CH6 ... Valuing Bonds

Chapter 6
Valuing Bonds
Copyright ©2017 Pearson Education, Ltd. All rights reserved. 6-1

Chapter Outline
6.1 Bond Cash Flows, Prices, and Yields

6.2 Dynamic Behavior of Bond Prices
6.3 The Yield Curve and Bond Arbitrage
6.4 Corporate Bonds
6.5 Sovereign Bonds

6.1 Bond Cash Flows, Prices, and
Yields
• Bond: A financial contract that typically has a stated maturity
and periodic interest payments.
• Bond Terminology
– Bond Certificate
• States the terms of the bond
– Maturity Date
• Final repayment date
– Term
• The time remaining until the repayment date
– Coupon
• Promised interest payments

6.1 Bond Cash Flows, Prices,
and Yields (cont'd)
• Bond Terminology
– Face Value
• Notional amount used to compute the interest
payments
– Coupon Rate
• Determines the amount of each coupon payment,
expressed as an APR
– Coupon Payment
Coupon Rate  Face Value

CPN 
Number of Coupon Payments per Year

6.2 (B) Zero-Coupon Bonds
• Known as “pure” discount bonds and sold at a

discount from face value
• Do not pay any interest over the life of the
bond.
• At maturity, the investor receives the par
value, usually $1000.
• Price of a zero-coupon bond is calculated by
merely discounting its par value at the
prevailing discount rate or yield to maturity.

6.2 (C) Amortization of a Zero-
Coupon Bond
Table 6.2
Amortized
Interest on a
Zero-Coupon
Bond
• The discount on a zero-coupon bond is amortized over its life.

• Interest earned is calculated for each 6-month period.
• for example .04*790.31=$31.62
• Interest is added to price to compute ending price.
• Zero-coupon bond investors have to pay tax on annual price
appreciation even though no cash is received.
Zero-Coupon Bonds
• Zero-Coupon Bond
– Does not make coupon payments
– Always sells at a discount (a price lower than
face value), so they are also called pure
discount bonds
– Treasury Bills are U.S. government zero-
coupon bonds with a maturity of up to one year.

Zero-Coupon Bonds (cont'd)
• Suppose that a one-year, risk-free, zero-

coupon bond with a $100,000 face value
has an initial price of $96,618.36. The cash
flows would be
– Although the bond pays no “interest,” your

compensation is the difference between the
initial price and the face value.

• Yield to Maturity
– The discount rate that sets the present value of
the promised bond payments equal to the
current market price of the bond.
• Price of a Zero-Coupon bond
FV
P 
(1  YTM n ) n

– For the one-year zero coupon bond:
100,000
96,618.36 
(1  YTM 1 )
100,000
1  YTM 1   1.035
96,618.36
• Thus, the YTM is 3.5%.

– Yield to Maturity of an n-Year Zero-Coupon Bond
1
 FV  n
YTM n     1
 P 

Textbook Example 6.1

Textbook Example 6.1 (cont'd)

Alternative Example 6.1
• Problem
– Suppose that the following zero-coupon bonds
are selling at the prices shown below per $100
face value. Determine the corresponding yield
to maturity for each bond.
Maturity 1 year 2 years 3 years 4 years
Price $98.04 $95.18 $91.51 $87.14

Alternative Example 6.1 (cont'd)
• Solution
YTM  (100 / 98.04)  1  0.02  2%

YTM  (100 / 95.18)1/2  1  0.025  2.5%
YTM  (100 / 91.51)1/3  1  0.03  3%
YTM  (100 / 87.14)1/4  1  0.035  3.5%

• Risk-Free Interest Rates

– A default-free zero-coupon bond that matures
on date n provides a risk-free return over the
same period. Thus, the Law of One Price
guarantees that the
risk-free interest rate equals the yield to
maturity on such a bond.
– Risk-Free Interest Rate with Maturity n
rn  YTM n

• Risk-Free Interest Rates

– Spot Interest Rate
• Another term for a default-free, zero-coupon yield
– Zero-Coupon Yield Curve
• A plot of the yield of risk-free zero-coupon bonds as a
function of the bond’s maturity date

Coupon Bonds
• Coupon Bonds
– Pay face value at maturity
– Pay regular coupon interest payments
• Treasury Notes
– U.S. Treasury coupon security with original
maturities of 1–10 years
• Treasury Bonds
– U.S. Treasury coupon security with original
maturities over 10 years



• Problem
– Suppose that Proctor & Gamble has just issued a
10-year, $1000 bond with a 4% coupon and
semi-annual coupon payments. What cash flows
will you receive if you hold the bond until
maturity?

