is the
realized yield?

14-30
Figure 14.5 Growth of Invested Funds

14-31

Which one is commonly used to refer to the rate
of return of a bond? Why?

14-32

• Reinvestment Assumptions
When you invest in bonds, there are two
sources of risks in terms of interest rates.
What are they?

14-33

• Reinvestment Assumptions
When you invest in bonds, there are two
sources of risks in terms of interest rates.
What are they?
Reinvestment rate risk vs price risk

14-34
Figure 14.6 Prices Path of two 30-Year

Maturity Bonds, Each Selling at a YTM of 8%
12%-coupon-rate
bond
vs
4%-coupon-rate
Bond

14-35
YTM vs. HPR

YTM HPR
• YTM is the average • HPR is the rate of return
return if the bond is held over a particular
to maturity. investment period.
• YTM depends on coupon • HPR depends on the
rate, maturity, and par bond’s price at the end of
value.
the holding period, an
• All of these are readily unknown future value.
observable.
• HPR can only be
forecasted.

14-36
Holding Period Return

• Holding Period Return
– Coupon
– Change in bond price
Consider a 30-year bond paying an annual coupon of $80 and
selling at par value of $1,000. 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, so the holding-period return also will be 8%.
But if the yield falls below 8%, the bond price will increase.
Suppose the yield falls and the price increases to $1,050. Then
the holding-period return is greater than 8%:

14-37
Figure 14.7 The Price of a 30-Year Zero-

Coupon Bond over Time

14-38
Default Risk and Bond Pricing
• Rating companies:
– Moody’s Investor Service, Standard &
Poor’s, Fitch
• Rating Categories
– Highest rating is AAA or Aaa
– Investment grade bonds are rated BBB
or Baa and above
– Speculative grade/junk bonds have
ratings below BBB or Baa.
14-39
Factors Used by Rating Companies
• Coverage ratios
• Leverage ratios
• Liquidity ratios
• Profitability ratios
• Cash flow to debt

14-40
Table 14.3 Financial Ratios and Default

Risk by Rating Class, Long-Term Debt

14-41
Figure 14.9 Discriminant Analysis

14-42
Protection Against Default

• Sinking funds – a way to call bonds
early
• Subordination of future debt– restrict
additional borrowing
• Dividend restrictions– force firm to
retain assets rather than paying them
out to shareholders
• Collateral – a particular asset
bondholders receive if the firm defaults

14-43
Protection Against Default

14-44
Default Risk and Yield

At home
• The risk structure of interest rates refers
to the pattern of default premiums.
• There is a difference between the yield
based on expected cash flows and yield
based on promised cash flows.
• The difference between the expected
YTM and the promised YTM is the
default risk premium.

14-45
Figure 14.11 Yield Spreads

14-46
Credit Default Swaps

At home from here on out
• A credit default swap (CDS) acts like an
insurance policy on the default risk of a
corporate bond or loan.
• CDS buyer pays annual premiums.
• CDS issuer agrees to buy the bond in a
default or pay the difference between par
and market values to the CDS buyer.

14-47
Credit Default Swaps

• Institutional bondholders, e.g. banks, used
CDS to enhance creditworthiness of their
loan portfolios, to manufacture AAA debt.
• CDS can also be used to speculate that
bond prices will fall.
• This means there can be more CDS
outstanding than there are bonds to
insure!

14-48
Figure 14.12 Prices of Credit Default

Swaps

14-49
Credit Risk and Collateralized Debt

Obligations (CDOs)
• Major mechanism to reallocate credit risk
in the fixed-income markets
– Structured Investment Vehicle (SIV)
often used to create the CDO
– Loans are pooled together and split
into tranches with different levels of
default risk.
– Mortgage-backed CDOs were an
investment disaster in 2007

14-50
Figure 14.13 Collateralized Debt

Obligations

14-51
Question 1
Which security has a higher effective annual
interest rate?
a. A 3-month T-bill selling at $97,645 with par
value $100,000.
b. A coupon bond selling at par and paying a
10% coupon semiannually.

14-52
Question 1
Which security has a higher effective annual interest rate?
a. A 3-month T-bill selling at $97,645 with par value
$100,000.
4
 100,000 
  − 1 = 1.024124 − 1 = 0.100 = 10.0%
 97,645 
b. A coupon bond selling at par and paying a 10% coupon
semiannually.
(1.05.2 − 1) = 0.1025 or 10.25%

14-53
Question 2
Fill in the table below for the following zero-coupon
bonds, all of which have par values of $1,000.

14-54
Question 2
Fill in the table below for the following zero-coupon
bonds, all of which have par values of $1,000.
Maturity Bond Equivalent

Price (years) YTM
$400.00 20.00 4.688%
500.00 20.00 3.526
500.00 10.00 7.177
385.54 10.00 10.000
463.19 10.00 8.000
400.00 11.91 8.000

14-55
Question 3
A 30-year maturity, 8% coupon bond paying coupons
semiannually is callable in five years at a call price of
$1,100. The bond currently sells at a yield to maturity
of 7% (3.5% per half-year).
a. What is the yield to call?
b. What is the yield to call if the call price is only
$1,050?
c. What is the yield to call if the call price is $1,100 but
the bond can be called in two years instead of five
years?
14-56
Question 3
A 30-year maturity, 8% coupon bond paying coupons
semiannually is callable in five years at a call price of $1,100.
The bond currently sells at a yield to maturity of 7% (3.5% per
half-year).
a. What is the yield to call?
The bond sells for $1,124.72 based on the 3.5% yield to
maturity. YTC: 3.368% semiannually, 6.736% annually
b. What is the yield to call if the call price is only $1,050?
2.976% semiannually, 5.952% annually
c. What is the yield to call if the call price is $1,100 but the bond
can be called in two years instead of five years?
3.031% semiannually, 6.062% annually
14-57
Question 3
A convertible bond has the following features:
Coupon 5.25%
Maturity June 15, 2030
Market price of bond $775
Market price of underlying common stock $28.00
Annual dividend $1.20
Conversion ratio 20.83 shares
Calculate the conversion premium for this bond

14-58
Question 3
Consider a bond with a 10% coupon and yield to maturity =
8%. If the bond’s yield to maturity remains constant, then in one
year, will the bond price be higher, lower, or unchanged? Why?

