Principles of Finance | Topic 2: Bond Prices | Slide 1/38

Principles of Finance

Topic 2: Bond Prices

Dr Yue (Lucy) Liu

University of Edinburgh Business School

Slides are based on Chapter 6 in Berk and DeMarzo (3rd edition)

Principles of Finance | Topic 2: Bond Prices | Slide 2/38

Synopsis

Last time, we learned how to value present value of streams of cash

flows.

We defined perpetuities and annuities.

We discussed the term structure of interest rates.

This time, we will learn how to price bonds.

⚫ Price of risk-free government bonds can be used to determine the risk-free interest rates.

⚫ Price of corporate bonds can be used as one factor determining the cost of capital.
Principles of Finance | Topic 2: Bond Prices | Slide 3/38

Sources:World Federation of Exchanges, Dealogic, BIS, Refinitiv, Bloomberg, SIFMA

Principles of Finance | Topic 2: Bond Prices | Slide 4/38

Outline

1 Bond cash flows, prices, yields, and yield curve

2 Dynamic behavior of bond prices

3 Corporate bonds

4
Principles of Finance | Topic 2: Bond Prices | Slide 5/38
Bond cash flows, prices, and yields

Outline

1 Bond cash flows, prices, yields, and yield curve

2 Dynamic behavior of bond prices

3 Corporate bonds

4
 Principles of Finance | Topic 2: Bond Prices | Slide 6/38
Bond cash flows, prices, and yields

A typical bond
?
A bond is a security sold by governments or corporations to raise money from investors today in
exchange for promised future payments.
Maturity date: 31 December 1995
The date of final repayment

Term: 10.25 years

The time remaining until the date of final repayment

Face value: $1,000

2 types of
The notional amount used to compute the interest payments.
payments

Coupon rate: 10% paid semiannually. Set by the issuer; by convention, expressed as an APR.

10% × $1,000 /2 = $50 every 6 months

Principles of Finance | Topic 2: Bond Prices | Slide 7/38
Bond cash flows, prices, and yields

U.S. Treasury securities

Table: Main types of U.S. Treasury securities

Name Maturity (T ) Coupon?

Treasury bills 0 ≤ T ≤ 1 year No

Treasury notes 1 year < T ≤ 10 years Yes

Treasury bonds 10 years < T Yes

Names of government bonds? Other types/terms of bonds?

US: Treasury securities Municipal bonds
UK: Gilt-edged securities Corporate bonds
Germany: Bunds
Japan: JGBs
Principles of Finance | Topic 2: Bond Prices | Slide 8/38
Bond cash flows, prices, and yields

Yield to maturity

• The return you will earn from holding this bond to maturity and receiving the promised payments.
• The discount rate at which the NPV=0.

YTM is the discount rate that sets the present value of the promised
bond payments equal to the current market price of the bond.

YTM is in fact the IRR of an investment in a bond.

YTM can be calculated approximately by trial-and-error.

It can also be calculated more accurately using Excel or a financial

calculator.
Principles of Finance | Topic 2: Bond Prices | Slide 9/38
Bond cash flows, prices, and yields

Zero-coupon bonds

⚫ Zero-coupon bonds
⚫ Coupon bonds

A zero-coupon bond does not make coupon payments.

Zero-coupon bonds trade at a discount.

Treasury bills are good examples of zero-coupon bonds.

Principles of Finance | Topic 2: Bond Prices | Slide 10/38
Bond cash flows, prices, and yields

Example 1: YTM of a zero coupon bond

The table below gives prices of 10 zero-coupon bonds with maturities up to 5

years. Derive the YTM for each bond and plot the term structure.

Discount bond Maturity Price

1 6 months = 0.5 years 98.04 %

2 12 months = 1.0 years 95.00 %

3 18 months = 1.5 years 92.05 %

4 24 months = 2.0 years 88.00 %
5 30 months = 2.5 years 85.02 %
6 36 months = 3.0 years 82.55 %

7 42 months = 3.5 years 79.42 %

8 48 months = 4.0 years 76.75 %
9 54 months = 4.5 years 74.25 %
10 60 months = 5.0 years 72.00 %
Principles of Finance | Topic 2: Bond Prices | Slide 11/38
Bond cash flows, prices, and yields

Face value
The price of bond 1 is:
100%
98.04% = 1
(1 + YTM) Per 6 months as a period
Then the YTM of bond 1 is:
100%
YTM = − 1 = 2.00%
98.04%
The price of bond 2 is:
100%
95.00% = 2
(1 + YTM) 2 periods in 1 year
Then the YTM of bond 2 is:
100% 1/2
YTM = ( ) − 1 = 2.60%
95.00%

Calculate the YTMs of remaining bonds in the same way.

