Chapter 10

Bond Prices
and Yields

McGraw-Hill/Irwin Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.
10.1 Bond Characteristics

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U.S. Credit Market Instruments O/S 2008 Q3
U.S. Equity Market (Common)
$19,648 Billion
U.S. Credit Market Debt
$51,796
Debt by Selected Major Borrowers (Not Exhaustive
List):
U.S. Government Securities
(Includes Agency & GSE) $13,850 (27%)

%s are percent of Total U.S. Credit Market Debt, source is Federal Reserve
Flow of Funds

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U.S. Credit Market Instruments O/S 2008 Q3

By Selected Major Borrowers (Not Exhaustive List)

$11,262 Billion
Corporate & Foreign Bonds
(22%)

$2,669 Billion
Municipal Bonds
G.O., Revenue, Notes (5%)

$14,720 Billion
Mortgages
(28%)

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 Bond Characteristics
• Face or par value
• Coupon rate
– Zero coupon bond
• Compounding and payments
– Accrued Interest
• Indenture

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 Treasury Notes and Bonds
• T Note maturities range up to 10 years
• T bond maturities range from 10 to 30 years
• Bid and ask price
– Quoted in dollars and 32nds as a percent of par
– Typical par = $1,000
• Accrued interest
– Quoted price does not include interest accrued

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Figure 10.1 Prices and Yields
of U.S. Treasuries

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 Corporate Bonds & Debt
• Most bonds are traded over the counter
• Par = $1,000
• Registered versus Bearer bonds
• Call provisions
• Convertible provision
• Put provision (putable bonds)
• Floating rate bonds
• Preferred Stock

10-8
Figure 10.2 Listing of
Corporate Bonds

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 Other Domestic Issuers
• Federal Home Loan Bank Board
• Farm Credit Agencies
• Ginnie Mae
• Fannie Mae
• Freddie Mac
• Municipalities

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 International Bonds
• Foreign bonds
– Issued by a borrower from a country other than the one
in which the bond is sold.
– Bonds are denominated in the currency of the country
in which it is sold.
• Yankee bonds, Samurai bonds, Bulldog bonds

• Eurobonds
– Bonds issued in the currency of one country but sold in
other national markets.
• Eurodollar bonds, Euroyen bonds

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 Innovations in the Bond Market
• Inverse floaters
– Coupon rate falls when interest rates rise & vice versa
• Asset-backed bonds
– Income from specified assets is used to service the
bond
• Pay-in-kind bonds
– Bond issuer may choose to pay interest by giving the
investor a bond rather than cash

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 Innovations in the Bond Market
• Catastrophe bonds
– In the event of a specified ‘disaster’ the bond issuer’s
required payments are reduced or eliminated.

• Indexed bonds
– Payments are tied to a price index or the price of a
commodity.
• TIPS (Treasury Inflation Protected Securities) With TIPS
the par value of the bond increases with the Consumer
Price Index.

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Hypothetical Principal and Interest
Payments on a TIPS

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10.2 BOND PRICING

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 Bond Prices & Yields
a) Bond Price for a corporate bond:
C = Coupon = 10%, interest rate = ytm = r = 12%, Maturity =
N or T = 10 years, P = price, Par = $1,000
What is the bond’s price using semiannual compounding?

 2N ½$C  Par
P   T

 T 1 (1  ½r)  (1  ½r)
2N

 20 $50  $1,000
P   T

 T 1 (1 . 06 )  (1  . 06 ) 20

P   $573.50  $311.80  $885.30

64.8% 35.2%

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 Bond Pricing Between
Coupon Dates
• The flat price or quoted price assumes the
bond is purchased on a coupon payment
date.

• If the bond buyer purchases a bond

between payment dates the buyer’s
invoice price = flat price + accrued
interest.

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 Bond Pricing Between
Coupon Dates
Annual Coupon$ Days since last coupon payment
Accrued Interest  
2 Days between coupon payments

• A bond has a flat price of $925.30 and an annual coupon

of $42.50. 160 days have passed since the last coupon
payment and there are 182 days separating the coupon
payments. What is the bond’s invoice price?
$42.50 160
Accrued Interest    $18.68
2 182
Invoice price  Flat Price  Accrued Interest

Invoice price  $925.30  $18.68  $943.98

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10.3 BOND YIELDS

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 Bond Prices and Yields
• Prices and Yields (required rates of return)
have an inverse relationship

• When yields get very high the value of the

bond will be very low

• When yields approach zero, the value of the

bond approaches the sum of the cash flows

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 Promised Yield to Maturity
(YTM)
• YTM is the discount rate that makes the present value of
a bond’s payments equal to its price
• Find the YTM for a 8% coupon, 30-year bond selling at
$1,276.76
 2N ½$C  Par
P   T

 T 1 (1  ½r)  (1  ½r)2N

 60 $40  $1,000
$1,276.76   T

 T 1 (1  ½r)  (1  ½r)60

r  3%
• Assumption of this calculation?