• Solution:
– Here is the timeline, based on a six-month
period:
– Note that the last payment is composed of both

a coupon payment of $20 and the face value
payment of $1000.

Coupon Bonds (cont'd)
– The YTM is the single discount rate that equates
the present value of the bond’s remaining cash
flows to its current price.
– Yield to Maturity of a Coupon Bond
1  1  FV
P  CPN  1  N 

y  (1  y )  (1  y ) N

Formula for Bond Yield
• Weighted average is used to get the average

investment over 15 year holding period.

Yield to Maturity
• YTM is the average rate of return earned on

a bond if it is held to maturity
Annual Accrued
Approximate interest  capital gains

yield to maturity Average value of bond
 M - Vd 
INT   
  N 
 2 Vd   M 
 
 3 



• Problem
– Consider the following semi-annual bond:
• $1000 par value
• 7 years until maturity
• 9% coupon rate
• Price is $1,080.55
– What is the bond’s yield to maturity?



6.2 Dynamic Behavior of Bond
Prices
• Discount
– A bond is selling at a discount if the price is
less than the face value.
• Par
– A bond is selling at par if the price is equal to
the face value.
• Premium
– A bond is selling at a premium if the price is
greater than the face value.

Discounts and Premiums
• If a coupon bond trades at a discount, an

investor will earn a return both from
receiving the coupons and from receiving a
face value that exceeds the price paid for
the bond.
– If a bond trades at a discount, its yield to
maturity will exceed its coupon rate.

Discounts and Premiums (cont'd)
• If a coupon bond trades at a premium, it will earn
a return from receiving the coupons, but this
return will be diminished by receiving a face value
less than the price paid for the bond.
• Most coupon bonds have a coupon rate so that the
bonds will initially trade at, or very close to, par.

Discounts and Premiums (cont'd)
Table 6.1 Bond Prices Immediately After a Coupon

Payment

Relationship of Yield to Maturity and
Coupon Rate
Table 6.2 Premium Bonds, Discount Bonds, and
Par Value Bonds



• Problem
– Suppose that Proctor & Gamble issued a bond
that has seven years remaining until maturity, a
$1000 face value, and a 4% coupon rate with
annual coupon payments. If the current market
interest rate is 3%, what is bond’s premium or
discount? What if the current market rate is
6%?

• Solution:
– At a market rate of 6%, the price of the bond will
be
– So the discount is $1000 – $888.35 = $111.65.

Time and Bond Prices
• Holding all other things constant, a bond’s

yield to maturity will not change over time.
• Holding all other things constant, the price
of discount or premium bond will move
toward par value over time.
• If a bond’s yield to maturity has not
changed, then the IRR of an investment in
the bond equals its yield to maturity even if
you sell the bond early.




Figure 6.1 The Effect of Time on
Bond Prices

Interest Rate Changes and Bond
Prices
• There is an inverse relationship between

interest rates and bond prices.
– As interest rates and bond yields rise, bond
prices fall.
– As interest rates and bond yields fall, bond
prices rise.

Interest Rate Changes
and Bond Prices (cont'd)
• The sensitivity of a bond’s price to changes

in interest rates is measured by the bond’s
duration.
– Bonds with high durations are highly sensitive to
interest rate changes.
– Bonds with low durations are less sensitive to
interest rate changes.



• Problem
– The University of Pennsylvania sold $300 million
of 100-year bonds with a yield to maturity of
4.67%. Assuming the bonds were sold at par
and pay an annual coupon, by what percentage
will the price of the bond change if its yield to
maturity decreases by 1%? Increases by 2%?

Valuing a Coupon Bond
Using Zero-Coupon Yields
• The price of a coupon bond must equal the
present value of its coupon payments and face
value.
– Price of a Coupon Bond
PV  PV (Bond Cash Flows)

CPN CPN CPN  FV
    
1  YTM 1 (1  YTM 2 ) 2
(1  YTM n ) n
100 100 100  1000

P   2
 3
 $1153
1.035 1.04 1.045

Coupon Bond Yields
• Given the yields for zero-coupon bonds, we

can price a coupon bond.
100 100 100  1000
P  1153   
(1  y ) (1  y ) 2
(1  y )3
100 100 100  1000

P   2
 3
 $1153
1.0444 1.0444 1.0444



Treasury Yield Curves
• Treasury Coupon-Paying Yield Curve

– Often referred to as “the yield curve”
• On-the-Run Bonds
– Most recently issued bonds
– The yield curve is often a plot of the yields on
these bonds.