Principles of Finance | Topic 2: Bond Prices | Slide 12/38
Bond cash flows, prices, and yields

EAR = ( 1+r per 6 months )2 -1

= (1+2%)2 -1
= 4.04%

Yield
Maturity Per 6 months P.a. as APR P.a. as EAR

0.5 years 2.00 % 4.00 % 4.04 %

1.0 years 2.60 % 5.20 % 5.26 %

1.5 years 2.80 % 5.60 % 5.68 %

2.0 years 3.25 % 6.50 % 6.60 %
2.5 years 3.30 % 6.60 % 6.71 %
3.0 years 3.25 % 6.50 % 6.60 %
3.5 years 3.35 % 6.70 % 6.80 %

4.0 years 3.36 % 6.72 % 6.84 %

4.5 years 3.36 % 6.72 % 6.84 %
5.0 years 3.34 % 6.68 % 6.79 %

Table: The term structure

Principles of Finance | Topic 2: Bond Prices | Slide 13/38
Bond cash flows, prices, and yields

8.00%

7.00%

6.00%

5.00%

4.00%

3.00%

2.00%

1.00%

0.00%
0.5 1 1.5 2 2.5 3 3.5 4 4.5 5

Figure: The zero-coupon yield curve

The horizontal axis shows the time to maturity.

The vertical axis shows YTM expressed as APR.
Principles of Finance | Topic 2: Bond Prices | Slide 14/38
Bond cash flows, prices, and yields

Coupon bonds

A coupon bond makes periodic coupon payments.

Coupon bonds can trade at a discount, at par, or at a premium.

Treasury notes and bonds are good examples of coupon bonds.

Principles of Finance | Topic 2: Bond Prices | Slide 15/38
Bond cash flows, prices, and yields

Example 2: Price of a coupon bond

Calculate the price of a 5-year, $1,000 coupon bond with a 5% coupon rate
and semiannual coupons.
⚫ Face value
⚫ Coupon rate
Price
(a) Assume that the term structure is flat at 6%. ⚫ Term (e.g. 5 years)
⚫ Term structure (e.g. YTM)
(b) Use the term structure derived in Example 1.

The cash flows of this bond are:

Notice that the cash flows look almost like those of an annuity.
Principles of Finance | Topic 2: Bond Prices | Slide 16/38
Bond cash flows, prices, and yields

For part (a), the price of the bond is:

Price = PV (annuity of $25 for 10 periods) + PV ($1, 000 in year 5)

$25 $25 $1, 000

= ( - ) + ( ) = $957.35
10 10
0.03 0.03(1.03) (1.03)

For part (b), the price of the bond is:

Price = PV (stream | term structure)

$25 $25 $25 $1, 025

= + + + ··· + = $930.77
1 2 3 10
1.0200 1.0260 1.0280 1.03338
Principles of Finance | Topic 2: Bond Prices | Slide 17/38
Bond cash flows, prices, and yields

Example 3: YTM of coupon bonds

Calculate the YTM of the coupon bond used in Example 2 approximately by

trial-and-error. Assume that the bond’s correct price is the one calculated in
part (b) of Example 2 (i.e., $930.77).

The price of the bond is:

Price = PV (annuity of $25 for 10 periods) + PV ($1, 000 in year 5)

$25 $25 $1, 000

= ( − ) + ( ) = $930.77
10 10
YTM YTM(1 + YTM) (1 + YTM)

We need a value for YTM that will yield a price as close to $930.77 as
possible.
Trial and error method
Principles of Finance | Topic 2: Bond Prices | Slide 18/38
Bond cash flows, prices, and yields

Remember the solution for part (a) of Example 2. We calculated that the
bond’s price is $ 957.35 when the interest rate was 3% per 6 months:

$25 $25 $1, 000

( - 10
)+ ( 10 )
= $957.35 > $930.77
0.03 0.03(1.03) (1.03)

1st trial: We should try a higher interest rate, say 4% per 6 months:

$25 $25 $1, 000

( - 10
) + ( 10
) = $878.34 < $930.77
0.04 0.04(1.04) (1.04)

2nd trial: We should try a lower rate that is between 3 and 4% per 6
months, say 3.5% per 6 months:

$25 $25 $1, 000

( - 10 ) + ( 10 ) = $916.83 < $930.77
0.035 0.035(1.035) (1.035)
Principles of Finance | Topic 2: Bond Prices | Slide 19/38
Bond cash flows, prices, and yields

3rd trial: Now, try a lower rate that is between 3 and 3.5% per 6 months,
say 3.25% per 6 months:

$25 $25 $1, 000

( - 10
) + ( ) = $936.83 > $930.77
0.0385 0.0385(1.0385) (1.0385)10

4th trial: Now, try a high rate that is between 3.25 and 3.5% per 6
months, say 3.375% per 6 months:

$25 $25 $1, 000

( - 10
)+ ( ) = $926.77 < $930.77
0.03375 0.03375(1.03375) (1.03375)10

Notice that after only 4 trials, we have found a YTM (3.375% per 6
months) that gives a price ($ 926.77), which is fairly close to the true
price ($930.77).
Principles of Finance | Topic 2: Bond Prices | Slide 20/38
Bond cash flows, prices, and yields

The benefit from further trials would get smaller with each trial such that
the true YTM would not be too far from 3.375% per 6 months = 6.75%
p.a.

