LECTURE 4

COMMERCE 308: INTRODUCTION

TO FINANCE
BOND VALUATION & INTEREST RATES

Hamed Ghanbari
 Lecture 4 Outline
2

Chapter 6

Sections6.1 to 6.5

Omit: Section 6.3, Yield to Call
 The Basic Structure of Bonds
3

In the broadest sense, a bond is any debt instrument that

promises a fixed income stream and full principal amount to
the bondholders

Bonds usually have the following characteristics:

A fixed face or par value (F), paid to the holder at maturity

A fixed coupon (C), which specifies the interest payable over the
life of the bond

A fixed maturity day (T)
Face
Coupons $F Value

$C $C $C $C $C
period Maturity
0 1 2 3 4 T
 Types of Bonds
4

The Maturity of a bond is the time until the final

payment from that bond is made. Bonds can be
classified by times to maturity.

Classification based on Time to Maturity:

Bills
or Paper Less than one year

Notes One to seven years

Bonds* Longer than one year

 *Note:In this course, and others, the term "Bond" will often
be used for forms of debt regardless of time to maturity.
 Bond Terms
5

Bullet/Balloon payment: When principal is repaid in one lump sump at

maturity

Bond indenture: Legal document specifying all relevant matters relating

to a bond issue (Payments, Interest rate, Collateral, Maturity, Par value,...)

Collateral: Assets that can serve as security for lender in case of bond
default

Par/Face/Maturity value: Amount paid at maturity of bond to lender

Term to Maturity: Time remaining to the maturity date

Coupon/Interest payment: Intermittent cash flows from borrower to lender

Default: When a borrower is unable to make necessary payments to

bondholder
 Security and Protective Provisions
6

Bonds can be classified based on how they are

secured

Mortgage bonds are secured by real assets

Debentures are either unsecured or secured, with a floating
charge over the firm’s assets

Collateral trust bonds are secured by pledged financial
assets, such as common stock, other bonds or Treasury bills

Equipment trust certificates are secured by pledged
equipment, such as railway rolling stock
 Security and Protective Provisions
7

 Protective Covenants are clauses in bond’s

indenture that restrict the actions of the issuer, can
be considered as a type of protective provisions
 Positivecovenants specify actions the firm agrees to
do, such as supply periodic financial statements and
maintain certain ratios
 Negative covenants specify actions the firm agrees to
avoid, such as restrictions on the size of its debt
 Bond Features
8

Call feature – allows the issuer to redeem or pay off

the bond prior to maturity, usually at a premium

Retractable bonds – allows the holder to sell the bonds
back to the issuer (force him to redeem) before maturity

Extendible bonds – allows the holder to extend the
maturity of the bond

Sinking funds – funds set aside by the issuer to ensure
the firm is able to redeem the bond at maturity

Convertible bonds – can be converted into a
predetermined amount of the company's equity at
certain times , at the discretion of the bondholder.
 Bond Valuation
9

The value of a bond is a function of:

Par/Face value

Term to maturity

Coupon rate

Investor’s required rate of return (discount rate is also

known as the bond’s yield to maturity)
 Bond Valuation
10

The market price of a bond is the present value of the

payments promised by the bond which are

PV of coupon payments plus (Its annuity)

PV of bond’s face value

I  1  F
B = PV0 = 1 − n
+ n
kb  (1 + kb )  (1 + kb )

 F: Bond’s face value PV Annuity PV Face Value

 n: Number of coupon's payments
 I: Coupon amount (Coupon Rate * Face Value)
 kb: Discount Rate
 Yield To Maturity (YTM)
11

The discount rate used to evaluate bonds referred to as

the yield to maturity (YTM). The Yield to Maturity (YTM)
of a bond is the effective interest rate you will receive from
the bond for the dollars you invest in it assuming you buy
the bond at the current price, hold it to maturity, receive
all the promised payments on their scheduled dates, and
invest all the cash flows receive at the YTM.

YTM can be always estimated by the bond pricing
formula.

