Lecture 6

Fixed Income Securities: Bond Basics

Bodie, Kane and Marcus 11E McGraw Hill: Chapter 14 &15

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 Basic features of a bond
 Pay a fixed amount of interest periodically to the holder of record
 Repay a fixed amount of principal at the date of maturity
 Bond market is divided by maturity
• Money market – short-term issues mature within one year
• Notes – intermediate-term issues that mature between one and ten years
• Bonds – long-term obligations with maturity greater than ten years
 Remaining life (maturity) affects price volatility
 The key thing to understand is that a bond is merely a contract between an issuer and an investor, whereby the
issuer agrees to make payments at specified times.
 These payments may be specified dollar amounts (perhaps expressed as coupon rate x par value) or floating
amounts based upon a margin above a reference rate.
 Bonds can be traded amongst investors, just like shares. This market is actually much larger than the share market,
but is less visible to the public.

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 Bond characteristics
 Intrinsic features:
• Coupon
• Maturity (or” term”)
• Principal( or “par value”)
• Option conditions (option for the issuer to repurchase the bond, which is more likely to be exercised if interest rates fall).
• Other conditions- e.g., convertibility; FRN; catastrophe; kangaroo/matilda; euro.
 Types of issues:
• Senior secured debt
• Senior unsecured debt
• Subordinated debt
 Participating issuers:
• Governments;
• Government agencies; and
• Corporations, for example:
­ Coupon bonds with bullet repayment
­ Floating-rate notes
­ Asset-backed securities
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 Price-yield relationship
 Bond value is the present value of expected cash flows.
 For a coupon-paying bond with bullet repayment of principal at maturity, our valuation equation is:
n
Ct Par
P   1  r   1  r 
t 1
t n

 1  1  r  n
 Par
If the coupon rate is constant, this P  C 
 1  r 
n
is an annuity stream, so value  r
becomes:

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 Price-yield relationship: implications
 The coupon rate is the promised coupon payment relative to the par value.
 The yield to maturity is the return which bond investors will earn if three outcomes are realised:
• There are no defaults; and
• Investors can reinvest all coupon payments at the same yield to maturity over the holding period
• The investor holds until maturity; or, if the investor sells before maturity, interest rates have not changed, so the sale price reflects the
same yield as when the bond was purchased.
 If yield < coupon rate, bond will be priced at a premium to its par value.
 If yield > coupon rate, bond will be priced at a discount to its par value.
 Price-yield relationship is convex (not a straight line)
 We can use yields on comparable bonds to price a new issue.
 We can infer the yield on a currently-traded bond from the price-yield relationship. That is, the yield to maturity is the
internal rate of return which equates bond price on the left hand side to the present value expression on the right hand
side.
 The current yield is the coupon payment relative to market price (analogous to the dividend yield for shares).

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 Valuation of bonds: Example
 In 2004, a $10,000 bond due in 2019 with 10% coupon with semiannual payments
 It is a convention in the bond market that interest rates are expressed as simple
interest rates (also called nominal rates) rather than effective annual rates. So the
coupon rate of 10% per year with semiannual payments implies coupons equal to 5%
of par value every six months ($500).
 Discount these payments at the investor’s required rate of return (say the risk-free
rate is 5% and the investor requires a default-risk premium of 3%, then the required
rate of return would be 8%)
 NB: We expect the bond to be priced at a premium because yield < coupon rate

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 Valuation of bonds: Example
 Present value of the interest payments (an annuity for 30 periods) at a rate of 4%
= $500 x (1-1/1.0430)/0.04
= $500 x 17.29
= $8646.02
 The present value of the principal
= $10,000/1.0430
= $3083.19
 Total value of bond = $11,729.20

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 Bond Yields: Yield to Maturity
 Interest rate that makes the present value of the bond’s payments equal to its price is
the yield to maturity (YTM)

 Solve the bond formula for r

PB = å C t + Par Value
T
t
t=1 (1+r) (1+r)
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 Yield to maturity: Example
 Use the information in Valuation of Bonds Example
 Say, in 1 year’s time, the bond price has fallen to $10,500. Our equation is:
10,500 = 500 x (1-1/1+r28)/r + 10,000/(1+r)28

 This implies that r = 4.676% and the yield to maturity is therefore 9.352%. That is,
substituting 4.676% into the RHS gives us $10,500, the price of the bond.
 Yields have risen, either because the risk-free rate rose, or investors demanded a higher
default risk premium.

