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Bond Basics
Bonds are simply long-term IOUs that represent
claims against a firm’s assets.
Bonds are a form of debt
Bonds are often referred to as fixed-income
investments.

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Key Features of a Bond
Debt instrument issued by a corp. or government.

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Key Features of a Bond
Par value = face amount of the bond, which is paid at
maturity (assume $1,000).

=
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Key Features of a Bond
Coupon rate – stated interest rate (generally
fixed) paid by the issuer. Multiply by par to get
dollar payment of interest.

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Key Features of a Bond
Maturity date – when the bond must be repaid.
Yield to maturity - rate of return earned on a bond
held until maturity.

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What is interest rate risk?
Interest rate risk is the concern that interest rates will
change, and therefore, a reduction in the value/price
of a security.

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Interest rate risk example
Suppose you just inherited $500,000. You intend to
invest the money and live off the interest.

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Interest rate risk example
You may invest in either a:
10-year bond
series of ten 1-year bonds
Both bonds currently yield 5%.

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If you choose the 1-year bond strategy:
After year 1, you receive $25,000 in
income and have $500,000 to reinvest.
But, if 1-year rates fall to 3%, your
annual income would fall to $15,000.

If you choose the 10-year bond strategy:

You can lock in a 5% interest rate, and
$25,000 annual income.

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 Interest Rate Risk
Price Risk
Change in price due to changes in
interest rates
Long-term bonds have more price risk
than short-term bonds
Low coupon rate bonds have more price
risk than high coupon rate bonds

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Bond Value
Bond Value = PV(coupons) + PV(par)
Bond Value = PV(annuity) + PV(lump sum)
Remember:
As interest rates increase present values decrease
( r → PV  )
As interest rates increase, bond prices decrease
and vice versa

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 Bond Valuation

Compute the value for an IBM Bond with a

6.375% coupon that will mature in 5 years
given that you require an 8% return on your
investment.

What are the annual interest payments ($)?

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IBM Bond Timeline:

2009 2010 2011 2012 2013

0 1 2 3 4 5

63.75 63.75 63.75 63.75 63.75

1,000.00

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 IBM Bond Timeline:

2009 2010 2011 2012 2013

0 1 2 3 4 5

63.75 63.75 63.75 63.75 63.75

1000.00

$63.75 Annuity for 5 years $1000 Lump Sum in 5 years

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 IBM Bond Timeline:

2009 2010 2011 2012 2013

0 1 2 3 4 5

63.75 63.75 63.75 63.75 63.75

1000.00

$63.75 Annuity for 5 years $1000 Lump Sum in 5 years

= 63.75 PMT 1000 FV 8% I 5N

= PV = 935.12
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 Most Bonds Pay Interest Semi-Annually:

What is the value of a bond with a semi-annual

coupon with 5 years to maturity, 9% (nominal)
coupon rate if an investor desires a 10% (nominal)
return?

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Most Bonds Pay Interest Semi-Annually:

e.g. semiannual coupon bond with 5 years

to maturity, 9% annual coupon rate.

Instead of 5 annual payments of $90, the bondholder

receives 10 semiannual payments of $45.

2013 2014 2015 2016 2017

0 1 2 3 4 5

45 45 45 45 45 45 45 45 45 45.00
1000.00

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Most Bonds Pay Interest Semi-Annually:

2013 2014 2015 2016 2017

0 1 2 3 4 5

45 45 45 45 45 45 45 45 45 45.00
1000.00
Compute the value of the bond given that you
require a 10% s-a. return on your investment.

Since interest is received every 6 months, we need to use

semiannual compounding
VB =
45 - PMT
1000 - FV
5% - I 20
10 - N
Most Bonds Pay Interest Semi-Annually:

2013 2014 2015 2016 2017

0 1 2 3 4 5

45 45 45 45 45 45 45 45 45 45
1,000
Compute the value of the bond given that you
require a 10% s-a. return on your investment.

Since interest is received every 6 months, we need to use

semiannual compounding

= PV = 961.39
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Semiannual Bonds
Coupon rate = 14% - Semiannual
YTM = 16% (APR)
Maturity = 7 years
Value of bond?
Number of coupon payments? (2t or N)
14 = 2 x 7 years
Semiannual coupon payment? (C/2 or PMT)
$70 = (14% x Face Value)/2
Semiannual yield? (YTM/2 or I/Y)
8% = 16%/2

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Semiannual Bonds
Semiannual coupon = $70 
1 -
1 

C

 1
YTM
2

2t 
 F
Semiannual yield = 8% Bond Value 
2

YTM
2


 1  YTM 2 
2t

 
Periods to maturity = 14  

Using the calculator:

Bond value = 14 N
70[1 – 1/(1.08)14] / .08 + 8 I/Y
1000 / (1.08)14 = 917.56 70
PMT
 1 
 1   1000 FV
(1.08)14 1000
B  70   14 CPT PV = -917.56
 0.08  (1 .08 )
 

Using Excel: =PV(0.08, 14, 70, 1000, 0)

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Yield to Maturity
2013 2014 2015 2016 2017
0 1 2 3 4 5

-1,000 80 80 80 80 80
1,000

 If bond Sells at a DISCOUNT (less than

$1,000) then YTM > Coupon Rate
 If bond Sells at a PREMIUM (more than
$1,000) then YTM < Coupon Rate

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 Valuing a Discount Bond
with Annual Coupons
Coupon rate = 10%
Annual coupons
Par = $1,000
Maturity = 5 years
YTM = 11%
Price= ?