You can use the IRR function of Excel to find that the true YTM is
3.3851% per 6 months, which is indeed not too far from 3.375% per 6
months.
Principles of Finance | Topic 2: Bond Prices | Slide 21/38

Bond cash flows, prices, and yields

Example 3: YTM of coupon bonds

Calculate the YTM of the coupon bond used in Example 2 approximately by

trial-and-error. Assume that the bond’s correct price is the one calculated in
part (b) of Example 2 (i.e., $930.77).

The price of the bond is:

Price = PV (annuity of $25 for 10 periods) + PV ($1, 000 in year 5)

$25 $25 $1, 000

= ( − ) + ( ) = $930.77
10 10
YTM YTM(1 + YTM) (1 + YTM)

We need a value for YTM that will yield a price as close to $930.77 as
Given:
possible.
⚫ Face value
YTM Price
⚫ Coupon rate
⚫ Term (e.g. 5 years)
Principles of Finance | Topic 2: Bond Prices | Slide 22/38
Dynamic behavior of bond prices

Outline

1 Bond cash flows, prices, and yields

⚫ Trade at a discount, par or a premium.

2 Dynamic behavior of bond prices ⚫ Price change due to the passage of time.
⚫ Price change due to the fluctuation of interest rates.

3 Corporate bonds

4
Principles of Finance | Topic 2: Bond Prices | Slide 23/38
Dynamic behavior of bond prices

Example 4: Bond prices and YTM

Assume that a 10 year bond with a face value of $1,000 and a coupon rate of
10% pays coupon semi-annually. What is the price of this bond if its YTM is:

(a) 10%, (b) 12%, (c) 8%?

If YTM is 10%, the bond’s price is:

Price = PV (annuity of $50 for 20 periods) + PV ($1, 000 in year 10)

$50 $50 $1, 000

= ( - 20 ) + ( ) = $1, 000
0.05 0.05(1 + 0.05) (1 + 0.05)20

This bond is trading at par: its price is equal to its face value.
Principles of Finance | Topic 2: Bond Prices | Slide 24/38
Dynamic behavior of bond prices

If YTM is 12%, the bond’s price is:

Price = PV (annuity of $50 for 20 periods) + PV ($1, 000 in year 10)

$50 $50 $1, 000

= ( - ) + ( ) = $885.30
0.06 0.06(1 + 0.06)20 (1 + 0.06)20

This bond is trading at a discount: its price is less than its face value.

If YTM is 8%, the bond’s price is:

Price = PV (annuity of $50 for 20 periods) + PV ($1, 000 in year 10)

$50 $50 $1, 000

= ( - ) + ( ) = $1135.90
0.04 0.04(1 + 0.04)20 (1 + 0.04)20

This bond is trading at a premium: its price is more than its face value.
 Price > Face value Premium Coupon rate > YTM

Price = Face value Par Coupon rate = YTM

Price < Face value Discount Coupon rate < YTM

Premium: f – p < 0 → r from (face value – price) < 0

r from coupon →YTM < Coupon rate
(i.e. coupon rate) r from (face value – price)
Par: f – p = 0 → r from (face value – price) = 0
→YTM = Coupon rate

Discount: f – p > 0 → r from (face value – price) > 0

→YTM > Coupon rate

YTM

⚫ Most issuers set coupon rate at the par level.

⚫ After issuance, the market price changes for time change and interest rate change.
Principles of Finance | Topic 2: Bond Prices | Slide 26/38
Dynamic behavior of bond prices

Outline

1 Bond cash flows, prices, and yields

⚫ Trade at a discount, par or a premium.

2 Dynamic behavior of bond prices ⚫ Price change due to the passage of time.
⚫ Price change due to the fluctuation of interest rates.

3 Corporate bonds

4
Principles of Finance | Topic 2: Bond Prices | Slide 27/38
Dynamic behavior of bond prices

A zero-coupon bond’s price sensitivity to time-to-maturity

Assume that the term structure is flat at 10%. What is the price of a
zero-coupon bond that has time-to-maturity of (a) 3 years, (b) 2 years, (c) 1
year, (d) 0 year?
The prices are:

3
Price(3 years to maturity ) = 100%/(1.1) = 75.13%
2
Price(2 years to maturity ) = 100%/(1.1) = 82.64%
1
Price(1 year to maturity ) = 100%/(1.1) = 90.91%
0
Price(0 year to maturity ) = 100%/(1.1) = 100.00%

The price increases as the time-to-maturity decreases.