14-59
Question 3
Consider a bond with a 10% coupon and yield to maturity =
8%. If the bond’s yield to maturity remains constant, then in one
year, will the bond price be higher, lower, or unchanged? Why?

14-60
Figure 14.6 Prices Path of two 30-Year

Maturity Bonds, Each Selling at a YTM of 8%
12%-coupon-rate
bond
vs
4%-coupon-rate
Bond

14-61
Consider an 8% coupon bond selling for $953.10

with three years until maturity making annual
coupon payments. The interest rates in the next
three years will be, with certainty, r1 = 8%, r2 =
10%, and r3 = 12%. Calculate the bond’s (a) yield
to maturity and (b) realized compound yield

14-62
Assume you have a 1-year investment horizon and are trying to choose
among three bonds. All have the same degree of default risk and mature in
10 years. The first is a zero-coupon bond that pays $1,000 at maturity. The
second has an 8% coupon rate and pays the $80 coupon once per
year. The third has a 10% coupon rate and pays the $100 coupon once per
year.
a. If all three bonds are now priced to yield 8% to maturity, what are the
prices of: (i) the zerocoupon bond; (ii) the 8% coupon bond; (iii) the 10%
coupon bond?
b. If you expect their yields to maturity to be 8% at the beginning of next
year, what will be the
price of each bond?
c. What is your before-tax holding-period return on each bond?

14-63
Assume you have a 1-year investment horizon and are trying to choose
among three bonds. All have the same degree of default risk and mature in
10 years. The first is a zero-coupon bond that pays $1,000 at maturity. The
second has an 8% coupon rate and pays the $80 coupon once per
year. The third has a 10% coupon rate and pays the $100 coupon once per
year.
d. If your tax bracket is 30% on ordinary income and 20% on capital gains
income, what will be the after-tax rate of return on each bond?

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CHAPTER 14

Bond Prices and Yields

INVESTMENTS | BODIE, KANE, MARCUS

– The indenture is the contract between

INVESTMENTS | BODIE, KANE, MARCUS

• The coupon rate determines the interest

INVESTMENTS | BODIE, KANE, MARCUS

U.S. Treasury Bonds

• Bonds and notes may be

INVESTMENTS | BODIE, KANE, MARCUS

INVESTMENTS | BODIE, KANE, MARCUS

When might the firm call the bond?

Callable bond vs Non callable bonds

INVESTMENTS | BODIE, KANE, MARCUS

When will the bondholder extend it?

INVESTMENTS | BODIE, KANE, MARCUS

• Floating rate bonds have an adjustable

INVESTMENTS | BODIE, KANE, MARCUS

• Dividends are paid in

Innovation in the Bond Market

INVESTMENTS | BODIE, KANE, MARCUS

Table 14.1 Principal and Interest Payments

INVESTMENTS | BODIE, KANE, MARCUS

INVESTMENTS | BODIE, KANE, MARCUS

INVESTMENTS | BODIE, KANE, MARCUS

Example 14.2: Bond Pricing

Price of a 30 year, 8% coupon bond.

INVESTMENTS | BODIE, KANE, MARCUS

Bond Prices and Yields

• Prices and yields (required rates of

INVESTMENTS | BODIE, KANE, MARCUS

Figure 14.3 The Inverse Relationship

INVESTMENTS | BODIE, KANE, MARCUS

Bond Prices and Yields

• Prices and yields (required rates of

INVESTMENTS | BODIE, KANE, MARCUS

Bond Prices and Yields

Sensitivity of the bond’s price to interest rate

INVESTMENTS | BODIE, KANE, MARCUS

Bond Prices and Yields

The longer the maturity, the more

INVESTMENTS | BODIE, KANE, MARCUS

INVESTMENTS | BODIE, KANE, MARCUS

Yield to Maturity Example

r = 3% per half year

YTM vs. Current Yield

INVESTMENTS | BODIE, KANE, MARCUS

Figure 14.4 Bond Prices: Callable and Straight

INVESTMENTS | BODIE, KANE, MARCUS

INVESTMENTS | BODIE, KANE, MARCUS

Realized Yield versus YTM

INVESTMENTS | BODIE, KANE, MARCUS

Figure 14.5 Growth of Invested Funds

INVESTMENTS | BODIE, KANE, MARCUS

Realized Yield versus YTM

INVESTMENTS | BODIE, KANE, MARCUS

Realized Yield versus YTM

INVESTMENTS | BODIE, KANE, MARCUS

Realized Yield versus YTM

INVESTMENTS | BODIE, KANE, MARCUS

Figure 14.6 Prices Path of two 30-Year

INVESTMENTS | BODIE, KANE, MARCUS

YTM vs. HPR