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Bond Yield to Maturity

We have expressed the price of an option-free
bond as a function of the bond’s yield to
maturity:

P =
c
2
1+
y
2
( )
i÷1+q
i=1
n
¿
+
1
1+
y
2
( )
n÷1+q

where q =
days from settlement to next coupon date
days in current coupon period
Bond Yield to Maturity
Different bonds have different yields
Risk differentials (quality spread)
Sector spreads (e.g. industrials v. utilities)
Optionality
Tax differences
Term differences
Benchmark: Treasuries
Risky bonds priced at a spread to Treasuries
Yield Curve
A graph of bond yields to maturity by time to
maturity is called a yield curve.
4.00%
4.50%
5.00%
5.50%
6.00%
6.50%
7.00%
3mo 6mo 1yr 2yr 3yr 5yr 10yr 30yr
Yield Curve
Typically, the yield curve is upward sloping
Yield to maturity rises with term to maturity
The excess of the long yield over the short yield is called a
“term premium”
4.00%
4.50%
5.00%
5.50%
6.00%
6.50%
7.00%
3mo 6mo 1yr 2yr 3yr 5yr 10yr 30yr
Yield Curve
Other shapes are also possible, however
Inverted: Commonly associated with recessions
Flat
-1.00%
1.00%
3.00%
5.00%
7.00%
9.00%
11.00%
13.00%
15.00%
3mo 6mo 1yr 2yr 3yr 5yr 10yr 30yr
Yield Curve
It used to be that most fixed income securities
were priced at a spread relative to the Treasury
yield curve.
For example:
If the yield to maturity on the 10-year Treasury
bond was 7%, then a 10-year Baa corporate bond
would be priced to yield 7% plus the Baa credit
spread.
The problem with this approach is that it ignores
differences in duration and convexity that may be
priced. Can you see why?
Yield Curve
Here’s yield curve data for on-the-run
Treasuries of various maturities:
Coupon Term (yrs) Yield Price
8.50% 1/2 5.10% $101.66
7.38% 1 5.49% $101.81
9.00% 1 1/2 5.63% $104.78
8.88% 2 5.81% $105.72
6.75% 2 1/2 5.86% $102.03
7.75% 3 5.93% $104.94
6.25% 3 1/2 6.03% $100.69
5.63% 4 6.09% $98.38
6.50% 4 1/2 6.10% $101.56
7.50% 5 6.16% $105.69
Notice the
range of
coupons.
These bonds
have very
different cash
flow patterns.
A Better Approach
To avoid the problems of comparability caused
by differing cash flow patterns among on-the-
run Treasuries, we can realize that each coupon
bond is really a package of single payment
bonds.
For example, a 2-year 10% coupon bond is
really a package of five single payment bonds:
 four for the semi-annual coupon payments and
one for the repayment of the corpus.
Zeroes
A single payment bond is called a “zero.”
A coupon bond can be thought of as a package
of zeroes,
one for each of the coupon payments and
one for the corpus.
In principle, any coupon bond could be
“stripped” or “unbundled” into its constituent
zeroes.
US Treasury STRIPS are unbundled coupon bonds.
Spot Yields
A “spot yield” is the current yield to maturity
on a zero coupon bond.
For example, the 1-year spot yield is the yield to
maturity on a 1-year zero.
The price (per dollar of corpus) of an n-year
zero is related to the n-year spot rate by the
formula:

0
P
n
=
1
1+
i
n
2
|
\
|
.
2n
Spot Yields
For example, if the 3 1/2 year spot yield is
6.05%, then the price (per dollar of corpus) of
the 3 1/2 year zero is:

0
P
3.5
=
1
1+
.0605
2
( )
2*3.5
=
1
1.03025
( )
7
= .811
Spot Yields
Alternatively, we can express the n-year spot
yield as a function of the price of an n-year
zero:

i
n
= 2
1
0
P
n
|
\

|
.
|
1
2n
÷1
|
\


|
.
|
|
Spot Yields
For example, if a 4 year zero is priced at $.79
per dollar of face value, then the 4-year spot
rate is:

i
4
= 2
1
0
P
4
|
\

|
.
|
1
2*4
÷1
|
\


|
.
|
|
= 2
1
.79
|
\
|
.
1
8
÷1
|
\

|
.
|
= 2 1.03059 ÷1 ( ) = 6.12%
Spot Yields
Term (yrs) Spot Yield Price of zero
1/2 5.10% $0.98
1 5.49% $0.95
1 1/2 5.64% $0.92
2 5.82% $0.89
2 1/2 5.88% $0.87
3 5.95% $0.84
3 1/2 6.05% $0.81
4 6.12% $0.79
4 1/2 6.12% $0.76
5 6.19% $0.74

0
P
2.5
=
1
1+
.0588
2
|
\
|
.
5
= .87

i
4.5
= 2
1
.76
|
\
|
.
1
9
÷1
|
\

|
.
|
= 6.12%
Price of a Coupon Bond
In principle, the price of an n-year coupon
bond ought to be equal to the total value of all
its constituent zeroes:

P =
c
2
1+
y
2
|
\
|
.
s
s=1
2n
¿
+
1
1+
y
2
|
\
|
.
2n
=
c
2
1+
i
s
2
2
|
\

|
.
|
s
s=1
2n
¿
+
1
1+
i
n
2
|
\
|
.
2n
Priced using yield to maturity Priced using spot yields
Price of a Coupon Bond
For example:
This bond actually traded at a price of $1.0569 or a yield
to maturity of 6.16%
n Spot Yield Price of zero Cash flow Value
1/2 5.10% $0.98 $0.0375 $0.0366
1 5.49% $0.95 $0.0375 $0.0355
1 1/2 5.64% $0.92 $0.0375 $0.0345
2 5.82% $0.89 $0.0375 $0.0334
2 1/2 5.88% $0.87 $0.0375 $0.0324
3 5.95% $0.84 $0.0375 $0.0315
3 1/2 6.05% $0.81 $0.0375 $0.0304
4 6.12% $0.79 $0.0375 $0.0295
4 1/2 6.12% $0.76 $0.0375 $0.0286
5 6.19% $0.74 $1.0375 $0.7647
$1.0571
5-year 7.5% coupon bond
STRIPS
Go to spreadsheet for comparison of stripping
and reconstituting 2 different 10-yr bonds.
Term Structure
The term structure of interest rates is the
pattern of spot rates over the range of
maturities.
A flat term structure means that spot yields are
equal at all maturities.
A normal term structure slopes upward
An inverted term structure slopes downward
Modern pricing practice is to regard any bond
as a package of zeros and price the package
using spreads relative to the term structure.
Bootstrapping
We can derive the theoretical term structure
from the yield curve using a procedure known
as “bootstrapping.”
Here’s yield curve information
Coupon Term (yrs) Yield Price
8.50% 1/2 5.10% $101.66
7.38% 1 5.49% $101.81
9.00% 1 1/2 5.63% $104.78
8.88% 2 5.81% $105.72
6.75% 2 1/2 5.86% $102.03
7.75% 3 5.93% $104.94
6.25% 3 1/2 6.03% $100.69
5.63% 4 6.09% $98.38
6.50% 4 1/2 6.10% $101.56
7.50% 5 6.16% $105.69
Bootstrapping
The first bond has 1/2 year to run
It is a single payment bond that will pay
$1.0425 per dollar of face value at maturity.
Its price is $1.0166 per dollar of face value.
Therefore the 1/2 year spot rate is

i
1/ 2
= 2
1.0425
1.0166
|
\
|
.
1
÷1
|
\

|
.
|
= 2 .0255 ( ) = 5.10%
Bootstrapping
Given the 1/2 year spot rate, we can determine
the price of the 1/2 year zero:

0
P
1/ 2
=
1
1+
i
1/ 2
2
|
\
|
.
2 1/ 2
( )
=
1
1+
.0510
2
|
\
|
.
= .9751
Bootstrapping
For each dollar of face value, the 1-year bond
will pay $.03675 in 6 months and $1.03675 in
one year.
It’s price ($1.0181 per dollar of face value)
should equal

$1.0181 =
$0.03675
1+
i
1/ 2
2
|
\
|
.
1
+
$1.03675
1+
i
1
2
|
\
|
.
2
Bootstrapping
But since the 6-months spot rate is 5.10%,

$1.0181 =
$0.03675
1+
.0510
2
|
\
|
.
1
+
$1.03675
1+
i
1
2
|
\
|
.
2
Which we can solve for the 1-year spot rate as

i
1
= 2
1.03675
1.0181÷ .03596
|
\
|
.
1/ 2
÷1
|
\

|
.
|
= 5.49%
Bootstrapping
Or, we could write

$1.0181 =
$0.03675
1+
i
1/ 2
2
|
\
|
.
1
+
$1.03675
1+
i
1
2
|
\
|
.
2
as

$1.0181= $0.03675*
0
P
1/ 2
+ $1.03675*
0
P
1
= $0.3675 .9751 ( )+ $1.03675*
0
P
1
= $0.03596+ $1.03675*
0
P
1
solve for
0
P
1
and then i
1

Bootstrapping
You continue this process to complete the
theoretical term structure
Coupon Maturity Yield Price Zero Price Spot Yield
8.50% 0.5 5.10% $101.66 $97.51 5.10%
7.38% 1 5.49% $101.81 $94.73 5.49%
9.00% 1.5 5.63% $104.78 $92.00 5.64%
8.88% 2 5.81% $105.72 $89.16 5.82%
6.75% 2.5 5.86% $102.03 $86.51 5.88%
7.75% 3 5.93% $104.94 $83.88 5.95%
6.25% 3.5 6.03% $100.69 $81.16 6.05%
5.63% 4 6.09% $98.38 $78.58 6.12%
6.50% 4.5 6.10% $101.56 $76.23 6.12%
7.50% 5 6.16% $105.69 $73.71 6.19%
Forward Rates
A forward rate of interest is a yield quoted now
on a zero coupon bond to be delivered in the
future.
For example, a 2-year rate 1-year forward is
the yield quoted today on a 2-year zero starting
one year from now and maturing 3 years from
now.
0 1 2 3
Forward Rates
Forward rates are embedded in the term
structure.
Suppose you own a zero that matures in 1 year
and yields 6%.
Interest could accumulate at the same rate over the
entire year or
It could accumulate at one rate for the first half year
and at another rate for the second half year such that
the average is 6%.
Forward Rates
0 1/2
1
Forward Rates
Algebraically, if you invest
0
P
1
at 6% for 1
year, and interest accumulates at the same rate
throughout the year, then at the end of a half
year you will have

0
P
1
1+
.06
2
|
\
|
.
And at the end of a
year you will have

0
P
1
1+
.06
2
|
\
|
.
2
Forward Rates
Alternatively, if you invest
0
P
1
at say 4% for
1/2 year, and then reinvest the proceeds at
another rate, say
1
r
1
, then at the end of a half
year you will have

0
P
1
1+
.04
2
|
\
|
.
And at the end of a
year you will have

0
P
1
1+
.04
2
|
\
|
.
1+
1
r
1
2
|
\
|
.
Forward Rates
These two accumulation paths will both result
in a 6% yield for the year if

1+
.06
2
|
\
|
.
2
= 1+
.04
2
|
\
|
.
1+
1
r
1
2
|
\
|
.
That is, if

1
r
1
= 2
1+
.06
2
( )
2
1+
.04
2
( )
|
\

|
.
|
÷1
|
\


|
.
|
Forward Rates
Generally

s
r
1
2
= 2
0
P
s
0
P
s+
1
2
|
\

|
.
|
÷1
|
\

|
.
|