This also holds for coupon bonds.

Figure: The Effect of Time on Bond Prices

Assumption: YTM remains at 5%

Cash flow: C C C C + Face Value

Time: 0 1 2 3

Holding YTM fixed, when the remaining time decreases:

FV effect:
FV
FV,
Discount (YTM>Coupon rate): FV effect dominates

Par (YTM=Coupon rate): Cancel out

Coupon effect:
Premium (YTM<Coupon rate): Coupon effect dominates
More coupons have been paid: price
Principles of Finance | Topic 2: Bond Prices | Slide 30/38
Dynamic behavior of bond prices

Outline

1 Bond cash flows, prices, and yields

⚫ Trade at a discount, par or a premium.

2 Dynamic behavior of bond prices ⚫ Price change due to the passage of time.
⚫ Price change due to the fluctuation of interest rates.

3 Corporate bonds

4
Principles of Finance | Topic 2: Bond Prices | Slide 31/38
Dynamic behavior of bond prices

A zero-coupon bond’s price sensitivity to interest rate changes

What is the price of a 1 year zero-coupon bond if the interest rate is:
(a) 3%, (b) 4%, (c) 5%?
The prices are:
1
Price(3%) = 100%/(1.03) = 97.09%
1
Price(4%) = 100%/(1.04) = 96.15%
1
Price(5%) = 100%/(1.05) = 95.24%

The price decreases as the interest rate increases.

1% increase in the interest rate from 4 to 5%, decreases the price by 0.95%.

1% decrease in the interest rate from 4 to 3%, increases the price by 0.97%.
Principles of Finance | Topic 2: Bond Prices | Slide 32/38
Dynamic behavior of bond prices

How about a zero-coupon bond with longer maturity? What is the price of a 10 year
zero-coupon bond if the interest rate is:
(a) 3%, (b) 4%, (c) 5%?

The prices are:

10
Price(3%) = 100%/(1.03) = 74.38%
10
Price(4%) = 100%/(1.04) = 67.56%
10
Price(5%) = 100%/(1.05) = 61.39%

The price again decreases (and should decrease) as the interest rate increases.

1% increase in the interest rate from 4 to 5%, decreases the price by 9.13%.

1% decrease in the interest rate from 4 to 3%, increases the price by 10.14%.

The price of this bond is much more sensitive to interest rate changes.
The sensitivity of bond price to change in r depends on the
timing of the cash flows (i.e. term).

Short term Vs. Long term

1 1
𝟏 𝟏𝟎
1.03 1.03

PV of a cash flow that will be received in the near future is less

dramatically affected by r than a cash flow in the distant future.
Principles of Finance | Topic 2: Bond Prices | Slide 34/38
Corporate bonds

Outline

1 Bond cash flows, prices, yields, and yield curve

2 Dynamic behavior of bond prices

3 Corporate bonds

4
Principles of Finance | Topic 2: Bond Prices | Slide 35/38
Corporate bonds

Corporate bond yields

Bonds issued by U.S. Treasury are generally considered as default-free

bonds.

There is a risk of default for bonds issued by corporations.

Investors pay less for bonds with credit risk than they would for an
otherwise identical default-free bond.
Price bond with credit risk < Price default-free bond

Because the YTM for a bond is calculated using the promised cash
flows, the yield of bonds with credit risk will be higher than that of
otherwise identical default-free bonds.
YTMbond with credit risk > YTMdefault-free bond
Principles of Finance | Topic 2: Bond Prices | Slide 36/38
Corporate bonds

Bond ratings

Rating Description by Moody’s

Investment Grade Debt
Aaa Judged to be of the best quality Has extremely strong capacity to meet financial commitment.
Aa Judged to be of high quality by all standards. Very strong
A Considered as upper-medium-grade obligations. Strong
Baa Considered as medium-grade obligations Adequate

Speculative bonds Junk bonds; high yield bonds

Ba Judged to have speculative elements Less vulnerable in the near term, but face major uncertainties.
B Generally lack the characteristics of the desirable investment.
Caa Are of poor standing. Currently vulnerable

Ca Are speculative in a high degree

C Lowest-rated class of bonds. Currently highly vulnerable

Risk of bankruptcy
Bond holders’ ability to lay claim to the firm’s assets in the event of a bankruptcy
Principles of Finance | Topic 2: Bond Prices | Slide 37/38
Corporate bonds

Corporate yield curves

Default spread or credit spread

(High for bonds with low ratings)