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 Valuing a Discount Bond
with Annual Coupons
Coupon rate = 10% Using the calculator:
5 N
Annual coupons
11 I/Y
Par = $1,000 100
Maturity = 5 years PMT
1000 FV
YTM = 11% CPT PV = -963.04

Using the formula:  1 

 1  5 
B = PV(annuity) + PV(lump sum) B  100 (1 .11 ) 1000
 5
B = 369.59 + 593.45 = 963.04  0.11  (1 .11 )
 

Using Excel: =PV(0.11, 5, 100, 1000, 0)

Note: When YTM > Coupon rate  Price < Par = “Discount Bond”
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Valuing a Premium Bond
with Annual Coupons
Coupon rate = 10%
Annual coupons
Par = $1,000
Maturity = 20 years
YTM = 8%
Price = ?

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Valuing a Premium Bond
with Annual Coupons
Coupon rate = 10% Using the calculator:
20 N
Annual coupons 8 I/Y
Par = $1,000 100
Maturity = 20 years PMT
1000 FV
YTM = 8% CPT PV = -1196.36
Using the formula:  1 
1 
 (1.08) 20 
B = PV(annuity) + PV(lump sum) 1000
B  100 
B = 981.81 + 214.55 = 1196.36  0.08  (1.08)
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 

Using Excel: =PV(0.08, 20, 100, 1000, 0)

Note: When YTM < Coupon rate  Price > Par = “Premium Bond”
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Yield to Maturity
If an investor purchases a 6.375% annual
coupon bond today for $900 and holds it until
maturity (5 years), what is the expected annual
rate of return (YTM)?
2013 2014 2015 2016 2017
0 1 2 3 4 5

63.75 63.75 63.75 63.75 63.75

-900
1000.00
??
+ ??
900

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Yield to Maturity
• If an investor purchases a 6.375% annual coupon
bond today for $900 and holds it until maturity (5
years), what is the expected annual rate of return ?
Will it be >< than 6.375%?
2013 2014 2015 2016 2017
0 1 2 3 4 5

63.75 63.75 63.75 63.75 63.75

-900
1000.00
??
+ ??
900 YTMB = 63.75 PMT 1000 FV
5N -900 PV
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I=?
 0 1 9 10
rd=?
...
90 90 90
PV1 1,000
.
.
.
PV10
PVM
887 Find rd that “works”!
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INPUTS 10 -887 90 1000
N I/YR PV PMT FV
OUTPUT 10.91

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Types of Bonds
Vanilla – fixed coupons, repaid at maturity
Zero Coupon – pay no explicit interest but instead,
sell at a deep discount
Convertible – can be converted into to stock

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Types of Bonds
Junk Bonds – below investment grade

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Government Bonds
Treasury Securities = Federal government debt
Treasury Bills (T-bills)
 Pure discount bonds
 Original maturity of one year or less

Treasury notes (T-notes)

 Coupon debt
 Original maturity between one and ten years

Treasury bonds (T-bonds)

 Coupon debt
 Original maturity greater than ten years

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Tax Consequences
A taxable bond has a yield of 8% and a
municipal bond has a yield of 6%
If you are in a 40% tax bracket, which bond
do you prefer?
8%(1 - .4) = 4.8%
The after-tax return on the corporate bond is 4.8%,
compared to a 6% return on the municipal
At what tax rate would you be indifferent
between the two bonds?
8%(1 – T) = 6%
T = 25%

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 Bond Ratings
 Moody’s , Standard & Poor’s and Fitch regularly
monitor issuer’s financial condition and assign
a rating to the debt
AAA Best Quality
Investment AA High Quality
Grade A Upper Medium Grade
BBB Medium Grade
BB Speculative
Below B Very Speculative
Investment CCC Very Very Speculative
Grade CC
(Junk) C No Interest Being Paid
D Currently in Default
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Bond Ratings –
Investment Quality
High Grade
Moody’s Aaa and S&P AAA – capacity to pay is
extremely strong
Moody’s Aa and S&P AA – capacity to pay is very strong
Medium Grade
Moody’s A and S&P A – capacity to pay is strong, but
more susceptible to changes in circumstances
Moody’s Baa and S&P BBB – capacity to pay is adequate,
adverse conditions will have more impact on the firm’s
ability to pay

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Bond Ratings - Speculative
Low Grade
Moody’s Ba, B, Caa and Ca
S&P BB, B, CCC, CC
Considered speculative with respect to capacity
to pay. The “B” ratings are the lowest
degree of speculation.
Very Low Grade
Moody’s C and S&P C – income bonds with no
interest being paid
Moody’s D and S&P D – in default with principal
and interest in arrears
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What affects Bond prices?
Risk
Interest rates

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What is the “term structure of interest rates”?
What is a “yield curve”?

Term structure: the relationship between

interest rates (or yields) and maturities.
A graph of the term structure is called the
yield curve.

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Draw a normal yield curve

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 Hypothetical Treasury Yield Curve
Interest
Rate (%) 1 yr 8.0%
15 Maturity risk premium 10 yr 11.4%
20 yr 12.65%
10 Inflation premium

Real risk-free rate

0 Years to Maturity
1 10 20

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What factors can explain the shape of this
yield curve?

This constructed yield curve is upward

sloping.
This is due to increasing expected inflation
and an increasing maturity risk premium.

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Current Yield Curve
Bloomberg

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Default risk
If an issuer defaults, investors receive less than
the promised return.
Influenced by the issuer’s financial strength
and the terms of the bond contract.

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