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 Yield to Maturity Example
 Suppose an 8% semi- annual coupon, 30 year bond is selling for
$1276.76. What is its average rate of return?

$40 1000
60

$1276.76   
(1 r )
60
t 1 (1 r )
t

• r = 3% per half year

• Bond equivalent yield = 6%
• EAR = ((1.03)2) – 1 = 6.09%
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 Bond Yields: YTM vs. Current Yield
 Yield to Maturity
• Bond’s internal rate of return
• The interest rate that makes the PV of a bond’s payments equal to its price; assumes
that all bond coupons can be reinvested at the YTM
 Current Yield
• Bond’s annual coupon payment divided by the bond price (80/1276.76=6.26%)
 For premium bonds
Coupon rate > Current yield > YTM
 For discount bonds, relationships are reversed
 So in example…coupon=8%, current yield=6.26% ytm= 6.09= premium bond.
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 Approximating the promised YTM
Incomeper year  Capital gain or loss per year
Approximate YTM 
Averageinvestmentbase
Par value- Price
Coupon payment
Term to maturity

Price  Par value
2

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 From example previous
Income per year  Capital gain or loss per year
Approximate YTM 
Average investment base
Par value - Price
Coupon payment 
Term to maturity

Price  Par value
2
1000 - 1276.76
80 
 30
1276.76  1000
2
 6.21% versus 6.09%
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 Bond Yields: Yield to Call
 Reflects return to investor if bond is called and cannot be held to maturity
 May be less than yield to maturity
 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
 To estimate the yield to call, just apply the same method just discussed, but assume the
bond is called at the first opportunity (or some stated time). So, instead of receiving the
par value at maturity, the investor received the call price at the exercise date.

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Figure 14.4 Bond Prices: Callable and Straight Debt

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 Bond Yields: Realized Yield versus YTM
 Reinvestment Assumptions
 Holding Period Return
• Changes in rates affect returns
• Reinvestment of coupon payments
• Change in price of the bond

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Figure 14.5 Growth of Invested Funds

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Figure 14.6 Prices over Time of 30-Year Maturity, YTM=8%

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 Bond Prices Over Time: YTM vs. HPR
YTM HPR

 It is the average return if the  It is the rate of return over a

bond is held to maturity particular investment period
 Depends on coupon rate,  Depends on the bond’s price at
maturity, and par value the end of the holding period, an
 All of these are readily unknown future value
observable  Can only be forecasted

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Figure 14.7 The Price of a 30-Year Zero-Coupon Bond over Time

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 What determines interest rates?
 Effect of economic factors
• Real growth rate
• Tightness or ease of capital market
• Expected inflation

 Impact of bond characteristics

• Credit quality
• Term to maturity

 Term structure of interest rates

• Expectations hypothesis
• Risk premium hypothesis
• Liquidity preference hypothesis
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 The Yield Curve
 The yield curve is a graph that displays the relationship between YTM and time to
maturity
 Information on expected future short-term rates can be implied from the yield curve

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Figure 15.1 Treasury Yield Curves

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 Yield Curve: Bond Pricing
 Yields on different maturity bonds are not all equal
 We need to consider each bond cash flow as a stand-alone zero-coupon
bond
 Bond stripping and bond reconstitution offer opportunities for arbitrage
 The value of the bond should be the sum of the values of its parts

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Table 15.1 Prices and Yields to Maturities on Zero-Coupon Bonds ($1,000 Face Value)

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 Example 15.1 Valuing Coupon Bonds
 Value a 3 year, 10% coupon bond using discount rates from Table 15.1:
$100 $100 $1100
Price   2
 3
1.05 1.06 1.07
• Price = $1082.17 and YTM = 6.88%
• 6.88% is less than the 3-year rate of 7%

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 Bond Pricing: Two Types of Yield Curves
Pure Yield Curve On-the-Run Yield Curve