YTM simply is an annual rate of return of the bond, given
the price of the bond and all the details regarding the
amount and timing of interest and principal payments
 Bond Valuation – Example
12

Example 1

What is the price of a $1,000 par value bond that
matures in 15 years, if it pays interest annually, based
on a 6% coupon rate. The market interest rate is 6%.
 Bond Valuation – Interest Rate Sensitivity
13

As time passes, interest rates change, but coupon payments

on the bond remain the same. Interest rate changes will have
an impact on the value of the bond. Why?

What is the problem with fixed interest structure?

A bond is issued with 6% annual interest and 15 years to maturity
 Lend $1000 today
 Receive $60 per year and at the end of 15 years get the $1000 back.

After 8 month, Interest rate in the market changes to 8%

 You can lend $1000
 Receive $80 per year and at the end of 15 years get the $1000 back.

Would you still interested in buying the old bond with 6%

interest?
 Bond Valuation – Example
14

Example 2

Following the example 1, now the market interest rate dropped
to 4% right after the bond issuance. What is the price of a
$1,000 par value bond that matures in 15 years, if it pays
interest annually, based on a 6% coupon rate.
 Bond Valuation – Example
15

Example 3

Following the example 1, now the market interest rate increased
to 8% right after the bond issuance. What is the price of a
$1,000 par value bond that matures in 15 years, if it pays
interest annually, based on a 6% coupon rate.
 Factors Affecting Bond Prices
16

The relationship between the coupon rate and the

bond’s yield-to-maturity (YTM) determines if the bond
will sell at a premium, at a discount, or at par

If Then Bond Sells at

Coupon Rate < YTM Market Price< Face Value Discount
Coupon Rate = YTM Market Price= Face Value Par
Coupon Rate > YTM Market Price > Face Value Premium
 Semi-annual Coupons
17

Most bonds pay semi-annual coupons

We must make adjustments

Divide the annual coupon payment by 2

Remember that n is the number of payments and not
the term of the bond

Divide the market rate by 2 to get the six-month market
yield. Notice that the bond yields are not effective
rates!
 Semi-annual Coupons – Example
18

Example 4

What is the price of a $1,000 par value 20 years
government bond that that pays interest semi-annual
coupon of 6%. The market annual interest rate is 8%.
 Factors Affecting Volatility of Bond Prices
19

There are three factors that affect the price volatility of

a bond

Yield to maturity
 Bond prices go down when the YTM goes up & vice-versa

Time to maturity
 Long bonds have greater price volatility than short bonds

Size of coupon
 Low coupon bonds have greater price volatility than high coupon
bonds
 Sensitivity Analysis – Market Yield
20

Bond prices increase when the market interest rate decreases

Bond prices decrease when the market interest rate increases

Because of convexity of Price-market yield graph, for a
given change in market interest rate, bond prices will change
more when interest rates are low than when they are high
 Sensitivity Analysis – Time to Maturity
21

The longer the bond, the longer the period for

which the cash flows are fixed

Long-maturity bonds have greater price volatility

than short-maturity bonds since it is more likely
that market interest rate changes during that
period
 Sensitivity Analysis – Size of Coupon
22

Low coupon bonds have greater price volatility than

high coupon bonds

High coupon bonds act like a stabilizing device,

since a greater proportion of the bond’s total cash
flows occur closer to today and are therefore their
present value is less affected by a change in YTM
 Sensitivity Analysis – Duration
23

Duration is a measure of interest rate risk, simply it

measures the sensitivity of the bond price (change in
bond price) to the change in market interest rate

The higher the duration, the more sensitive the bond is
to changes in interest rates

A bond’s duration will be higher if its:

YTM is lower

Term to maturity is longer

Coupon is lower
 Bond Quotations
24

Assume we have the following Quote

Issuer Coupon Maturity Price/Bid Yield (%)
Canada 3.75 Sep 01/11 102.71 1.02

Government of Canada issued this bond

The bond pays an annual coupon rate of 3.75%

The bond matures on September 01, 2011

The bond is selling at 102.71% of the face value of $1000

The bond’s quoted annual yield to maturity is 1.02%

 Cash Versus Quoted Prices
25

The quoted price is the price of bond reported by the

media at its coupon date.

If a bond is sold at a date other than its coupon date
then the price paid for the bond is equal to cash price.

The cash price is the price paid by an investor, and
includes both the quoted price plus any interest that
has accrued since the last coupon payment date.