6.4 Corporate Bonds
• Corporate Bonds
– Issued by corporations
• Credit Risk
– Risk of default

Corporate Bond Yields
• Investors pay less for bonds with credit risk

than they would for an otherwise identical
default-free bond.
• The yield of bonds with credit risk will be
higher than that of otherwise identical
default-free bonds.

Corporate Bond Yields (cont'd)
• Certain Default
– The yield to maturity of a certain default bond is
not equal to the expected return of investing in
the bond. The yield to maturity will always be
higher than the expected return of investing in
the bond.

• Risk of Default
– Consider a one-year, $1000, zero-coupon bond
issued. Assume that the bond payoffs are
uncertain.
• There is a 50% chance that the bond will repay its face
value in full and a 50% chance that the bond will
default and you will receive $900. Thus, you would
expect to receive $950.
• Because of the uncertainty, the discount rate is 5.1%.

• Risk of Default
– The price of the bond will be
950
P   $903.90
1.051
– The yield to maturity will be
FV 1000
YTM   1   1  .1063
P 903.90

• Risk of Default
– A bond’s expected return will be less than the
yield to maturity if there is a risk of default.
– A higher yield to maturity does not necessarily
imply that a bond’s expected return is higher.

Table 6.3 Price, Expected Return, and Yield to Maturity of

a One-Year, Zero-Coupon Avant Bond with Different
Likelihoods of Default

Bond Ratings
• Investment Grade Bonds

• Speculative Bonds
– Also known as Junk Bonds or High-Yield Bonds

Table 6.4 Bond Ratings

Table 6.4 Bond Ratings (cont’d)

Corporate Yield Curves
• Default Spread
– Also known as Credit Spread
– The difference between the yield on corporate
bonds and Treasury yields

Figure 6.3 Corporate Yield Curves
for Various Ratings, August 2015
Source: Yahoo! Finance

Figure 6.4 Yield Spreads and the
Financial Crisis
Source:
Bloomberg.com

6.5 Sovereign Bonds
• Bonds issued by national governments

– U.S. Treasury securities are generally considered
to be default free.
– All sovereign bonds are not default free,
• e.g. Greece defaulted on its outstanding debt in 2012.
– Importance of inflation expectations
• Potential to “inflate away” the debt
– European sovereign debt, the EMU, and the ECB

Chapter Quiz
1. What is the relationship between a bond’s price and

its yield to maturity?
2. If a bond’s yield to maturity does not change, how
does its cash price change between coupon
payments?
3. How does a bond’s coupon rate affect its duration –
the bond price’s sensitivity to interest rate changes?
4. Explain why two coupon bonds with the same
maturity may each have a different yield to maturity.
5. There are two reasons the yield of a defaultable bond
exceeds the yield of an otherwise identical default-
free bond. What are they?

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Chapter 6

Copyright ©2017 Pearson Education, Ltd. All rights reserved. 6-1

6.1 Bond Cash Flows, Prices, and Yields

Copyright ©2017 Pearson Education, Ltd. All rights reserved. 6-2

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Coupon Rate  Face Value

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• Known as “pure” discount bonds and sold at a

Copyright ©2017 Pearson Education, Ltd. All rights reserved. 6-5

• The discount on a zero-coupon bond is amortized over its life.

Copyright ©2017 Pearson Education, Ltd. All rights reserved. 6-7

• Suppose that a one-year, risk-free, zero-

– Although the bond pays no “interest,” your

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Copyright ©2017 Pearson Education, Ltd. All rights reserved. 6-9

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Maturity 1 year 2 years 3 years 4 years

Price $98.04 $95.18 $91.51 $87.14

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YTM  (100 / 98.04)  1  0.02  2%

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• Risk-Free Interest Rates

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• Risk-Free Interest Rates

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– Note that the last payment is composed of both

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– Yield to Maturity of a Coupon Bond

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• Weighted average is used to get the average

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• YTM is the average rate of return earned on

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– What is the bond’s yield to maturity?

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• If a coupon bond trades at a discount, an

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Table 6.1 Bond Prices Immediately After a Coupon

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– So the discount is $1000 – $888.35 = $111.65.

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• Holding all other things constant, a bond’s

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