 Uses stripped or zero coupon  Uses recently-issued coupon

Treasuries bonds selling at or near par
 May differ significantly from the  The one typically published by
on-the-run yield curve the financial press

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 The Yield Curve and Future Interest Rates
 Yield Curve Under Certainty
• Suppose you want to invest for 2 years
­ Buy and hold a 2-year zero
or
­ Rollover a series of 1-year bonds

• Equilibrium requires that both strategies provide the same return

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Figure 15.2 Two 2-Year Investment Programs

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 The Yield Curve and Future Interest Rates
 Yield Curve Under Certainty
• Buy and hold vs. rollover:

1  y2 
2
 1  r1 1  r2 
1
1  y 2   1  r1 1  r2   2

• Next year’s 1-year rate (r2) is just enough to make rolling over a series of 1-
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 The Yield Curve and Future Interest Rates
 Yield Curve Under Certainty
• Spot rate
­ The rate that prevails today for a given maturity
• Short rate
­ The rate for a given maturity (e.g. one year) at different points in time
• A spot rate is the geometric average of its component short rates

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 The Yield Curve and Future Interest Rates
Short Rates and Yield Curve Slope
When next year’s short rate, When next year’s short rate,
r2 , is greater than this year’s r2 , is less than this year’s
short rate, r1, the yield curve short rate, r1, the yield curve
slopes up slopes down

May indicate rates are expected May indicate rates are expected
to rise to fall

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Figure 15.3 Short Rates versus Spot Rates

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 The Yield Curve and Future Interest Rates
Forward rates
(1  yn ) n
(1  f n ) 
(1  yn 1 ) n 1

• fn = One-year forward rate for period n

n 1
• yn = Yield for a security with a maturity of n
(1  yn )  (1  yn 1 ) (1  f n )
n

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 Example 15.4 Forward Rates
 The forward interest rate is a forecast of a future short rate.
 Rate for 4-year maturity = 8%, rate for 3-year maturity = 7%.

1 f4 
 1  y4  4

1.084
 1.1106
1  y3  3
1.07 3

f 4  11.06%

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 Interest Rate Uncertainty and Forward Rates
Suppose that today’s rate is 5% and the expected short rate for the following year is
E(r2) = 6%. The value of a 2-year zero is:
$1000
 $898.47
1.051.06
The value of a 1-year zero is:

$1000
 $952.38
1.05

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 Interest Rate Uncertainty and Forward Rates
 The investor wants to invest for 1 year
• Buy the 2-year bond today and plan to sell it at the end of the first year for $1000/1.06 =$943.40
or
• Buy the 1-year bond today and hold to maturity
• What if next year’s interest rate is more (or less) than 6%?
­ The actual return on the 2-year bond is uncertain!

 Investors require a risk premium to hold a longer-term bond

 This liquidity premium compensates short-term investors for the uncertainty about future prices

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 Theories of Term Structure
 The Expectations Hypothesis Theory
• Observed long-term rate is a function of today’s short-term rate and expected future
short-term rates
• fn = E(rn) and liquidity premiums are zero

 Liquidity Preference Theory

• Long-term bonds are more risky; therefore, fn generally exceeds E(rn)
• The excess of fn over E(rn) is the liquidity premium
• The yield curve has an upward bias built into the long-term rates because of the
liquidity premium
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 Interpreting the Term Structure

 The yield curve reflects expectations of future interest rates

 The forecasts of future rates are clouded by other factors, such as
liquidity premiums
 An upward sloping curve could indicate:
• Rates are expected to rise
and/or
• Investors require large liquidity premiums to hold long term bonds

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 Interpreting the Term Structure
 The yield curve is a good predictor of the business cycle
• Long term rates tend to rise in anticipation of economic expansion
• Inverted yield curve may indicate that interest rates are expected to fall
and signal a recession

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 Interpreting the Term Structure
 The yield curve is a good predictor of the business cycle
• Long term rates tend to rise in anticipation of economic expansion
• Inverted yield curve may indicate that interest rates are expected to fall and signal a
recession

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42

Readings
 Readings
 Chapter 14.1, 14.2, 14.3, 14.4
 Chapter 15 (except for 15.6)

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THANK YOU