Cash Price = Quoted Price + Accrued Interest

 Cash Versus Quoted Prices – Example
26

Example 5

Find the cash price of the following semi-annual bond on August

30th, 2010, if the quoted price on March 1st, 2010

Issuer Coupon Maturity Price/Bid Yield (%)
Canada 3.75 Sep 01/11 102.71 1.02
 Yield to Maturity – Example
27

Example 6

Estimate the YTM on a 15 year 10% bond that pays
semi-annual coupons which is selling at $950.
 Yield to Maturity – Example
28

Example 7

What is the holding period return of a 9% annual
coupon bond with a face value of $1000 and with five
years to maturity if it is purchased at the beginning of
year 1 at a Yield-to-Maturity (market rate) of 6.0%
and sold at the beginning of year 2? Assume that rates
do not change.
 Holding Period Return
29

Ending Begining any Income any Payment

- + -
Holding Period Price Price Between Between
=
Return Begining Price
 Yield to Maturity – Example
30

Example 8

Rank the interest sensitivity of the following from least
sensitive (to an interest rate change) to the most
sensitive.

I. 8% coupon, 20 year maturity, par bond

II. 8% coupon, 20 year maturity, premium bond

III. 8% coupon, 20 year maturity, discount bond

 Current Yield
31

The current yield is the yield on the bond’s current

market price provided by the annual coupon.

It is the ratio of the annual coupon interest divided by
the current market price
Annual interest
CY =
B

It is not a true measure of the return to the bondholder
because it does not consider potential capital gain or
capital losses based on the relationship between the
purchase price of the bond and it’s par value.
 Current Yield – Example
32

Example 8

What is the current yield of a bond which is trading at
a premium to its face value, 110 cents on the dollar
when its coupon rate is 3%.
 Interest Rate Determinants
33

Interest is the “price” of borrowed money

Interest is measured in basis points, or 1/100th of 1% (e.g., 250
basis points is 2.5%)

Interest rates rise when the demand for loanable funds rises

Interest rates fall when the demand for loanable funds falls

Interest rate = risk-free-rate + risk-premium

The risk-free rate is an abstract concept, and usually the yield on
short-term government treasury bills is used as its proxy and
comprised of
 The real rate, which is compensation for deferring consumption
 The expected inflation rate, which is compensation for the expected
loss of purchasing power over the term of the short-term T-bill
 Real vs. Nominal Rates – Fisher Equation
34

If we call the risk-free rate the nominal rate, then the

relationship between the real rate, the nominal rate,
and expected inflation is usually referred to as the
Fisher Equation
R F = R eal rate + Expected Inflation

When inflation is low, can safely use the approximation

formula:
RNominal = RReal + Expected Inflation

When inflation is high, use the exact form of the Fisher

Equation:
(1 + RNominal ) = (1 + RReal )(1 + Expected Inflation )
 Term Structure of Interest Rates
35

Is a set of rates (YTM) for all maturities of a given risk-

class of debt securities (for example, Government of
Canada Bonds) at a given point in time.

The relation between interest rate and the term to
maturity of the underlying debt instrument plotted on a
graph is called a Yield Curve

The four typical shapes of yield curves:
 Upward sloping (the most common shape)
 Downward sloping
 Flat
 Humped
 Historical Yield Curves
1990, 1994, 1998, 2004
36

FIGURE 6-4

16

14

12

10
Percent

0
1 mth 3 mths 6 mths 1 yr 2yrs 5 yrs 7 yrs 10 yrs 30 yrs
Term Left to Maturity
1990 1994 1998 2004
 Three Theories of the Term Structure
37

Liquidity preference theory posits that investors must be

paid a liquidity premium in order to be compensated for
the interest rate risk inherent in holding less liquid, longer-
term debt

Expectations theory suggests that the yield curve reflects
investors expectation of the future interest rates. In other
words, the interest rates of various maturities are
dependent on each other

Market segmentation theory suggests that different markets
exist for securities of different maturities that therefore the
two ends of the yield curve can have different factors
affecting them and the rates can determined separately
 Risk Premiums (Yield Spreads)
38