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Figure 10.3 The Inverse Relationship
Between Bond Prices and Yields

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Alternative Measures of Yield
• Current Yield
– Annual dollar coupon divided by the price

• Yield to Call
– Call price replaces par
– Call date replaces maturity

• Holding Period Yield

– Considers actual reinvestment rate on coupons
– Considers any change in price if the bond is sold prior to
maturity

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Yield to Call Illustrated

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Figure 10.4 Bond Prices:
Callable and Straight Debt

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Figure 10.5 Growth of $1000
invested in a 2 year bond

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Example 10.5 Growth of $1000
invested in a 2 year bond

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10.4 BOND PRICES OVER
TIME

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Premium and Discount Bonds
• Premium Bond
– Coupon rate exceeds yield to maturity
– Bond price will decline to par over its maturity

• Discount Bond
– Yield to maturity exceeds coupon rate
– Bond price will increase to par over its maturity

• Can you explain why these price change will occur?

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 Figure 10.6 Premium and
Discount Bonds over Time

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 Figure 10.7 The Price of a
Zero Coupon Bond over Time
How does one earn a rate of return on a zero
coupon bond?
Par
P
(1  r)N

What are
STRIPS?

How is the price

appreciation
taxed?

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10.5 DEFAULT RISK AND
BOND PRICING

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 Default Risk and Ratings
• Main Ratings Companies
– Moody’s Investor Service
– Standard & Poor’s
– Fitch

• Main Rating Categories

– Investment grade
– Speculative grade (junk bonds)

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Figure 10.8 Definitions of Bond Rating Classes

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 Factors Used by Rating
Companies
• Coverage ratios
– TIE and Fixed Charges Coverage ratio
• Leverag e ratios
– Debt to equity or Debt to assets
• Liquidity ratios
– Current and quick ratio
• Profitability ratios
– Return on assets and return on equity
• Cash flow to debt
– Cash flow to debt

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Financial Ratios and Default Risk

10-36
 Protection Against Default
• Sinking funds
– Issuer may repurchase a given fraction of the
outstanding bonds each year, or
– Issuer may either repurchase at the lower of open
market price or at a pre-specified price, usually par;
bonds are chosen randomly
• Serial bonds
– Staggered maturity dates
• Subordination of future debt
– Senior debt holders must be paid in full before junior
debt holders.

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 Protection Against Default
• Dividend restrictions
– Limit on liquidating dividends

• Collateral
– A specific asset pledged against possible default on a
bond.

– What is a bond called that has no specific collateral?

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Figure 10.9 Callable Bond
Issued by Mobil

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Example 10.10 YTM and
Default

10-40
Figure 10.10 Yields Spreads on 10 year
bonds

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 Credit Default Swaps
A credit default swap (CDS) is an insurance policy on the
default risk of a bond or loan.
•The seller of the swap collects an annual premium (and
sometimes an upfront fee) from the swap buyer.

•The buyer of the swap collects nothing unless the bond

issuer or loan borrower defaults, in which case the seller of
the swap essentially pays the drop in value from par to the
swap buyer.

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 Credit Default Swaps
• CDSs can be used to speculate on financial health of
firms.
– Swap buyer need not hold the underlying bond or
loan.
– At their peak there were reportedly $63 trillion worth
of CDS; US GDP is about $14 trillion.
– What is the implication of the size of this market if the
economy experiences greater than expected
defaults?
– Did this contribute to the Financial Crisis of 2008?

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Credit Default Swaps

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 Credit Default Swaps
• New regulations on CDS will be
implemented
– CDS contracts will be required to be traded on
an exchange with collateral requirements to
limit risk.

– Exchange trading will also increase

transparency of positions of institutions.

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10.6 THE YIELD CURVE

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Term Structure of Interest Rates
• Relationship between yields to maturity
and maturity

• Yield curve: a graph of the yields on

bonds relative to the number of years to
maturity
– Have to be similar risk or other factors would
be influencing yields

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Figure 10.12 Treasury Yield
Curves

10-48
 Theories of the Term Structure
• Expectations
– Long term rates are a function of expected future
short term rates
– Upward slope means that the market is expecting
higher future short term rates
– Downward slope means that the market is expecting
lower future short term rates

• Liquidity Preference
– Upward bias over expectations
– The observed long-term rate includes a risk premium

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Figure 10.13 Returns to Two
2-year Investment Strategies

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 Forward Rates Implied
in the Yield Curve
(1 yn)  (1 y (1 f n)
n n 1

n 1)
2 1
(1.12 )  (1 .11) (1.1301)
For example, using 1-yr and 2-yr rates
Longer term rate, yn = 12%
Shorter term rate, yn-1 = 11%
Forward rate, a one-year rate in one year =
13.01%
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Figure 10.14 Illustrative Yield
Curves

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Figure 10.15 Term Spread

10-53