More risky bonds (e.g., BBB-rated corporate bonds) will

have higher YTM than government bonds (of same maturity)
because of the additional default risk that BBBs carry

The yield spread is the difference between the YTM on a
BBB-rated corporate bond and a Government of Canada
bond of the same maturity. It represents the default risk
premium investors demand for investing in the more risky
corporate bond

Yield spreads widen during recessions and narrow during
times of economic expansion
 Risk Premiums (Yield Spreads)
Yield Curves for Different Risk Classes
39

16

14

12
Yield
10
Spread
Percent

0
1 mth 3 mths 6 mths 1 yr 2yrs 5 yrs 7 yrs 10 yrs 30 yrs
Term Left to Maturity
BBB Corporates Government of Canada Bonds
 Debt Ratings
40

Rating agencies, such as the Dominion Bond Rating Service

(DBRS), Standard & Poors (S&P), and Moody’s assign all
publicly traded bonds a risk rating
 Other Types of Bonds and Debt Instruments
Treasury Bills
41

Treasury bills are short-term obligations of the government

with an initial term to maturity of one year or less

Issued at a discount to face value with face value being
paid at maturity

The price of Treasury bill:

P = the market price of the T-bill F
PT-bill =

F = the face value of the T-bill  n 
1 + k BEY  

kBEY = the bond equivalent yield  365 

n = the number of days until maturity
 Treasury Bills – Example
42

Example 9

What is the yield on a $100,000 Treasury bill with 180

days until maturity and a market price of $98,200?

 Other Types of Bonds and Debt Instruments
Zero coupon bonds
43

Zero coupon bonds are bonds issued at a discount which

pay no coupons and mature at par or face value

Since no coupons are paid, there is no reinvestment rate risk

The price of a zero-coupon bond is the present value of the face
value of the bond:
F
B= n
( b)
1 + k

Example 10

What is the market price of a $50,000 zero coupon bond
with 25 years to maturity that is currently yielding 6%?
 Other Types of Bonds and Debt Instruments
Floating Rate, Real Return, and CSBs
44

Floating rate bonds have coupon rates that float with some
reference rate, such as the yield on Treasury bills

Since the coupon rate floats, or is variable, the market price will
typically be close to the bond’s face value

Real return bonds are issued by the Government of Canada to
protect investors against unexpected inflation

Each period, the face value of the real return bond is grossed up by
the inflation rate. The coupon is then paid on the grossed up face
value.

Canada Savings Bonds (CSBs) are issued by the Government of
Canada as either regular interest bonds (interest paid annually)
or compound interest bonds (interest compounds over the life of
the bond)

There is no secondary market for Canada Savings Bonds; instead, they
are redeemable at any chartered bank in Canada at their face value
 Practice Problem 1
45

Jane Doe recently inherited some bonds (face value

$100,000, 5 percent annual coupon) from her father, and
soon thereafter she became engaged to Jack Sparrow. Jack
wants Jane to cash in the bonds so the two of them can use the
money to "live like royalty" for two years in Monte Carlo.
These bonds mature on January 1, 2032, and it is now
January 1, 2012. Coupons on these bonds are paid annually
on December 31 of each year. Annual coupon bonds with
similar risk and maturity are currently yielding 12 percent. If
Jane sells her bonds now and puts the proceeds into an
account which pays 10 percent compounded annually, what
would be the largest equal annual amounts she could
withdraw for two years, beginning today (i.e., two
withdrawals, the first withdrawal today and the second
withdrawal one year from today)?
 Practice Problem 2
46

You are the owner of 100 bonds issued by Misery Inc. These
bonds have 8 years remaining to maturity, an annual coupon
payment of $80, and a par value of $1,000. Unfortunately,
Misery is on the brink of bankruptcy. The creditors, including
yourself, have agreed to a postponement of the next 4
interest payments (otherwise, the next interest payment would
have been due in 1 year). The remaining interest payments,
for years 5 through 8, will be made as scheduled. The
postponed payments will accrue interest at an annual rate of
6%, and they will then be paid as a lump sum at maturity 8
years hence. The required rate of return on these bonds,
considering their substantial risk, is now 28%.

What is the present value of each bond (Price today)?
 Next Lecture
47

We will do equities

Read assigned readings from Chapter 7